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CYBX > SEC Filings for CYBX > Form 10-Q on 24-Feb-2012All Recent SEC Filings

Show all filings for CYBERONICS INC

Form 10-Q for CYBERONICS INC


24-Feb-2012

Quarterly Report


ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Cautionary Statement Regarding Forward Looking Statements

This Quarterly Report on Form 10-Q ("Form 10-Q") contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and
Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"). The Private Securities Litigation Reform Act of 1995 provides a "safe harbor" for certain forward-looking statements. The words "believe," "expect," "anticipate," "plan," "intend," "foresee," "should," "would," "could," "may" or other similar expressions are intended to identify forward-looking statements. These forward-looking statements are based on our current expectations and beliefs concerning future developments and their potential effects on us. There can be no assurance that future developments affecting us will be those that we anticipate. All comments concerning our expectations for future revenues and operating results are based on our forecasts for our existing operations. These forward-looking statements involve significant risks and uncertainties (some of which are beyond our control) and assumptions. They are subject to change based upon various factors, including but not limited to the risks and uncertainties summarized below:

- Changes in our common stock price;
- Changes in our profitability;
- Regulatory activities and announcements;
- Effectiveness of our internal controls over financial reporting;
- Fluctuations in future quarterly operating results;
- Failure to comply with, or changes in laws, regulations or administrative practices affecting government regulation of our products, including, but not limited to, United States ("U.S.") Food and Drug Administration ("FDA") laws and regulations;
- Our ability to access capital, including credit markets;
- Failure to expand or maintain market acceptance or reimbursement for the use of vagus nerve stimulation therapy ("VNS Therapy") or any component which comprises the VNS Therapy® System for the treatment of epilepsy and depression;
- Any legislative or administrative reform to the healthcare system, including the U.S. Medicare or Medicaid systems, or the international reimbursement systems that significantly reduces reimbursement for procedures using the VNS Therapy System, or any component thereof, or denies coverage for such procedures, as well as adverse decisions relating to our products by administrators of such systems on coverage or reimbursement issues;
- Failure to maintain the current regulatory approvals for our epilepsy and depression indications;
- Failure to develop VNS Therapy for the treatment of other indications;
- Unfavorable results from clinical studies;
- Variations in sales and operating expenses relative to estimates;
- Our dependence on certain suppliers and manufacturers to provide certain materials, components and contract services necessary for the production of the VNS Therapy System;
- Product liability-related losses and costs;
- Protection, expiration and validity of our intellectual property;
- Changes in technology;
- Failure to comply with applicable laws and regulations, including federal and state privacy and security laws and regulations;
- International operational and economic risks and concerns;
- Failure to attract or retain key personnel;
- Outcomes of pending or future lawsuits and governmental investigations;
- Changes in accounting rules that adversely affect the characterization of our consolidated results of income, financial position or cash flows;
- Changes in customer spending patterns; and
- Continued volatility in the global market and worldwide economic conditions.


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Other factors that could cause our actual results to differ from our projected results are described in (1) Part II, Item 1A and elsewhere in this Form 10-Q,
(2) our Annual Report on Form 10-K for the period ended April 29, 2011, ("2011 Form 10-K"), (3) our reports and registration statements filed and furnished from time to time with the U.S. Securities & Exchange Commission (the "SEC") and
(4) other announcements we make from time to time.

Readers are cautioned not to place undue reliance on forward-looking statements, which speak only as of the date hereof. We undertake no obligation to publicly update or revise any forward-looking statements after the date they are made, whether as a result of new information, future events or otherwise. You should read the following discussion and analysis in conjunction with our unaudited condensed consolidated financial statements and related notes included elsewhere in this report. Operating results for the thirteen and thirty-nine weeks ended January 27, 2012 are not necessarily indicative of future results, including the full fiscal year. You should also refer to our Annual Consolidated Financial Statements, Notes thereto, and Management's Discussion and Analysis of Financial Condition and Results of Operations and "Risk Factors" contained in our 2011 Form 10-K.

