a5822223.htm
U.S. SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 or 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the Quarter ended September 26, 2008

Commission File Number 1-16137

GREATBATCH, INC.
(Exact name of Registrant as specified in its charter)

Delaware
(State of incorporation)

16-1531026
(I.R.S. employer identification no.)

10000 Wehrle Drive
Clarence, New York
14031
(Address of principal executive offices)

(716) 759-5600
(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 [  ]
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer [   ]
  
Accelerated filer                  [X]
Non-accelerated filer   [   ]
  
Smaller reporting company [   ]
 
Indicate by check mark whether the Registrant is a shell company (as defined in Exchange Act Rule 12b-2).  Yes [  ]  No [ X ]
 
The number of shares outstanding of the Company’s common stock, $0.001 par value per share, as of November 4, 2008 was: 22,912,001 shares.
GREATBATCH, INC.
TABLE OF CONTENTS FOR FORM 10-Q
AS OF AND FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 26, 2008

   
Page
     
COVER PAGE
1
     
TABLE OF CONTENTS
2
     
     
ITEM 1.  
     
 
3
     
 
4
     
 
5
     
 
6
     
 
7
     
ITEM 2.  
 
33
     
ITEM 3.
50
     
ITEM 4. 
52
     
     
ITEM 1. 
53
     
ITEM 1A.
53
     
ITEM 2. 
53
     
ITEM 3.  
53
     
ITEM 4. 
53
     
ITEM 5.
54
     
ITEM 6.
54
     
54
     
54
 
PART I - FINANCIAL INFORMATION
ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 
 
CONDENSED CONSOLIDATED BALANCE SHEETS - Unaudited
  
(in thousands except share and per share data)
  
   
As of
  
   
September 26,
    
December 28,
  
ASSETS
  
2008
    
2007
  
Current assets:
            
Cash and cash equivalents
   $ 20,015     $ 33,473  
Short-term investments available for sale
     -       7,017  
Accounts receivable, net of allowance of $1,997 in 2008
                
and $758 in 2007
     84,806       56,962  
Inventories, net of reserve
     98,833       71,882  
Refundable income taxes
     1,401       377  
Deferred income taxes
     7,899       6,469  
Prepaid expenses and other current assets
     5,460       5,044  
Total current assets
     218,414       181,224  
Property, plant and equipment, net
     171,297       114,946  
Amortizing intangible assets, net
     92,301       71,268  
Trademarks and tradenames
     36,117       32,582  
Goodwill
     299,858       248,540  
Other assets
     14,947       15,291  
Total assets
   $ 832,934     $ 663,851  
LIABILITIES AND STOCKHOLDERS’ EQUITY
                
Current liabilities:
                
Accounts payable
   $ 53,792     $ 33,433  
Accrued expenses and other current liabilities
     35,345       30,975  
Total current liabilities
     89,137       64,408  
Long-term debt
     352,315       241,198  
Deferred income taxes
     43,855       35,346  
Other long-term liabilities
     4,419       228  
Total liabilities
     489,726       341,180  
Stockholders' equity:
                
Preferred stock, $0.001 par value, authorized 100,000,000
                
shares; no shares issued or outstanding in 2008 or 2007
     -       -  
Common stock, $0.001 par value, authorized 100,000,000
                
shares; 22,910,699 shares issued and outstanding in 2008 and
                
22,477,340 shares issued and 22,470,299 shares outstanding in 2007
     23       22  
Additional paid-in capital
     248,570       238,574  
Treasury stock, at cost, no shares in 2008 and 7,041 shares in 2007
     -       (140 )
Retained earnings
     94,275       84,215  
Accumulated other comprehensive income
     340       -  
Total stockholders’ equity
     343,208       322,671  
Total liabilities and stockholders' equity
   $ 832,934     $ 663,851  
 
The accompanying notes are an integral part of these condensed consolidated financial statements.
- 3 -
 
 
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
  
AND COMPREHENSIVE INCOME - Unaudited
  
(in thousands except per share data)
  
                         
   
Three months ended
    
Nine months ended
  
   
September 26,
    
September 28,
    
September 26,
    
September 28,
  
   
2008
    
2007
    
2008
    
2007
  
                         
Sales
   $ 136,242     $ 79,009     $ 400,044     $ 234,331  
Costs and expenses:
                                
Cost of sales - excluding amortization
                                
of intangible assets
     92,779       48,647       285,856       141,697  
Cost of sales - amortization of intangible assets
     1,710       1,222       5,141       3,164  
Selling, general and administrative expenses
     15,681       11,362       52,685       32,130  
Research, development and engineering costs, net
     6,793       8,423       23,722       21,856  
Acquired in-process research and development
     -       (2,260 )     2,240       16,093  
Other operating expense, net
     3,565       1,275       7,474       4,796  
Operating income
     15,714       10,340       22,926       14,595  
Interest expense
     3,268       2,112       9,908       5,345  
Interest income
     (142 )     (1,586 )     (663 )     (6,028 )
Gain on sale of investment security
     -       -       -       (4,001 )
Gain on extinguishment of debt
     -       -       -       (4,473 )
Other (income) expense, net
     (234 )     70       (1,597 )     156  
Income before provision for income taxes
     12,822       9,744       15,278       23,596  
Provision for income taxes
     5,193       4,744       5,218       11,326  
Net income
   $ 7,629     $ 5,000     $ 10,060     $ 12,270  
                                 
Earnings per share:
                                
Basic
   $ 0.34     $ 0.23     $ 0.45     $ 0.55  
Diluted
   $ 0.33     $ 0.22     $ 0.44     $ 0.54  
                                 
Weighted average shares outstanding:
                                
Basic
     22,557       22,214       22,493       22,129  
Diluted
     24,087       23,872       22,697       24,739  
                                 
Comprehensive income:
                                
Net income
   $ 7,629     $ 5,000     $ 10,060     $ 12,270  
Foreign currency translation adjustment
     (4,914 )     -       366       -  
Unrealized loss on interest rate swap, net of tax
     (351 )     -       (26 )     -  
Unrealized loss on short-term investments:
                                
Unrealized loss on short-term investments
                                
during the period, net of tax
     (20 )     -       -       (869 )
Less: reclassification adjustment for net realized gain on
                                
short-term investments during the period, net of tax
     -       -       -       (2,601 )
      (20 )     -       -       (3,470 )
Other comprehensive income (loss)
     (5,285 )     -       340       (3,470 )
Comprehensive income
   $ 2,344     $ 5,000     $ 10,400     $ 8,800  
                                 
The accompanying notes are an integral part of these condensed consolidated financial statements.
  
 
- 4 -
 
 
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS - Unaudited
  
(in thousands)
  
             
   
Nine months ended
  
   
September 26,
    
September 28,
  
   
2008
    
2007
  
Cash flows from operating activities:
            
Net income
   $ 10,060     $ 12,270  
Adjustments to reconcile net income to net cash provided
                
by operating activities:
                
Depreciation and amortization
     35,206       18,539  
Stock-based compensation
     8,073       7,092  
Gain on sale of investment security
     -       (4,001 )
Gain on extinguishment of debt
     -       (4,473 )
Acquired in-process research and development
     2,240       16,093  
Other non-cash gains
     75       (126 )
Deferred income taxes
     2,837       (8,378 )
Changes in operating assets and liabilities:
                
Accounts receivable
     (17,205 )     (8,205 )
Inventories
     (8,055 )     (4,936 )
Prepaid expenses and other current assets
     46       (610 )
Accounts payable
     15,555       8,721  
Accrued expenses and other current liabilities
     (631 )     (4,090 )
Income taxes refundable/payable
     (1,163 )     2,946  
Net cash provided by operating activities
     47,038       30,842  
                 
Cash flows from investing activities:
                
Purchase of short-term investments
     (2,010 )     (59,208 )
Proceeds from maturity/disposition of short-term investments
     9,027       109,971  
Acquisition of property, plant and equipment
     (35,830 )     (10,852 )
Purchase of cost method investments
     (2,550 )     (1,750 )
Acquisitions, net of cash acquired
     (104,817 )     (109,737 )
Other investing activities
     266       407  
Net cash used in investing activities
     (135,914 )     (71,169 )
                 
Cash flows from financing activities:
                
Borrowings (repayments) under short-term line of credit
     -       (1,000 )
Principal payments of long-term debt
     (40,651 )     (6,093 )
Proceeds from issuance of long-term debt
     117,000       76,000  
Debt issuance costs
     -       (6,619 )
Issuance of common stock
     956       2,699  
Excess tax benefits from stock-based awards
     171       377  
Repurchase of treasury stock
     (793 )     (205 )
Net cash provided by financing activities
     76,683       65,159  
                 
Effect of foreign currency exchange rates on cash and cash equivalents
     (1,265 )     -  
Net increase (decrease) in cash and cash equivalents
     (13,458 )     24,832  
Cash and cash equivalents, beginning of year
     33,473       71,147  
Cash and cash equivalents, end of period
   $ 20,015     $ 95,979  
                 
The accompanying notes are an integral part of these condensed consolidated financial statements.
  
