CONMED Corp (CNMD) FY 2021 MD&A

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion should be read in conjunction with our Consolidated Financial Statements and related notes contained elsewhere in this report.

This section of this Form 10-K generally discusses 2021 and 2020 items and year-to-year comparisons between 2021 and 2020. Discussions of 2019 items and year-to-year comparisons between 2020 and 2019 that are not included in this Form 10-K can be found in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part II, Item 7 of the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2020.

Overview of CONMED Corporation

CONMED Corporation (“CONMED”, the “Company”, “we” or “us”) is a medical technology company that provides devices and equipment for surgical procedures.  The Company’s products are used by surgeons and other healthcare professionals in a variety of specialties including orthopedics, general surgery, gynecology, thoracic surgery and gastroenterology.

Our product lines consist of orthopedic surgery and general surgery. Orthopedic surgery consists of sports medicine instrumentation and small bone, large bone and specialty powered surgical instruments as well as, imaging systems for use in minimally invasive surgical procedures and fees related to the promotion and marketing of sports medicine allograft tissue. General surgery consists of a complete line of endo-mechanical instrumentation for minimally invasive laparoscopic and gastrointestinal procedures, smoke evacuation devices, a line of cardiac monitoring products as well as electrosurgical generators and related instruments. These product lines as a percentage of consolidated net sales are as follows:

A significant amount of our products are used in surgical procedures with approximately 81% of our revenues derived from the sale of single-use products.  Our capital equipment offerings also facilitate the ongoing sale of related single-use products and accessories, thus providing us with a recurring revenue stream.  We manufacture substantially all of our products in facilities located in the United States and Mexico.  We market our products both domestically and internationally directly to customers and through distributors.  International sales approximated 45% in 2021, 44% in 2020 and 46% in 2019.

COVID-19

Our business continues to be impacted by the COVID-19 pandemic as variants of the virus emerge, with hospitals and surgery centers reducing the number of, or postponing, non-urgent surgical procedures in order to minimize the risk of infection and allow for proper staffing. We continue to restrict access to our facilities while maintaining production and distribution. While revenues increased in 2021 compared to 2020, we believe we will continue to experience market variability as a result of the pandemic that could influence sales, suppliers, patients and customers. There remains significant uncertainty related to the COVID-19 pandemic, including the duration and severity of future impacts to the business. See "Item 1A. Risk Factors" for more information. For additional discussion regarding COVID 19, see Liquidity and Capital Resources below.

Critical Accounting Policies

Preparation of our financial statements requires us to make estimates and assumptions which affect the reported amounts of assets, liabilities, revenues and expenses.  Note 1 describes the significant accounting policies used in preparation of the consolidated financial statements.  The most significant areas involving management judgments and estimates are described below and are considered by management to be critical to understanding the financial condition and results of operations of CONMED Corporation. Actual results may or may not differ from these estimates.

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Goodwill and Intangible Assets

We have a history of growth through acquisitions.  Assets and liabilities of acquired businesses are recorded at their estimated fair values as of the date of acquisition.  Goodwill represents costs in excess of fair values assigned to the underlying net assets of acquired businesses.  Factors that contribute to the recognition of goodwill include synergies that are expected to increase net sales and profits; acquisition of a talented workforce; cost savings opportunities; the strategic benefit of expanding our presence in core and adjacent markets; and diversifying our product portfolio. Customer and distributor relationships, trademarks, tradenames, developed technology, patents and other intangible assets primarily represent allocations of purchase price to identifiable intangible assets of acquired businesses. Sales representation, marketing and promotional rights represent intangible assets created under our agreement with Musculoskeletal Transplant Foundation (“MTF”).  Determining the fair value of intangible assets acquired as part of a business combination requires us to make significant estimates. These estimates include the amount and timing of projected future cash flows of each project or technology, revenue growth rates, projected cost of sales, customer attrition rates, the discount rate used to discount those cash flows to present value, the assessment of the asset’s useful life, and the consideration of legal, technical, regulatory, economic, and competitive risks. As these are significant estimates, we would obtain the assistance of a third-party valuation specialist in estimating fair values of intangible assets for significant acquisitions.