Business Overview

We are a medical device company incorporated as a Delaware corporation in 1987, engaged in the design, development, sales and marketing of implantable medical devices that provide a unique neuromodulation therapy, VNS Therapy, for the treatment of refractory epilepsy and treatment-resistant depression ("TRD") and other device solutions for the management of epilepsy.

Our proprietary VNS Therapy System includes the following:

- An implantable pulse generator to provide the appropriate stimulation to the vagus nerve;
- A lead that connects the generator to the vagus nerve;
- Associated equipment to assist with the implant procedure;
- Equipment to assist the treating physician with setting the stimulation parameters for each patient;
- Appropriate instruction manuals; and
- Magnets to temporarily suspend or induce stimulation manually.

The VNS Therapy pulse generator and lead are surgically implanted into patients, generally during an outpatient procedure. The battery contained in the generator has a finite life, which varies according to the model and the stimulation parameters and settings used for each patient. At or near the end of the useful life of a battery, a patient may, with the advice of a physician, choose to implant a new generator, with or without replacing the original lead.

The FDA approved our VNS Therapy System in July 1997 for use as an adjunctive therapy in epilepsy patients over 12 years of age in reducing the frequency of partial onset seizures that are refractory or resistant to antiepileptic drugs. Regulatory bodies in Canada, the European Economic Area, certain countries in Eastern Europe, Russia, South America, Africa, Australia and certain countries in Asia, including Japan, China and Taiwan, have approved the VNS Therapy System for the treatment of epilepsy, many without age restrictions or seizure-type limitations. In July 2005, the FDA approved the VNS Therapy System for the adjunctive long-term treatment of chronic or recurrent depression for patients 18 years of age or older who are experiencing a major depressive episode and have not had an adequate response to four or more adequate anti-depressant treatments. Regulatory bodies in the European Economic Area, Canada and Israel have approved the VNS Therapy System for the treatment of chronic or recurrent depression in patients who are in a treatment-resistant or treatment-intolerant depressive episode without age restrictions.

Our ability to successfully expand the commercialization of the VNS Therapy System depends on obtaining and maintaining favorable insurance coverage, coding and reimbursement for the device, the implant procedure and follow-up care. Currently, there is broad coverage, coding and reimbursement for VNS Therapy for the treatment of refractory epilepsy. The Centers for Medicare and Medicaid Services ("CMS"), which we estimate pays for approximately 25% of the VNS Therapy System implants, issues an annual update to the reimbursement amounts received by our customers.


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We believe reimbursement or payment rates from private insurers were largely unchanged over the past year. However, CMS made significant changes to the amounts that are reimbursed to hospitals for the generator and the lead for calendar year 2011. In November 2010, effective for calendar year 2011, CMS announced a final rate for reimbursement of the generator portion of the VNS Therapy System for hospitals. The rate represented an increase of approximately 6% over the rate in calendar year 2010. Further, for calendar year 2011, CMS introduced a new reimbursement code and an "interim final" rate paid to hospitals for implantation of both the generator and the lead portions of the VNS Therapy System. The new combined generator and lead reimbursement code rate is approximately 7% less overall when compared to separate rates used in calendar year 2010. Further, CMS approved decreases in physician reimbursement for implantation of both the generator and the lead. In November 2011, CMS announced calendar year 2012 final rates, which increased by 6.4% for full systems and increased by 3.0% for generator-only replacements.

There can be no assurance that future changes to CMS reimbursement will not have an adverse effect on our future operating results. A decrease in reimbursement rates or a change in reimbursement methodology by CMS could have an adverse impact on our business and our future operating results. We continue to work with CMS to ensure favorable and appropriate reimbursement for our products and related procedures.