 
- 5 -
 
 
CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY - Unaudited
  
(in thousands)
  
                                                 
                                                 
                                       
Accumulated
        
               
Additional
    
Treasury
          
Other
    
Total
  
   
Common Stock
    
Paid-In
    
Stock
    
Retained
    
Comprehensive
    
Stockholders'
  
   
Shares
    
Amount
    
Capital
    
Shares
    
Amount
    
Earnings
    
Income
    
Equity
  
                                                 
Balance, December 28, 2007
     22,477     $ 22     $ 238,574       (7 )   $ (140 )   $ 84,215     $ -     $ 322,671  
Stock-based compensation
     -       -       4,808       -       -       -       -       4,808  
Grant/forfeiture of restricted stock
     94       1       (793 )     36       793       -       -       1  
Vesting of restricted stock units
     51       -       -       -       -       -       -       -  
Exercise of stock options
     61       -       956       -       -       -       -       956  
Repurchase of shares to settle employee tax
                                                                
witholding on vested restricted stock and
                                                                
restricted stock units
     -       -       -       (29 )      (653 )      -       -       (653 ) 
Tax impact from stock based awards
     -       -       80       -       -       -       -       80  
Shares issued in connection with
                                                                
the Quan Emerteq acquisition
     60       -       1,473       -       -       -       -       1,473  
Shares contributed to 401(k) Plan
     168       -       3,472       -       -       -       -       3,472  
Net income
     -       -       -       -       -       10,060       -       10,060  
Total other comprehensive income
     -       -       -       -       -       -       340       340  
Balance, September 26, 2008
     22,911     $ 23     $ 248,570       -     $ -     $ 94,275     $ 340     $ 343,208  
                                                                 
                                                                 
                                                                 
The accompanying notes are an integral part of these condensed consolidated financial statements.
  
 
- 6 -
GREATBATCH, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – Unaudited
1.
BASIS OF PRESENTATION

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information (Accounting Principles Board Opinion (“APB”) No. 28, Interim Financial Reporting) and with the instructions to Form 10-Q and Article 10 of Regulation S-X.  Accordingly, they do not include all of the information necessary for a fair presentation of financial position, results of operations, and cash flows in conformity with accounting principles generally accepted in the United States of America (“US GAAP”).  Operating results for interim periods are not necessarily indicative of results that may be expected for the fiscal year as a whole.  In the opinion of management, the condensed consolidated financial statements reflect all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation of the results of Greatbatch, Inc. and its wholly-owned subsidiary Greatbatch Ltd. (collectively “Greatbatch” or the “Company”) for the periods presented.  The preparation of financial statements in conformity with US GAAP requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, sales, expenses, and related disclosures at the date of the financial statements and during the reporting period.  Actual results could differ from these estimates.  The December 28, 2007 condensed consolidated balance sheet data was derived from audited financial statements but does not include all disclosures required by US GAAP.  For further information, refer to the consolidated financial statements and notes included in the Company’s Annual Report on Form 10-K for the year ended December 28, 2007.  The Company utilizes a fifty-two, fifty-three week fiscal year ending on the Friday nearest December 31st. For 52-week years, each quarter contains 13 weeks.  The third quarter of 2008 and 2007 each contained 13 weeks and ended on September 26, and September 28, respectively.

2.
ACQUISITIONS

P Medical Holding SA
On January 7, 2008, the Company acquired P Medical Holding SA (“Precimed”) with administrative offices in Orvin, Switzerland and Exton, PA, manufacturing operations in Switzerland and Indiana and sales offices in Japan, China and the United Kingdom.  This transaction diversifies the Company’s revenue and establishes the Company as a leading supplier to the orthopedics industry.

This transaction was accounted for under the purchase method of accounting in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 141 Business Combinations.  Accordingly, the results of Precimed’s operations were included in the condensed consolidated financial statements from the date of acquisition.  The aggregate purchase price was $82.5 million, consisting of the cash issued at closing to Precimed shareholders ($79.8 million), and other direct acquisition-related costs, including financial advisory, legal and accounting services ($2.7 million).  Additionally, the purchase agreement includes a contingent payment which can range from 0 Swiss Francs (“CHF”) to 12,000,000 CHF depending on Precimed’s 2008 earnings performance.  Based upon the exchange ratio of 0.9173 CHF per one U.S. dollar as of September 26, 2008, the maximum contingent payment would be approximately $11.0 million and is subject to change due to foreign currency fluctuations and the final calculation of the contingent payment in the first quarter of 2009.  During the third quarter of 2008, a $2.5 million contingent payment, which was based upon future earnings, was accrued relating to an acquisition consummated by Precimed in 2006.  The purchase price was funded with cash on hand and borrowings under the Company’s revolving credit agreement. Concurrently with the closing of the acquisition, the Company assumed and immediately repaid $31.7 million of Precimed’s long-term debt.
- 7 -
 
GREATBATCH, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – Unaudited
 
The cost of the acquisition was allocated to the assets acquired and liabilities assumed from Precimed based on their preliminary fair values as of the acquisition date, with the amount exceeding the fair value recorded as goodwill.  As the estimated fair values of certain assets and liabilities are preliminary in nature, they are subject to adjustment as additional information is obtained, including, but not limited to, settlement of the contingent payment, the finalization of our intangible asset valuation, the final reconciliation and valuation of tangible assets, the Company incurring direct acquisition costs in connection with this transaction and the resolution of pre-acquisition tax positions.  The valuations will be finalized within 12 months of the close of the acquisition.  Any changes to the preliminary valuation may result in material adjustments to the fair value of the assets and liabilities acquired, as well as goodwill.

The following table summarizes the preliminary allocation of the cost of the acquisition to the assets acquired and liabilities assumed as of the close of the acquisition (in thousands):
 
   
As of
  
(in thousands)
  
January 7, 2008
  
Assets acquired
      
    Current assets
   $ 34,190  
    Property, plant and equipment
     25,534  
    Acquired IPR&D
     2,240  
    Amortizing intangible assets
     28,902  
    Trademarks and tradenames
     3,514  
    Goodwill
     45,073  
    Other assets
     1,275  
Total assets acquired
     140,728  
Liabilities assumed
        
    Current liabilities
     25,634  
    Long-term liabilities
     32,600  
Total liabilities assumed
     58,234  
Purchase price
   $ 82,494  
 
The fair values of the assets acquired were preliminarily determined using one of three valuation approaches: market, income and cost.  The selection of a particular method for a given asset depended on the reliability of available data and the nature of the asset, among other considerations.  The market approach, which estimates the value for a subject asset based on available market pricing for comparable assets, was utilized for land and in-process and finished inventory.  The income approach, which estimates the value for a subject asset based on the present value of cash flows projected to be generated by the asset, was used for certain intangible assets such as technology and patents, customer relationships, trademarks and tradenames, in-process research and development (“IPR&D”) and for the noncompete agreements with employees.  The projected cash flows were discounted at a required rate of return that reflects the relative risk of the Precimed transaction and the time value of money.  The projected cash flows for each asset considered multiple factors, including current revenue from existing customers, attrition trends, reasonable contract renewal assumptions from the perspective of a marketplace participant, and expected profit margins giving consideration to historical and expected margins.  The cost approach was used for the majority of real and personal property and raw materials inventory.  The cost to replace a given asset reflects the estimated reproduction or replacement cost for the property, less an allowance for loss in value due to depreciation or obsolescence, with specific consideration given to economic obsolescence if indicated.
- 8 -
GREATBATCH, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – Unaudited
 
Current assets and current liabilities – The fair value of current assets (except inventory) and current liabilities was assumed to approximate their carrying value as of the acquisition date due to the short-term nature of these assets and liabilities.