Goodwill and intangible assets deemed to have indefinite lives are not amortized, but are subject to at least annual impairment testing. It is our policy to perform our annual impairment testing in the fourth quarter. The identification and measurement of goodwill impairment involves the estimation of the fair value of our business. Estimates of fair value are based on the best information available as of the date of the assessment. We completed our goodwill impairment testing of our single reporting unit during the fourth quarter of 2021. We performed our impairment test utilizing the market capitalization approach to determine whether the fair value of a reporting unit is less than its carrying amount. Based upon our assessment, the fair value of our reporting unit continues to exceed carrying value.

Intangible assets with a finite life are amortized over the estimated useful life of the asset and are evaluated each reporting period to determine whether events and circumstances warrant a revision to the remaining period of amortization.  Intangible assets subject to amortization are reviewed for impairment whenever events or changes in circumstances indicate that its carrying amount may not be recoverable. The carrying amount of an intangible asset subject to amortization is not recoverable if it exceeds the sum of the undiscounted cash flows expected to result from the use of the asset.  An impairment loss is recognized by reducing the carrying amount of the intangible asset to its current fair value.

For all other indefinite-lived intangible assets, we perform a qualitative impairment test. Based upon this assessment, we have determined that our indefinite-lived intangible assets are not impaired.

See Note 6 for further discussion of goodwill and other intangible assets.

Pension Plan

We sponsor a defined benefit pension plan (the “pension plan”) that was frozen in 2009. It covered substantially all our United States based employees at the time it was frozen. In conjunction with the pension plan, we recorded a pension benefit obligation totaling $95.5 million as of December 31, 2021. In accounting for this pension plan, we are required to make a number of assumptions, including the discount rate and mortality. The discount rate represents the interest rate used in estimating the present value of projected cash flows to settle the Company’s pension obligations. The discount rate assumption is determined by using a full yield curve approach, which involves applying the specific spot rates along the yield curve used in the determination of the benefit obligation that correlates to the relevant projected cash flows. The mortality assumptions are based on the Pri-2012 Mortality Tables using the MP-2021 mortality improvement scale.

In performing a sensitivity analysis on the pension benefit obligation, a 0.25% increase in our discount rate would decrease the pension benefit obligation by $2.6 million and a 0.25% decrease in the discount rate would increase the pension benefit obligation by $2.7 million. See Note 12 for further discussion of the pension plan.

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Consolidated Results of Operations

The following table presents, as a percentage of net sales, certain categories included in our consolidated statements of comprehensive income for the periods indicated:

Net Sales

The following table presents net sales by product line for the years ended December 31, 2021, 2020 and 2019:

(a) Refer to Non-GAAP Financial Measures below for further details.

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Net sales increased 17.2% to $1,010.6 million in 2021 from $862.5 million in 2020 driven by increases across all product lines as the COVID-19 pandemic had a significant impact on sales during 2020 as hospitals and surgery centers deferred non-urgent surgeries.

•Orthopedic surgery sales increased 17.0% in 2021 to $438.4 million from $374.7 million in 2020 as procedure volumes returned to more normal levels in 2021 after a 2020 which was significantly impacted by the COVID-19 pandemic.

•General surgery sales increased 17.3% in 2021 to $572.2 million from $487.8 million in 2020. The increase was mainly driven by continued growth in our advanced surgical products, including our AirSeal® and Buffalo Filter® products, and our advanced endoscopic technology products.

Cost of Sales

Cost of sales was $442.6 million in 2021 compared to $402.2 million in 2020.  Gross profit margins were 56.2% in 2021 and 53.4% in 2020.  The increase in gross profit margin of 2.8 percentage points in 2021 was driven by an increase in sales and more favorable product mix as well as the absence in 2021 of certain costs incurred in 2020 including the following:

•$6.6 million in costs related to plant underutilization due to abnormally low production as a result of decreased sales caused by the COVID-19 pandemic;

•$4.0 million in costs related to the consolidation of manufacturing operations including winding down operations at certain locations and moving production lines to other facilities;

•$2.8 million in costs related to inventory step-up adjustments from a previous acquisition;

•$2.2 million in costs related to product rationalization; and

•$1.1 million in restructuring costs related to a voluntary separation arrangement as a result of the COVID-19 pandemic.