The fair value of the in-process and finished inventory acquired was estimated by applying a version of the market approach called the comparable sales method.  This approach estimates the fair value of the asset by calculating the potential sales generated from selling the inventory and subtracting from it the costs related to the completion and sale of that inventory and a reasonable profit allowance.  Based upon this methodology, the Company recorded the inventory acquired at fair value resulting in an increase in inventory of $5.6 million.  During the first quarter of 2008, the Company expensed as cost of sales the step-up value relating to the acquired Precimed inventory sold during 2008.  Raw materials inventory was valued at replacement cost.

Property, plant and equipment (“PP&E”) - The fair value of the PP&E acquired was estimated by applying the cost approach for personal property, buildings and building improvements and the market approach for land.  The cost approach was applied by developing a replacement cost and adjusting for depreciation and obsolescence.  The value of the land acquired was derived from market prices for comparable properties.

Intangible assets - The purchase price was allocated to specific intangible assets on a preliminary basis as follows (dollars in thousands):
     
Fair
value
assigned
    
Weighted
average
amortization
period (years)
    
Weighted
average
discount
rate
  
 
Amortizing intangible assets
                  
 
Customer relationships
   $ 16,111       20       13 %
 
Technology and patents
     11,771       15       14 %
 
Noncompete agreements
     1,020       5       13 %
      $ 28,902       17       13 %
                           
 
Trademarks and tradenames
   $ 3,514    
indefinite
       13 %
 
Acquired IPR&D
   $ 2,240       -       14 %

Customer relationships – Customer relationships represent the preliminary estimated fair value of both the contractual and non-contractual customer relationships Precimed has as of the acquisition date.  The primary customers of Precimed include Johnson & Johnson, Smith & Nephew, Stryker, Medtronic and Zimmer, some of which are also customers of Greatbatch.  These relationships were valued separately from goodwill at the amount which an independent third party would be willing to pay for these relationships.  The fair value of customer relationships was determined using the multi-period excess-earnings method, a form of the income approach.  The Company determined that the estimated useful life of the intangible assets associated with the existing customer relationships is approximately 20 years.  This life was based upon historical customer attrition and management’s understanding of the industry and regulatory environment.  The expected cash flows associated with these customer relationships were nominal after 20 years.
- 9 -
 
GREATBATCH, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – Unaudited
 
Technology and patents - Technology and patents consists of technical processes, patented and unpatented technology, manufacturing know-how and the understanding with respect to products or processes that have been developed by Precimed and that will be leveraged in current and future products. The fair value of technology and patents acquired was determined utilizing the relief from royalty method.  The Company determined that the estimated useful life of the technology and patents is approximately 15 years. This life is based upon management’s estimate of the product life cycle associated with technology and patents before they will be replaced by new technologies. The expected cash flows associated with technology and patents were nominal after 15 years.

Trademarks and tradenames – Trademarks and tradenames represent the estimated fair value of corporate and product names acquired from Precimed, which will be utilized by the Company in the future.  These tradenames were valued separately from goodwill at the amount which an independent third party would be willing to pay for use of these names.  The fair value of the trademarks and tradenames was determined by applying the relief from royalty method of the income approach.  The tradenames are inherently valuable as the Company believes they convey favorable perceptions about the products with which they are associated.  This in turn generates consistent and increased demand for the products, which provides the Company with greater revenues, as well as greater production and operating efficiencies.  Thus, the Company will realize larger profit margins than companies without the tradenames.  At this time, the Company intends to utilize these trademarks and tradenames for an indefinite period of time, thus these intangible assets are not being amortized but are tested for impairment on an annual basis.

Acquired IPR&D - Approximately $2.2 million of the purchase price represents the estimated fair value of acquired IPR&D projects that had not yet reached technological feasibility and had no alternative future use.  Accordingly, the amount was immediately expensed on the acquisition date and is not deductible for tax purposes.  The value assigned to IPR&D related to Reamer, Instrument Kit, Locking Plate and Cutting Guide projects.  These projects primarily represent the next generation of products already being sold by Precimed which incorporate new enhancements and customer modifications.  The Company expects to commercially launch these products in 2008 and 2009.  For purposes of valuing the IPR&D, the Company estimated total costs to complete the projects to be approximately $0.2 million. If the Company is not successful in completing these projects on a timely basis, future sales may be adversely affected resulting in erosion of the Company’s market share.

The fair value of these projects was determined based on the excess earnings method.  This model utilized discount rates that took into consideration the internal rate of return expected from the Precimed transaction and the risks surrounding the successful development and commercialization of each of the IPR&D projects.  The Company believes that the estimated acquired IPR&D amounts represent their fair value at the date of acquisition and do not exceed the amount an independent third party would be willing to pay for the projects.

Goodwill - The excess of the purchase price over the preliminary fair value of net tangible and intangible assets acquired of $45.1 million was allocated to goodwill.  Various factors contributed to the establishment of goodwill, including: the value of Precimed’s highly trained assembled work force and management team; the expected revenue growth over time that is attributable to increased market penetration from future products and customers; and the incremental value to the Company’s IMC business from expanding and diversifying its revenues.  The goodwill acquired in connection with the Precimed acquisition was allocated to the Company’s IMC business segment and is not deductible for tax purposes.
 
- 10 -
GREATBATCH, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – Unaudited
 
DePuy Orthopedics Chaumont, France Facility
On February 11, 2008, Precimed acquired the assets of DePuy Orthopedics (“DePuy”) Chaumont, France manufacturing facility (the “Chaumont Facility”).  The Chaumont Facility produces hip and shoulder implants for DePuy Ireland which distributes them worldwide through various DePuy selling entities.  This transaction, which included a new four year supply agreement with DePuy, enhances Greatbatch’s and Precimed’s strategic relationship with DePuy, one of the largest orthopedic companies in the world.  The addition of this facility will align Precimed closer to its orthopedic customers and further extends its offerings to a full range of orthopedic implants.

This transaction was accounted for under the purchase method of accounting.  Accordingly, the results of the Chaumont Facility were included in our condensed consolidated financial statements from the date of acquisition.  The aggregate purchase price was approximately $28.7 million, consisting of the cash issued to DePuy ($27.0 million), and other direct acquisition-related costs, including financial advisory, transfer tax, legal and accounting fees ($1.7 million).  The aggregate purchase price was preliminarily allocated to the assets acquired ($6.3 million inventory, $13.4 million PP&E) and liability assumed from the Chaumont Facility based on their fair values as of the close of the acquisition, with the amount exceeding the fair value recorded as goodwill ($6.2 million).  As the values of certain assets and liabilities are preliminary in nature, they are subject to adjustment as additional information is obtained, including, but not limited to, the finalization of our valuation, the final reconciliation and confirmation of tangible assets, the Company incurring direct acquisition costs in connection with this transaction and the resolution of tax positions.  Any changes to the preliminary valuation may result in material adjustments to the fair value of the assets and liabilities acquired, as well as goodwill.

Various factors contributed to the establishment of goodwill, including: the value of the Chaumont Facility’s highly trained assembled work force; the expected revenue growth over time and the incremental value to the Company’s Orthopedics business from having the capability to manufacture joint implants; and the strategic partnership established with DePuy, one of the largest orthopedic companies in the world.  Goodwill resulting from the Chaumont Facility acquisition was allocated to the Company’s IMC business segment and is not deductible for tax purposes.

Pro Forma Results (Unaudited)
The following unaudited pro forma information presents the consolidated results of operations of the Company, Precimed, and the Chaumont Facility as if those acquisitions had occurred as of the beginning of each of the fiscal periods presented.  Additionally, 2007 amounts reflect the Company’s 2007 acquisition of Enpath Medical, Inc. (June 2007) (“Enpath”), Quan Emerteq LLC (November 2007) (“Quan”) and Engineered Assemblies Corporation (“EAC”) (November 2007) as if those acquisitions had occurred as of the beginning of 2007 (in thousands, except per share amounts):
    
     
Three months ended
    
Nine months ended
  
 
(Unaudited)
  
September 26,
2008
    
September 28,
2007
    
September 26,
2008
    
September 28,
2007
  
 
Sales
   $ 136,242     $ 119,386     $ 414,859     $ 379,746  
 
Net income
     7,629       5,686       16,632       23,097  
 
Earnings per share:
                                
 
       Basic
   $ 0.34     $ 0.25     $ 0.74     $ 1.04  
 
       Diluted
   $ 0.33     $ 0.25     $ 0.72     $ 0.98  
- 11 -
GREATBATCH, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – Unaudited
 
The unaudited pro forma information presents the combined operating results of Greatbatch, Precimed, the Chaumont Facility, Enpath, Quan and EAC, with the results prior to the acquisition date adjusted to include the pro forma impact of the amortization of acquired intangible assets and depreciation of fixed assets based on the preliminary purchase price allocation, the elimination of the non-recurring IPR&D charge ($2.2 million in 2008 and $16.1 million in 2007) and inventory step-up amortization recorded by Greatbatch ($6.4 million in 2008 and $1.3 million in 2007), the adjustment to interest income/expense reflecting the cash paid in connection with the acquisition, including acquisition-related expenses, at Greatbatch’s weighted average interest income/expense rate, and the impact of income taxes on the pro forma adjustments utilizing the applicable statutory tax rate, except for IPR&D which is not deductible for tax purposes.  The unaudited pro forma consolidated basic and diluted earnings per share are based on the consolidated basic and diluted weighted average shares of Greatbatch.

The unaudited pro forma results are presented for illustrative purposes only and do not reflect the realization of potential cost savings, and any related integration costs.  Certain cost savings may result from the acquisition; however, there can be no assurance that these cost savings will be achieved.  These pro forma results do not purport to be indicative of the results that would have actually been obtained if the acquisitions occurred as of the beginning of each of the periods presented, nor does the pro forma data intend to be a projection of results that may be obtained in the future.


3.
SUPPLEMENTAL CASH FLOW INFORMATION
 
   
Nine months ended
  
   
September 26,
    
September 28,
  
   
2008
    
2007
  
Noncash investing and financing activities (in thousands):
            
Net unrealized loss on available-for-sale securities
   $ -     $ (869 )
Unrealized loss on interest rate swap, net
     (26 )     -  
Common stock contributed to 401(k) Plan
     3,472       2,956  
Property, plant and equipment purchases included
                
in accounts payable
     4,170       1,958  
Deferred financing fees and acquisition costs included in
                
accrued expenses and other current liabilities
     293       1,029  
Exchange of convertible subordinated notes
     -       117,782  
Shares issued in connection with a 2007 business acquisition
     1,473       -  
                 
Cash paid during the period for:
                
Interest
   $ 6,020     $ 2,429  
Income taxes
     2,643       16,718  
Acquisition of noncash assets and liabilities:
                
Assets acquired
   $ 167,195     $ 126,182  
Liabilities assumed
     58,906       15,678  
 
- 12 -
GREATBATCH, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – Unaudited
 
4.
INVENTORIES

Inventories are comprised of the following (in thousands):
 
     
September 26,
    
December 28,
  
     
2008
    
2007
  
               
 
Raw materials
   $ 45,545     $ 38,561  
 
Work-in-process
     29,861       19,603  
 
Finished goods
     23,427       13,718  
 
Total
   $ 98,833     $ 71,882  
 
5.
INTANGIBLE ASSETS

Amortizing intangible assets are comprised of the following (in thousands):

     
Gross
carrying
amount
    
Accumulated
amortization
    
Foreign
currency
translation
    
Net carrying
amount
  
 
September 26, 2008
                        
 
Purchased technology and patents
   $ 81,639     $ (34,113 )   $ 98     $ 47,624  
 
Customer relationships
     46,094       (3,299 )     218       43,013  
 
Other
     3,508       (1,854 )     10       1,664  
 
Total amortizing intangible assets
   $ 131,241     $ (39,266 )   $ 326     $ 92,301  
                                   
 
December 28, 2007
                                
 
Purchased technology and patents
   $ 69,813     $ (28,968 )   $ -     $ 40,845  
 
Customer relationships
     29,983       (840 )     -       29,143  
 
Other
     2,660       (1,380 )     -       1,280  
 
Total amortizing intangible assets
   $ 102,456     $ (31,188 )   $ -     $ 71,268  

 
Aggregate amortization expense for the third quarter of 2008 and 2007 was $2.6 million and $1.6   million, respectively.  Aggregate amortization expense for the nine months ended September 26, 2008 and September 28, 2007 was $8.1 million and $3.6 million, respectively.  As of September 26, 2008, amortization expense is estimated to be $2.7 million for the remainder of 2008, $10.1 million for 2009, $9.6 million for 2010, $9.5 million for 2011, $9.4 million for 2012 and $8.6 million for 2013.

 
The change in trademarks and tradenames during 2008 is as follows (in thousands):
 
 
Balance at December 28, 2007
   $ 32,582  
 
Acquired in 2008
     3,514  
 
Foreign currency translation
     21  
 
Balance at September 26, 2008
   $ 36,117  
 
The Company is currently performing a review of its market strategy to determine the best use of its “non-Greatbatch” tradenames, including those acquired with its recent acquisitions.  The outcome of this review may impact the useful lives of the Company’s “non-Greatbatch” tradenames which had a value of $20.3 million as of September 26, 2008.
- 13 -
 
GREATBATCH, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – Unaudited
 
 
 
The change in goodwill during 2008 is as follows (in thousands):
 
 
     
IMC
    
Electrochem
    
Total
  
 
Balance at December 28, 2007
   $ 238,810     $ 9,730     $ 248,540  
 
Adjustments to goodwill related to 2007 acquisitions
     (29 )     213       184  
 
Goodwill recorded for 2008 acquisitions
     51,288       -       51,288  
 
Foreign currency translation
     (154 )     -       (154 )
 
Balance at September 26, 2008
   $ 289,915     $ 9,943     $ 299,858  
 
6.
LONG-TERM DEBT

Long-term debt is comprised of the following (in thousands):
 
     
September 26,
    
December 28,
  
     
2008
    
2007
  
               
 
Revolving line of credit
   $ 110,000     $ -  
 
Convertible subordinated notes
                
 
2.25% convertible subordinated notes I, due 2013
     52,218       52,218  
 
2.25% convertible subordinated notes II, due 2013
     197,782       197,782  
 
Unamortized discount
     (7,685 )     (8,802 )
 
Total convertible subordinated notes
     242,315       241,198  
 
Total long-term debt
   $ 352,315     $ 241,198  
 
Revolving Line of Credit - The Company has a senior credit facility (the “Credit Facility”) consisting of a $235 million revolving line of credit, which can be increased to $335 million upon the Company’s request.  The Credit Facility also contains a $15 million letter of credit subfacility and a $15 million swingline subfacility.  The Credit Facility is secured by the Company’s non-realty assets including cash, accounts and notes receivable, and inventories, and has an expiration date of May 22, 2012 with a one-time option to extend to April 1, 2013 if no default has occurred.  Interest rates under the Credit Facility are, at the Company’s option, based upon the current prime rate or the LIBOR rate plus a margin that varies with the Company’s leverage ratio.  If interest is paid based upon the prime rate, the applicable margin is between minus 1.25% and 0.00%.  If interest is paid based upon the LIBOR rate, the applicable margin is between 1.00% and 2.00%.  The Company is required to pay a commitment fee between 0.125% and 0.250% per annum on the unused portion of the Credit Facility based on the Company’s leverage ratio.

The Credit Facility contains limitations on the incurrence of indebtedness, limitations on the incurrence of liens and licensing of intellectual property, limitations on investments and restrictions on certain payments.  Except to the extent paid for by common equity of Greatbatch or paid for out of cash on hand, the Credit Facility limits the amount paid for acquisitions in total to $100 million.  The restrictions on payments, among other things, limit repurchases of Greatbatch’s stock to $60 million and limits the ability of the Company to make cash payments upon conversion of CSN II (as defined below).  These limitations can be waived upon the Company’s request and approval of a simple majority of the lenders.  Such waiver was obtained in order to fund the Precimed acquisition.
- 14 -
GREATBATCH, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – Unaudited
The Credit Facility also requires the Company to maintain a ratio of adjusted EBITDA, as defined in the credit agreement, to interest expense of at least 3.00 to 1.00, and a total leverage ratio, as defined in the credit agreement, of not greater than 5.00 to 1.00 from May 22, 2007 through September 29, 2009 and not greater than 4.50 to 1.00 from September 30, 2009 and thereafter.

The Credit Facility contains customary events of default.  Upon the occurrence and during the continuance of an event of default, a majority of the lenders may declare the outstanding advances and all other obligations under the Credit Facility immediately due and payable.

In connection with the Company’s acquisition of Precimed and the Chaumont Facility, the Company borrowed $117 million under its revolving line of credit in the first quarter of 2008. The Company repaid $7.0 million under the revolving line of credit since that time.  The weighted average interest rate on these borrowings as of September 26, 2008, which does not include the impact of the interest rate swap described below, was 4.1%.  Interest rates reset based upon the six-month ($87 million), three-month ($15 million) and two-month ($8 million) LIBOR rate. Based upon current capital needs, management does not anticipate making significant principal payments on the revolving line of credit within the next twelve months.  As of September 26, 2008, the Company had $125 million available under its revolving line of credit.