Refer to Note 14 for further details.

Selling and Administrative Expense

Selling and administrative expense was $414.8 million in 2021 compared to $373.8 million in 2020. Selling and administrative expense as a percentage of net sales was 41.0% in 2021 and 43.3% in 2020.

The decrease in selling and administrative expense as a percentage of net sales in 2021 was mainly driven by higher sales in 2021 while continuing to manage our expense levels in response to the COVID-19 pandemic. In addition, 2020 included the following expenses:

•$4.8 million in severance costs related to a voluntary termination program and costs associated with the restructuring of our Orthopedic sales force;

•a $2.1 million write-off of field inventory used for customer demonstration and evaluation of products resulting from the product rationalization initiative; and

•$1.2 million in severance and integration costs mainly related to the Buffalo Filter acquisition.

Research and Development Expense

Research and development expense was $43.6 million in 2021 and $40.5 million in 2020.  As a percentage of net sales, research and development expense was 4.3% in 2021 and 4.7% in 2020. The lower spend as a percentage of net sales in 2021 was driven by higher sales in 2021.

Interest Expense

Interest expense decreased to $35.5 million in 2021 compared to $44.1 million in 2020.  The weighted average interest rates on our borrowings were 2.76% in 2021 decreasing from 3.65% in 2020. The decrease in interest expense is primarily due to decreases in our weighted average interest rates compared to prior year driven by lowering borrowings and lower interest rates as a result of the seventh amended and restated senior credit agreement.

Other Expense

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Other expense during the year ended December 31, 2021 was related to costs associated with our seventh amended and restated senior credit agreement entered into July 16, 2021, as further described in Note 7. These costs included $1.1 million related to a loss on the early extinguishment of debt and third party fees.

Provision for Income Taxes

A provision (benefit) for income taxes was recorded at an effective rate of 14.4% and (493.9)% in 2021 and 2020, respectively. As compared to the federal statutory rate of 21.0%, the 2021 effective tax rate was lower primarily due to benefits from federal tax items including stock compensation and changes in the valuation allowance relating to certain foreign operations. The 2020 effective tax rate was lower than the federal statutory rate primarily due to benefits from federal tax items including stock compensation and tax regulations regarding United States tax on foreign earnings at different rates as well as settlements with taxing authorities. A reconciliation of the United States statutory income tax rate to our effective tax rate is included in Note 8.

Non-GAAP Financial Measures

Net sales on a "constant currency" basis is a non-GAAP measure. The Company analyzes net sales on a constant currency basis to better measure the comparability of results between periods. To measure percentage sales growth in constant currency, the Company removes the impact of changes in foreign currency exchange rates that affect the comparability and trend of net sales.

Because non-GAAP financial measures are not standardized, it may not be possible to compare this financial measure with other companies' non-GAAP financial measures having the same or similar names. This adjusted financial measure should not be considered in isolation or as a substitute for reported net sales growth, the most directly comparable GAAP financial measure. This non-GAAP financial measure is an additional way of viewing net sales that, when viewed with our GAAP results, provides a more complete understanding of our business. The Company strongly encourages investors and shareholders to review our financial statements and publicly-filed reports in their entirety and not to rely on any single financial measure.

Liquidity and Capital Resources

Our liquidity needs arise primarily from capital investments, working capital requirements and payments on indebtedness under the seventh amended and restated senior credit agreement, described below. We have historically met these liquidity requirements with funds generated from operations and borrowings under our revolving credit facility. In addition, we have historically used term borrowings, including borrowings under the amended and restated senior credit agreement and borrowings under separate loan facilities, in the case of real property purchases, to finance our acquisitions. We also have the ability to raise funds through the sale of stock or we may issue debt through a private placement or public offering.