Interest Rate Swap – During the first quarter of 2008, the Company entered into an $80 million notional receive floating-pay fixed interest rate swap indexed to the six-month LIBOR rate that expires on July 7, 2010.  The objective of this swap is to hedge against potential changes in cash flows on $80 million of the Company’s revolving line of credit, which is indexed to the six-month LIBOR rate.  No credit risk was hedged.  The receive variable leg of the swap and the variable rate paid on the revolving line of credit bear the same rate of interest, excluding the credit spread, and reset and pay interest on the same dates.  The Company intends to continue electing the six-month LIBOR as the benchmark interest rate on the debt.  If the Company repays the debt it intends to replace the hedged item with similarly indexed forecast cash flows.  The pay fixed leg of the swap bears an interest rate of 3.09%, which does not include the credit spread (currently 1.00%).

The Company accounts for this interest rate swap under SFAS No. 133 Accounting for Derivative Instruments and Hedging Activities, as amended.  SFAS No. 133 requires that all derivatives are recognized as either assets or liabilities in the condensed consolidated balance sheet at fair value.  Changes in the fair value of the derivatives are recorded each period in current earnings or other comprehensive income, depending on whether the derivative is used in a qualifying hedge strategy and, if so, whether the hedge is a cash flow or fair value hedge.  In order to qualify as a hedge, the Company must document the hedging strategy at its inception, including the nature of the risk being hedged and how the effectiveness of the hedge will be measured.  The Company evaluates hedge effectiveness at inception and on an ongoing basis.  If a derivative is no longer expected to be highly effective, hedge accounting is discontinued.
 
- 15 -
GREATBATCH, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – Unaudited
 
The Company designated the interest rate swap as a cash flow hedge.  The Company recognizes the portion of the change in fair value of the interest rate swap that is considered effective as a direct charge or credit to accumulated other comprehensive income (a component of stockholders’ equity), net of tax.  The ineffective portion of the change in fair value, if any, is recorded to interest expense.  Amounts recorded in accumulated other comprehensive income are periodically reclassified to interest expense to offset interest expense on the hedged portion of the revolving line of credit resulting from fluctuations in the six-month LIBOR interest rate.
 
The negative fair value of the interest rate swap of $0.04 million as of September 26, 2008 is based on Level 2 measurements in the fair value hierarchy as described in SFAS No. 157 – see Note 8 – and is recorded in other current liabilities.  As of September 26, 2008, a negative fair value adjustment of $0.03 million was recorded in accumulated other comprehensive income, net of income tax benefits of $0.01 million.  No portion of the change in fair value of the interest rate swap during the first nine months of 2008 was considered ineffective.  The amount recorded as an offset to interest expense during the first nine months of 2008 related to the interest rate swap was $0.4 million.
 
Convertible Subordinated Notes - In May 2003, the Company completed a private placement of $170 million of 2.25% convertible subordinated notes, due 2013 (“CSN I”).  In March 2007, the Company entered into separate, privately negotiated agreements to exchange $117.8 million of CSN I for an equivalent principal amount of a new series of 2.25% convertible subordinated notes due 2013 (“CSN II”) (collectively the “Exchange”) at a 5% discount.  The primary purpose of the Exchange was to eliminate the June 15, 2010 call and put option that is included in the terms of CSN I.  In connection with the Exchange, the Company issued an additional $80 million aggregate principal amount of CSN II at a price of $950 per $1,000 of principal.

The Exchange was accounted for as an extinguishment of debt and resulted in a pre-tax gain of $4.5 million in the first quarter of 2007.  As a result of the extinguishment, the Company had to recapture the tax interest expense that was previously deducted on the extinguished notes.  This resulted in an additional current income tax liability of approximately $11.3 million, which was paid throughout 2007.  This amount was previously recorded as a non-current deferred tax liability on the balance sheet.  The following is a summary of the significant terms of CSN I and CSN II:

CSN I - The notes bear interest at 2.25% per annum, payable semi-annually.  Holders may convert the notes into shares of the Company’s common stock at a conversion price of $40.29 per share, which is equivalent to a conversion ratio of 24.8219 shares per $1,000 of principal, subject to adjustment, before the close of business on June 15, 2013 only under the following circumstances: (1) during any fiscal quarter commencing after July 4, 2003, if the closing sale price of the Company’s common stock exceeds 120% of the $40.29 conversion price for at least 20 trading days in the 30 consecutive trading day period ending on the last trading day of the preceding fiscal quarter; (2) subject to certain exceptions, during the five business days after any five consecutive trading day period in which the trading price per $1,000 of principal for each day of such period was less than 98% of the product of the closing sale price of the Company’s common stock and the number of shares issuable upon conversion of $1,000 of principal; (3) if the notes have been called for redemption; or (4) upon the occurrence of certain corporate events.
 
- 16 -
GREATBATCH, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – Unaudited
 
Beginning June 20, 2010, the Company may redeem any of the notes at a redemption price of 100% of their principal amount, plus accrued interest.  Note holders may require the Company to repurchase their notes on June 15, 2010 or at any time prior to their maturity following a fundamental change, as defined in the indenture, at a repurchase price of 100% of their principal amount, plus accrued interest.  The notes are subordinated in right of payment to all of our senior indebtedness and effectively subordinated to all debts and other liabilities of the Company’s subsidiaries.

Beginning with the six-month interest period commencing June 15, 2010, the Company will pay additional contingent interest during any six-month interest period if the trading price of the notes for each of the five trading days immediately preceding the first day of the interest period equals or exceeds 120% of the principal amount of the notes.

CSN II - The notes bear interest at 2.25% per annum, payable semi-annually.  The holders may convert the notes into shares of the Company’s common stock at a conversion price of $34.70 per share, which is equivalent to a conversion ratio of 28.8219 shares per $1,000 of principal.  The conversion price and the conversion ratio will adjust automatically upon certain changes to the Company’s capitalization.

The notes are convertible at the option of the holders at such time as: (i) the closing price of the Company’s common stock exceeds 150% of the conversion price of the notes for 20 out of 30 consecutive trading days; (ii) the trading price per $1,000 of principal is less than 98% of the product of the closing sale price of common stock for each day during any five consecutive trading day period and the conversion rate per $1,000 of principal; (iii) the notes have been called for redemption; (iv) the Company distributes to all holders of common stock rights or warrants entitling them to purchase additional shares of common stock at less than the average closing price of common stock for the ten trading days immediately preceding the announcement of the distribution; (v) the Company distributes to all holders of common stock any form of dividend which has a per share value exceeding 5% of the price of the common stock on the day prior to such date of distribution; (vi) the Company effects a consolidation, merger, share exchange or sale of assets pursuant to which its common stock is converted to cash or other property; (vii) the period beginning 60 days prior to but excluding June 15, 2013; and (viii) certain fundamental changes, as defined in the indenture, occur or are approved by the Board of Directors.

Conversions in connection with corporate transactions that constitute a fundamental change require the Company to pay a premium make-whole amount whereby the conversion ratio on the notes may be increased by up to 8.2 shares per $1,000 of principal.  The premium make-whole amount will be paid in shares of common stock upon any such conversion, subject to the net share settlement feature of the notes described below.

The notes contain a net share settlement feature that requires the Company to pay cash for each $1,000 of principal to be converted.  Any amounts in excess of $1,000 will be settled in shares of the Company’s common stock, or at the Company’s option, cash.  The Company has an irrevocable election to pay the holders in shares of its common stock, which it currently does not plan to exercise.
 
The notes are redeemable by the Company at any time on or after June 20, 2012, or at the option of a holder upon the occurrence of certain fundamental changes, as defined in the indenture, affecting the Company.  The notes are subordinated in right of payment to all of our senior indebtedness and effectively subordinated to all debts and other liabilities of the Company’s subsidiaries.
 
- 17 -
GREATBATCH, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – Unaudited
 
Beginning with the six-month interest period commencing June 15, 2012, the Company will pay additional contingent interest during any six-month interest period if the trading price of the notes for each of the five trading days immediately preceding the first day of the interest period equals or exceeds 120% of the principal amount of the notes.

Acquired Debt - Concurrently with the close of the Precimed acquisition, the Company assumed and repaid $31.7 million of long-term debt acquired. Additionally, the Company assumed a mortgage note of $2.0 million with a former owner that carried an interest rate of 3%.  The Company repaid this note in full in September 2008.

Deferred Financing Fees - The following is a reconciliation of deferred financing fees for the first nine months of 2008, which are included in other assets (in thousands):
 
 
Balance at December 28, 2007
   $ 6,411  
 
Financing costs deferred
     14  
 
Amortization during the period
     (993 )
 
Balance at September 26, 2008
   $ 5,432  
 
7.
PENSION PLANS

In connection with the Precimed and Chaumont Facility acquisitions, the Company recorded a pension liability related to defined benefit pension plans provided to non-U.S. employees of those businesses.  Under these plans, benefits accrue to employees based upon years of service, position, age and compensation.  The liability and corresponding expense related to these pension plans is based on actuarial computations of current and future benefits for employees.  Pension expense is charged to current operating expenses.  The accumulated benefit obligation, projected benefit obligation and fair value of plan assets as of the acquisition date, which was also the measurement date, were $12.3 million, $14.0 million and $10.5 million, respectively.

 
The change in the net pension liability for the first nine months of 2008 is as follows (in thousands):
 
 
Balance at December 28, 2007
   $ -  
 
Acquired in 2008
     3,534  
 
Net periodic pension cost
     581  
 
Foreign currency translation
     7  
 
Balance at September 26, 2008
   $ 4,122  
 
Net pension cost is comprised of the following (in thousands):
 
     
Nine months ended
  
     
September 26,
2008
  
 
Service cost
   $ 532  
 
Interest cost
     377  
 
Expected return on plan assets
     (328 )
 
Net pension cost
   $ 581  
 
- 18 -
GREATBATCH, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – Unaudited
 
The principal actuarial assumptions used were as follows:
 
 
Discount rate
     3.9 %
 
Expected rate of return on plan assets
     4.0 %
 
Salary growth
     2.6 %
 
The discount rate used is based on the yields of foreign government bonds with a duration matching the duration of the liabilities plus 20 to 30 basis points to reflect the risk of investing in corporate bonds.  The expected rate of return on plan assets reflects long-term earnings expectations on existing plan assets and those contributions expected to be received during the current plan year.  In estimating that rate, appropriate consideration was given to historical returns earned by plan assets in the fund and the rates of return expected to be available for reinvestment.  Rates of return were adjusted to reflect current capital market assumptions and changes in investment allocations.  Equity securities and fixed income securities were assumed to earn a return in the range of 7% to 8% and 3% to 4%, respectively.  The long-term inflation rate was estimated to be 1.8%.  When these overall return expectations are applied to the pension plan’s target allocation, the expected rate of return is determined to be 4.0%.

The weighted average asset allocation as of the valuation date was as follows:
 
 
Asset Category:
  
Target
    
Actual
  
 
Bonds
     60 %     52 %
 
Equity
     25 %     32 %
 
Other
     15 %     16 %
                   
        100 %     100 %
 
This allocation is consistent with the Company’s goal of diversifying the pension plans assets in order to preserve capital while achieving investment results that will contribute to the proper funding of pension obligations and cash flow requirements.
 
Estimated benefit payments over the next ten years are as follows (in thousands):
 
 
Remainder 2008
   $ 242  
 
2009
     975  
 
2010
     874  
 
2011
     940  
 
2012
     1,045  
 
2013-2017
     5,747  
 
- 19 -
GREATBATCH, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – Unaudited
 
8.
FAIR VALUE MEASUREMENTS
 
Beginning in fiscal year 2008, the Company adopted the provisions of SFAS No. 157, Fair Value Measurements, for all financial assets and liabilities and nonfinancial assets and liabilities that are recognized or disclosed at fair value on a recurring basis (at least annually).  Under this standard, fair value is defined as the price that would be received to sell an asset or paid to transfer a liability (i.e. the “exit price”) in an orderly transaction between market participants at the measurement date.

SFAS No. 157 establishes a hierarchy for inputs used in measuring fair value that maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring that the most observable inputs be used when available.  Observable inputs are inputs that market participants would use in pricing the asset or liability developed based on market data obtained from sources independent of the Company.  Unobservable inputs are inputs that reflect the Company’s assumptions about the assumptions market participants would use in pricing the asset or liability developed based on the best information available in the circumstances.  The hierarchy is broken down into three levels based on the reliability of inputs as follows:

Level 1 — Valuations based on quoted prices in active markets for identical assets or liabilities that the Company has the ability to access.  Since valuations are based on quoted prices that are readily and regularly available in an active market, valuation of these products does not entail a significant degree of judgment.
 
Level 2 — Valuation is determined from quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar instruments in markets that are not active or by model-based techniques in which all significant inputs are observable in the market.
 
Level 3—Valuations based on inputs that are unobservable and significant to the overall fair value measurement.  The degree of judgment exercised in determining fair value is greatest for instruments categorized in Level 3.
 
The availability of observable inputs can vary from asset/liability to asset/liability and is affected by a wide variety of factors, including, the type of asset/liability, whether the asset/liability is established in the marketplace, and other characteristics particular to the transaction.  To the extent that valuation is based on models or inputs that are less observable or unobservable in the market, the determination of fair value requires more judgment.  In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy.  In such cases, for disclosure purposes the level in the fair value hierarchy within which the fair value measurement in its entirety falls is determined based on the lowest level input that is significant to the fair value measurement in its entirety.
 
Fair value is a market-based measure considered from the perspective of a market participant rather than an entity-specific measure.  Therefore, even when market assumptions are not readily available, assumptions are required to reflect those that market participants would use in pricing the asset or liability at the measurement date.
 
- 20 -
GREATBATCH, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – Unaudited
Valuation Techniques
Short-term investments available for sale - The fair value of short-term investments available for sale is obtained from an independent pricing service that utilizes multidimensional relational models with observable market data inputs to estimate fair value.  These observable market data inputs include benchmark yields, reported trades, broker/dealer quotes, issuer spreads, benchmark securities, bids, offers and reference data.  The Company’s short-term investments available for sale are categorized in Level 2 of the fair value hierarchy.  The Company did not have any short-term investments available for sale as of September 26, 2008.

Interest rate swap - The fair value of our interest rate swap is obtained from an independent pricing service that utilizes cash flow models with observable market data inputs to estimate fair value.  These observable market data inputs include LIBOR and swap rates.  The Company’s interest rate swap is categorized in Level 2 of the fair value hierarchy.

The following table provides information regarding financial assets and liabilities measured at fair value on a recurring basis (in thousands):
 
           
Fair value measurements at reporting date using
  
 
Description
  
At
September 26,
2008
    
Quoted prices
in active
markets for
identical assets
(Level 1)
    
Significant
other
observable
inputs
(Level 2)
    
Significant
unobservable
inputs
(Level 3)
  
 
Liabilities
                        
 
Interest rate swap
   $ (40 )   $ -     $ (40 )   $ -  
 
As of September 26, 2008, the Company did not have any nonfinancial assets and liabilities that are recognized or disclosed at fair value on a recurring basis.
 
9.
STOCK-BASED COMPENSATION
 
Under SFAS No. 123(R), the Company records compensation costs related to all stock-based awards.  Compensation costs related to share-based payments for the three and nine months ended September 26, 2008 totaled $1.5 million, $1.0 million net of tax, or $0.04 per diluted share and $4.8 million, $3.2 million net of tax, or $0.14 per diluted share, respectively.  This compares to $1.4 million, $0.9 million net of tax, or $0.04 per diluted share and $4.3 million, $2.8 million net of tax, or $0.11 per diluted share for the three and nine months ended September 28, 2007, respectively.

In October 2008, the Board of Directors approved the award of approximately 400,000 performance-based stock options to management in accordance with the Company’s supplemental annual long-term incentive plan.  These stock options were awarded with an exercise price equal to the closing Greatbatch stock price on the date of grant of $21.88.
 
- 21 -
GREATBATCH, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – Unaudited
 
The following table summarizes stock option activity related to the Company’s stock-based incentive plans:
 
     
Number of
stock options
    
Weighted
average
exercise
price
    
Weighted
average
remaining
contractual
life
(in years)
    
Aggregate
intrinsic
value(1)
(in millions)
  
                           
                           
 
Outstanding at December 28, 2007
     1,744,022     $ 25.04              
 
     Granted
     442,630       20.09              
 
     Exercised
     (60,560 )     15.79              
 
     Forfeited or Expired
     (113,400 )     26.09              
                               
 
Outstanding at September 26, 2008
     2,012,692     $ 24.17       7.2     $ 5.8  
 
Exercisable at September 26, 2008
     960,380     $ 25.39       5.8     $ 2.3  
 
 
 (1)
Intrinsic value is calculated for in-the-money options (exercise price less than market price) outstanding and/or exercisable as the difference between the market price of our common shares as of September 26, 2008 ($25.78) and the exercise price of the underlying options, multiplied by the number of options outstanding and/or exercisable.