We had total cash on hand at December 31, 2021 of $20.8 million, of which approximately $17.7 million was held by our foreign subsidiaries outside the United States with unremitted earnings. During 2021, we redeployed $28.2 million of cash from certain non-U.S. subsidiaries primarily for U.S. debt reduction which consisted primarily of earnings that were taxed in 2017 as part of the deemed repatriation toll charge implemented by Tax Reform. We may repatriate funds from certain foreign subsidiaries in the future. Refer to Note 8 for further details.

Operating Cash Flows

Our net working capital position was $263.5 million at December 31, 2021.  Net cash provided by operating activities was $111.8 million in 2021 and $64.5 million in 2020 generated on net income of $62.5 million in 2021 and $9.5 million in 2020.   The increase in cash provided by operating activities in 2021 as compared to 2020 was mainly driven by higher sales and net income in 2021 as the COVID-19 pandemic had a negative impact on sales during 2020. Significant impacts to operating cash flows include:

•A decrease in cash flows from accounts receivable based on the timing of sales and cash receipts;

•A decrease in cash flows from inventory as we increased inventory levels to mitigate inventory supply challenges;

•A decrease in cash flows from other assets primarily related to higher field inventory requirements due to more sales force activity in 2021;

•An increase in cash flows from accounts payable is primarily due to the timing of payments; and

•An increase in cash from accrued compensation and benefits caused by higher commissions and incentive compensation accruals associated with increased sales.

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Investing Cash Flows

Net cash used in investing activities increased to $14.9 million in 2021 compared to $13.6 million in 2020 primarily due to higher capital expenditures in 2021 compared to 2020.

Financing Cash Flows

Financing activities in 2021 used cash of $101.5 million compared to $52.1 million in 2020. Below is a summary of the significant financing activities impacting the change during 2021 compared to 2020:

•We had net payments on our revolving line of credit of $67.0 million, inclusive of the impact of the seventh amended and restated senior credit agreement, compared to $13.0 million in net payments during 2020.

•We had net payments on our term loan of $14.2 million, inclusive of a $52.4 million impact on both borrowings and repayments between independent counterparties associated with the seventh amended and restated credit agreement, compared to $13.3 million in payments during the prior year.

•We paid $6.2 million and $2.7 million in 2021 and 2020, respectively, in contingent consideration related to prior acquisitions.

Other Liquidity Matters

Our cash balances and cash flows generated from operations may be used to fund strategic investments, business acquisitions, working capital needs, research and development, common stock repurchases and payments of dividends to our shareholders. Management believes that cash flow from operations, including cash and cash equivalents on hand and available borrowing capacity under our seventh amended and restated senior credit agreement, will be adequate to meet our anticipated operating working capital requirements, debt service, funding of capital expenditures, dividend payments and common stock repurchases in the foreseeable future. In addition, management believes we could access capital markets, as necessary, to fund future business acquisitions.

We continue to monitor our spending and expenses in light of our expectation that our revenues will continue to be impacted by the pandemic. While the results of operations support continued recovery, there remains uncertainty in the financial markets related to the COVID-19 pandemic which may have an impact on the demand for post-pandemic surgery levels that are difficult to predict. If the downturn is more severe and prolonged than we currently expect, we may need to take further steps to reduce our costs, or to refinance our debt. See “Item 1A. Risk Factors - Risks Related to Our Indebtedness."

On July 16, 2021, we entered into a seventh amended and restated senior credit agreement which extends the maturity of the term loan and revolving credit facilities to July 16, 2026 and reduced the applicable interest rate margins and commitment fees on the borrowings.

There were $227.6 million in borrowings outstanding on the term loan facility as of December 31, 2021. There were $140.0 million in borrowings outstanding under the revolving credit facility as of December 31, 2021. Our available borrowings on the revolving credit facility at December 31, 2021 were $442.5 million with approximately $2.5 million of the facility set aside for outstanding letters of credit.

The seventh amended and restated senior credit agreement contains covenants and restrictions which, among other things, require the maintenance of certain financial ratios and restrict dividend payments and the incurrence of certain indebtedness and other activities, including acquisitions and dispositions.  We were in full compliance with these covenants and restrictions as of December 31, 2021. We are also required, under certain circumstances, to make mandatory prepayments from net cash proceeds from any issuance of equity and asset sales.

See Note 7 for further information on our financing agreements and outstanding debt obligations.