The weighted-average fair value and assumptions used to value options granted are as follows:
 
     
Nine months ended
  
     
September 26,
    
September 28,
  
     
2008
    
2007
  
 
Weighted-average fair value
   $ 7.94     $ 12.33  
 
Risk-free interest rate
     2.92 %     4.62 %
 
Expected volatility
     40 %     41 %
 
Expected life (in years)
     5.2       5.4  
 
Expected dividend yield
     0 %     0 %
                   
 
The following table summarizes restricted stock and restricted stock unit activity related to the Company’s plans:
 
           
Weighted average
  
     
Activity
    
fair value
  
               
 
Nonvested at December 28, 2007
     282,134     $ 24.96  
 
Shares granted
     141,793       20.06  
 
Shares vested
     (94,221 )     23.72  
 
Shares forfeited
     (11,570 )     22.15  
                   
 
Nonvested at September 26, 2008
     318,136     $ 23.24  
 
- 22 -
GREATBATCH, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – Unaudited
 
10.
OTHER OPERATING EXPENSES
 
Other operating expenses, net in the Company’s Condensed Consolidated Statements of Operations and Comprehensive Income are comprised of the following (in thousands):
 
   
Three months ended
    
Nine months ended
  
   
September 26,
    
September 28,
    
September 26,
    
September 28,
  
   
2008
    
2007
    
2008
    
2007
  
(a) 2005 facility shutdowns and consolidations
   $ 335     $ 1,040     $ 672     $ 4,289  
(b) 2007 & 2008 facility shutdowns and consolidations
     1,322       126       2,954       408  
(c) Integration costs
     1,812       -       3,876       -  
     Asset dispositions and other
     96       109       (28 )     99  
    $ 3,565     $ 1,275     $ 7,474     $ 4,796  
 
(a) 2005 facility shutdowns and consolidations. In the first quarter of 2005, the Company announced its intent to close the Carson City, NV facility and consolidate the work performed at that facility into the Tijuana, Mexico facility.  This consolidation project was completed in the third quarter of 2007.

In the fourth quarter of 2005, the Company announced its intent to close both the Columbia, MD facility (“Columbia Facility”) and the Fremont, CA Advanced Research Laboratory (“ARL”).  The Company also announced that the manufacturing operations at the Columbia Facility will be moved into the Tijuana Facility and that the research, development and engineering and product development functions at the Columbia Facility and at ARL will relocate to the Technology Center in Clarence, NY.  The ARL portion of this consolidation project was completed in the fourth quarter of 2006.  The Columbia Facility portion of this consolidation project was completed in the third quarter of 2008.

The total cost for these facility consolidations was $18.8 million. The major categories of costs include the following:

 
a.
Severance and retention - $7.4 million;
 
b.
Production inefficiencies and revalidation - $1.6 million;
 
c.
Accelerated depreciation and asset write-offs - $1.1 million;
 
d.
Personnel - $5.9 million; and
 
e.
Other - $2.8 million.

All categories of costs are considered to be cash expenditures, except accelerated depreciation and asset write-offs.  The expenses for the facility shutdowns and consolidations are included in the IMC business segment.
 
- 23 -
GREATBATCH, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – Unaudited
 
Accrued liabilities related to the 2005 facility shutdowns and consolidations are comprised of the following (in thousands):

     
Severance
and
retention
    
Production
inefficiencies
and
revalidation
    
Personnel
    
Other
    
Total
  
 
Balance, December 29, 2006
   $ 2,904     $ -     $ -     $ -     $ 2,904  
 
Restructuring charges
     1,405       1,037       1,678       577       4,697  
 
Cash payments
     (2,459 )     (1,037 )     (1,678 )     (577 )     (5,751 )
 
Balance, December 28, 2007
   $ 1,850     $ -     $ -     $ -     $ 1,850  
                                           
 
Restructuring charges
     159       42       193       278       672  
 
Cash payments
     (1,798 )     (42 )     (193 )     (278 )     (2,311 )
 
Balance, September 26, 2008
   $ 211     $ -     $ -     $ -     $ 211  
 
(b) 2007 & 2008 facility shutdowns and consolidations. In the first quarter of 2007, the Company announced that it will close its current Electrochem manufacturing facility in Canton, MA and construct a new 80,000 square foot replacement facility in Raynham, MA. This initiative is not cost savings driven but capacity driven for the commercial group.

In the second quarter of 2007, the Company announced that it will consolidate its corporate offices in Clarence, NY into its existing Research and Development center also in Clarence, NY after an expansion of that facility was complete.  This expansion and relocation was completed in the third quarter of 2008.

As a result of its acquisitions in 2007 and 2008, during the second quarter of 2008, the Company began reorganizing and consolidating various general and administrative and research and development functions throughout the organization in order to optimize those resources.

During the third quarter of 2008, the Company ceased manufacturing at its facility in Suzhou, China, which was acquired from EAC, and closed its manufacturing facility in Orchard Park, NY, which was acquired from Intellisensing, LLC.  Additionally, the Company initiated the consolidation of one Switzerland manufacturing location, which was acquired from Precimed.  The operations at these facilities will be relocated to existing facilities which have excess capacity.

The above initiatives are expected to be completed over the next three to nine months.  The total cost for these facility shutdowns and consolidations is expected to be approximately $5.5 million to $6.9 million of which $3.5 million has been incurred through September 26, 2008.  The major categories of costs include the following:

 
a.
Severance and retention - $1.5 million - $1.9 million;
 
b.
Production inefficiencies and revalidation - $1.6 million - $2.0 million;
 
c.
Accelerated depreciation and asset write-offs - $1.6 million - $2.0 million;
 
d.
Personnel - $0.3 million - $0.4 million; and
 
e.
Other - $0.5 million - $0.6 million.
 
- 24 -
GREATBATCH, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (con't) – Unaudited
 
All categories of costs are considered to be cash expenditures, except accelerated depreciation and asset write-offs.  For the nine months ended September 26, 2008 expenses of $1.1 million related to the Electrochem facility expansion, Suzhou, China shutdown and Orchard Park facility consolidation which are included in the Electrochem business segment.  For the nine months ended September 26, 2008 costs related to the relocation of the Company’s corporate offices and reorganizing and consolidating various general and administrative and research and development functions of $1.4 million were included in the IMC business segment. The costs incurred in 2007 relate to the facility expansion in Raynham, MA and are included in the Electrochem business segment.  As of September 26, 2008 and December 28, 2007, $0.2 million and $0.5 million of accrued consolidation expenses relate to the IMC business segment, respectively.  The remaining $0.4 million of restructuring charges were not allocated as they primarily related to corporate functions.

Accrued liabilities related to the 2007 & 2008 facility shutdowns and consolidations are comprised of the following (in thousands):
 
     
Severance
and
retention
    
Production
inefficiencies
and
revalidation
    
Accelerated
depreciation/
asset
write-offs
    
Personnel
    
Other
    
Total
  
 
Balance, December 29, 2006
   $ 570     $ -     $ -     $ -     $ -     $ 570  
 
Restructuring charges
     -       -       531       -       -       531  
 
Write-offs
     -       -       (531 )     -       -       (531 )
 
Cash payments
     -       -       -       -       -       -  
 
Balance, December 28, 2007
   $ 570     $ -     $ -     $ -     $ -     $ 570  
                                                   
 
Restructuring charges
     1,439       461       788       82       184       2,954  
 
Write-offs
     -       -       (788 )     -       -       (788 )
 
Cash payments
     (1,756 )     (461 )     -       (82 )     (184 )     (2,483 )
 
Balance, September 26, 2008
   $ 253     $ -     $ -     $ -     $ -     $ 253  
 
Subsequent Event - In October 2008, management of the Company approved a plan for the closure of its Teterboro, New Jersey (Electrochem manufacturing), Blaine, Minnesota (Therapy Delivery manufacturing) and Exton, Pennsylvania (Orthopedics corporate office) facilities. The operations at these facilities will be moved to other existing facilities of the Company with excess capacity.

The total cost for these facility consolidations is estimated to be between $5.7 million and $7.0 million and will be incurred over the next twelve to fifteen months.  The major categories of costs include:

 
a.
Severance and retention - $2.1 million to $2.5 million;
 
b.
Production inefficiencies and revalidation - $0.3 million to $0.5 million;
 
c.
Accelerated depreciation and asset write-offs - $1.5 million to $1.7 million;
 
d.
Personnel - $1.2 million to $1.4 million; and
 
e.
Other - $0.6 million to $0.9 million.

(c) Integration costs. During the first nine months of 2008, the Company incurred costs related to the integration of the companies acquired in 2007 and 2008.  The integration initiatives include the implementation of the Oracle ERP system, training and compliance with Company policies as well as the implementation of lean manufacturing and six sigma initiatives.  The expenses are primarily for consultants, relocation and travel costs that will not be required after the integrations are completed.  The Company expects to continue to incur these types of costs for the remainder of 2008 and into the first half of 2009 at a quarterly rate that is consistent with the current quarter amount.
 
- 25 -
GREATBATCH, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (con't) – Unaudited
11.
INCOME TAXES
 
During the third quarter of 2008, the balance of unrecognized tax benefits increased approximately $0.6 million to $1.7 million.  This is a result of an increase of $0.7 million relating to tax positions taken in the current year, offset by $0.1 million relating to a settlement with a taxing authority.  As of September 26, 2008, approximately $0.9 million of unrecognized tax benefits would impact goodwill if recognized prior to December 31, 2008 (the adoption date of FAS 141R).  Of the remaining approximately $0.8 million of unrecognized tax benefits, approximately $0.6 million would favorably impact the effective tax rate (net of federal benefit on state issues), if recognized.  We are still analyzing the impact of Financial Accounting Standards Board (“FASB”) Interpretation No. 48 Accounting for Uncertainty in Income Taxes, an Interpretation of FASB SFAS No. 109,  with respect to the 2008 acquisitions.  The Company does not anticipate that the total unrecognized tax benefits would significantly change within the next twelve months.

In the fourth quarter of 2008, the Emergency Economic Stabilization Act (the Act) was signed into law.  This Act extended the research and development tax credit for 2008 and 2009, retroactive to the beginning of 2008.  In accordance with US GAAP, reported net earnings for the third quarter of 2008 do not include this benefit, which will be recognized as a reduction in the overall effective tax rate in the fourth quarter.
 
12.
COMMITMENTS AND CONTINGENCIES
 
Litigation – The Company is a party to various legal actions arising in the normal course of business. While the Company does not believe that the ultimate resolution of any such pending actions will have a material adverse effect on its results of operations, financial position or cash flows, except as indicated below, litigation is subject to inherent uncertainties.  If an unfavorable ruling were to occur, there exists the possibility of a material adverse impact in the period in which the ruling occurs.

As previously reported, on June 12, 2006, Enpath was named as defendant in a patent infringement action filed by Pressure Products Medical Supplies, Inc. (“Pressure Products”) in the U.S. District Court in the Eastern District of Texas.  Pressure Products alleged that Enpath’s FlowGuard™ valved introducer, which has been on the market for more than three years, infringes claims in the Pressure Products patents and sought damages and injunctive relief.  Revenues from products sold that include the FlowGuard™ valved introducer were approximately $3.0 million, $2.0 million and $1.5 million for 2007, 2006 and 2005, respectively.  Pressure Products made the same allegations against Enpath’s ViaSeal™ prototype introducer, which has not been sold. Enpath filed an answer denying liability and a counterclaim seeking to invalidate the patents. Trial began on June 6, 2008 and on June 12, 2008, a jury found that Enpath is infringing the Pressure Products patents, but not willfully, and awarded damages in the amount of $1.1 million, which was significantly less than what was sought. Pressure Products filed post-trial motions to enforce the judgment, enjoin future sales of FlowGuard™ and ViaSeal™, seek enhanced damages and seek an award of attorneys’ fees.  Enpath filed a motion to overturn the jury verdict and have the court invalidate the patents as a matter of law.  Following a hearing on those motions on July 31, 2008, the Court denied Enpath’s motion to overturn the jury verdict, denied Pressure Products’ motions for enhanced damages and attorneys’ fees (though the court made a limited award of attorneys’ fees related to Enpath’s counterclaim for antitrust and patent misuse), enjoined sales of ViaSeal™, but permitted future sales of FlowGuard™ provided that Enpath, pending any appeal, pay into an escrow fund a royalty of between $1.50 and $2.25 for each sale of a FlowGuard™ valved introducer.  The amount accrued as escrow during the third quarter of 2008 was $0.08 million.  The Court further awarded Pressure Products costs and fees, which were extensively reduced following Enpath’s objections.  Although there can be no assurance as to the ultimate outcome, Enpath continues to believe that Pressure Products’ case is without merit.  Accordingly, Enpath appealed the final judgment to the U.S. Court of Appeals for the Federal Circuit and the appeal was docketed with the Federal Circuit on September 29, 2008.  In connection with the appeals process, the Company was required to post a $1.8 million bond in order to cover any potential pre and post-judgment interest and/or costs.  During the third quarter of 2008 the Company incurred $0.3 million ($4.2 million year-to-date) of costs related to this litigation.
 
- 26 -
GREATBATCH, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (con't) – Unaudited
 
During 2002, a former non-medical customer commenced an action alleging that Greatbatch had used proprietary information of the customer to develop certain products.  We have meritorious defenses and are vigorously defending the matter.  The potential risk of loss is up to $1.7 million.

Product Warranties - The Company generally warrants that its products will meet customer specifications and will be free from defects in materials and workmanship.  The Company accrues its estimated exposure to warranty claims based upon recent historical experience and other specific information as it becomes available.

The change in aggregate product warranty liability for the quarter ended September 26, 2008 is as follows (in thousands):
 
 
Beginning balance at June 27, 2008
   $ 1,373  
 
Additions to warranty reserve
     577  
 
Warranty claims paid
     (209 )
 
Ending balance at September 26, 2008
   $ 1,741  
 
Purchase Commitments – Contractual obligations for purchase of goods or services are defined as agreements that are enforceable and legally binding on the Company and that specify all significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction.  Our purchase orders are normally based on our current manufacturing needs and are fulfilled by our vendors within short time horizons.  We enter into blanket orders with vendors that have preferred pricing and terms, however these orders are normally cancelable by us without penalty.  As of September 26, 2008, the total contractual obligation related to such expenditures is approximately $20.7 million and primarily relate to material purchase commitments.  These commitments will be financed by existing cash, availability under the Company’s line of credit or cash generated from operations.  We also enter into contracts for outsourced services; however, the obligations under these contracts were not significant and the contracts generally contain clauses allowing for cancellation without significant penalty.

Operating Leases - The Company is a party to various operating lease agreements for buildings, equipment and software.  Minimum future annual operating lease payments are $0.6 million for the remainder of 2008; $2.1 million in 2009; $1.6 million in 2010; $1.4 million in 2011; $1.4 million in 2012 and $3.4 million thereafter.  The Company primarily leases buildings, which accounts for the majority of the future lease payments.
 
- 27 -
GREATBATCH, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (con't) – Unaudited
 
Foreign Currency Contract - In December 2007, the Company entered into a forward contract to purchase 80,000,000 CHF, at an exchange rate of 1.1389 CHF per one U.S. dollar, in order to partially fund the purchase price of Precimed, which was payable in Swiss Francs.  In January 2008, the Company entered into an additional forward contract to purchase 20,000,000 CHF at an exchange rate of 1.1156 per one U.S. dollar.  The Company entered into a similar foreign exchange contract in January 2008 in order to fund the purchase price of the Chaumont Facility, which was payable in Euros.  The net result of the above contracts, which were settled upon the funding of the respective acquisitions, was a gain of $2.4 million, $1.6 million of which was recorded in the first quarter of 2008 as other income.

13.
EARNINGS PER SHARE (“EPS”)

The following table reflects the calculation of basic and diluted EPS (in thousands, except per share amounts):
 
   
Three months ended
    
Nine months ended
  
   
September 26,
    
September 28,
    
September 26,
    
September 28,
  
   
2008
    
2007
    
2008
    
2007
  
Numerator for basic earnings per share:
                        
Net income
   $ 7,629     $ 5,000     $ 10,060     $ 12,270  
Effect of dilutive securities:
                                
Interest expense on convertible notes and related
deferred financing fees, net of tax
     223       223       -       1,175  
Numerator for diluted earnings per share
   $ 7,852     $ 5,223     $ 10,060     $ 13,445