Our Board of Directors has authorized a $200.0 million share repurchase program. Through December 31, 2021, we have repurchased a total of 6.1 million shares of common stock aggregating $162.6 million under this authorization and have $37.4 million remaining available for share repurchases.  The repurchase program calls for shares to be purchased in the open market or in private transactions from time to time.  We may suspend or discontinue the share repurchase program at any time.  We have not purchased any shares of common stock under the share repurchase program during 2021.  We have financed the repurchases and may finance additional repurchases through operating cash flow and from available borrowings under our revolving credit facility.

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The Board of Directors declared a quarterly cash dividend of $0.20 per share in 2020 and 2021. Future decisions as to the payment of dividends will be at the discretion of the Board of Directors. See "Item 1A. Risk Factors - Other Risk Factors Related to our Business - Our Board of Directors may, in the future, limit or discontinue payment of a dividend on common stock."

We expect an increased level of capital spending during the year ending December 31, 2022 compared to 2021. Capital spending will be monitored and controlled as the year progresses. We expect to use operating cash flows to satisfy capital spending requirements.

The following table summarizes our contractual obligations for the next five years and thereafter (amounts in thousands) as of December 31, 2021.  Purchase obligations represent purchase orders for goods and services placed in the ordinary course of business.

In addition to the above contractual obligations, we are required to make periodic interest payments on our long-term debt obligations (see additional discussion under Item 7A. “Quantitative and Qualitative Disclosures About Market Risk—Interest Rate Risk” and Note 7).  The above table also does not include unrecognized tax benefits of approximately $0.2 million, the timing and certainty of recognition for which is not known (See Note 8).

Stock-based Compensation

We have reserved shares of common stock for issuance to employees and directors under two shareholder-approved share-based compensation plans (the "Plans").  The Plans provide for grants of stock options, stock appreciation rights (“SARs”), dividend equivalent rights, restricted stock, restricted stock units (“RSUs”), performance share units (“PSUs”) and other equity-based and equity-related awards.  The exercise price on all outstanding stock options and SARs is equal to the quoted fair market value of the stock at the date of grant.  RSUs and PSUs are valued at the market value of the underlying stock on the date of grant.  Stock options, SARs, RSUs and PSUs are generally non-transferable other than on death and generally become exercisable over a four to five year period from date of grant.  Stock options and SARs expire ten years from date of grant.  SARs are only settled in shares of the Company’s stock (See Note 9). Total pre-tax stock-based compensation expense recognized in the consolidated statements of comprehensive income was $16.3 million, $13.1 million and $11.8 million for the years ended December 31, 2021, 2020 and 2019, respectively.

Other Matters

Through April 1, 2020, our credit facility allowed us to seek to sell products to certain customers in Iran in compliance with applicable laws and regulations and subject to certain terms and conditions, including pre-approval by us and our lenders of the identity of any distributor and prior review of each of the end-customers. We had sales to a third-party distributor in Iran during the first quarter of 2020. We limited such sales into Iran to products that qualified as “medical supplies” within the meaning of the general license, or covered by specific licenses, provided by the Iranian Transactions and Sanctions Regulations set forth in the regulations promulgated by the Office of Foreign Assets Control (“OFAC”) of the United States Department of the Treasury set forth at 31 C.F.R. § 560.530. We have implemented certain controls and processes designed to ensure that the ultimate end-users for the products are those permitted under the OFAC general license, and that the sales and transactions with the Iranian distributor otherwise comply with the requirements of the OFAC regulations. The expected revenues and net profits associated with sales to the Iranian distributor were not material to our overall results of operations.

We do not believe that our activities to date have been subject to required disclosure under Section 13(r) of the Securities Exchange Act of 1934 (the “Exchange Act”), which, among other things, requires disclosure of transactions and activities knowingly entered into with the Government of Iran that do not benefit from an OFAC license and with certain

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designated parties. If, however, activities are in the future discovered to be within the scope of the transactions and activities captured by Section 13(r) of the Exchange Act, we will make the required disclosures and notices.

New Accounting Pronouncements

See Note 17 for a discussion of new accounting pronouncements.