We continue to invest and support the development of future generations of our VNS Therapy System, including generators employing new stimulation paradigms, cardiac and brain-based seizure detection, rechargeable battery and wireless communication technology. We also continue to fund and develop other devices that support our focus on device solutions for epilepsy management, such as event monitoring, logging and notification technology using external heart monitoring and movement-related sensor advancements. We sponsor post-marketing studies in in appropriate indications to build clinical evidence for VNS Therapy.

On August 15, 2011, we announced that we discovered a hardware-related design issue with the AspireHC™ (High Capacity) Model 105 and AspireSR™ (Seizure Response) Model 106 generators. The hardware-related design issue did not affect earlier models of our pulse generator, and we continued to sell earlier models. We found that the stimulation output current delivered by the AspireHC and AspireSR generators to a patient's nerve could be less than the output current programmed by a physician. While we believe that the generators do not pose an immediate health risk to patients, we (i) stopped shipment of AspireHC and AspireSR generators, (ii) suspended enrollment in our E-36 AspireSR generator clinical trial, (iii) notified physicians treating patients implanted with the AspireHC generator of the issue and what to consider as they monitor these patients, (iv) withdrew the AspireHC and AspireSR generators from the field, (v) identified the cause of the problem and implemented and tested the solution, and
(vi) submitted applications to both the FDA and its European notified body, DEKRA Certification, B.V. for the approval of the improved AspireHC generator.

In December 2011, the FDA approved our re-designed AspireHC generator and we resumed our limited commercial release of the generator in the U.S. With CE Mark approval in November 2011, we also resumed limited commercial release in Europe.

In the fourth fiscal quarter of fiscal year 2011, we commenced a European clinical trial (E-36) to support regulatory approval in Europe of our AspireSR generator with the first human implant on April 27, 2011. The AspireSR generator is a device that employs a cardiac-based seizure detection system and delivers responsive VNS Therapy. We suspended this trial in August 2011 and are currently re-submitting the appropriate applications to re-start this trial. We expect that trial enrollment will recommence by approximately the end of our fiscal year, April 27, 2012 or shortly thereafter.

In addition, we are investing in pre-clinical research related to the use of VNS Therapy for the treatment of chronic heart failure.


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The VNS Therapy System is indicated as an adjunctive treatment for patients 18 years of age or older who are experiencing a major depressive episode and have not had an adequate response to four or more adequate antidepressant treatments. In Canada and the European Union, the VNS Therapy System is indicated for the treatment of chronic or recurrent depression in patients who are in a treatment-resistant or treatment-intolerant major depressive episode. Pursuant to the post-market surveillance conditions specified as part of our FDA marketing approval, we were required to conduct two clinical studies on TRD patients:

- One post-approval study, the dosing study, was a randomized study assessing three different stimulation intensities. We completed the 331 patient dosing study in February 2010 and submitted our final study report to the FDA in August 2010. In February 2011, we received notification from the FDA that we have fulfilled all study requirements related to the dosing study. Based on the results of the dosing study and other post-approval clinical studies and analysis, we are currently in discussions with selected payers, including CMS, with the objective of obtaining coverage and reimbursement of VNS Therapy for TRD, although we cannot assure that this objective will be met.

- The other post-approval study, the TRD Registry, is a longitudinal study intended to follow patients with TRD in two treatment groups - one group receiving adjunctive VNS Therapy and the other group receiving treatment-as-usual. We expect the TRD registry to be completed in calendar year 2015.

Proprietary protection for our products is important to our business. We seek U.S. and foreign patents on selected inventions, acquire licenses under selected patents of third parties, and enter into confidentiality agreements with our employees, vendors and consultants with respect to technology that we consider important to our business. We also rely on trade secrets, unpatented know-how and continuing technological innovation to develop and maintain our competitive position. Under the terms of our epilepsy patent license agreement we have been paying royalties at a rate of 3% of net sales of generators and leads. The epilepsy patent expired on July 16, 2011 in the U.S. and, as a result, we discontinued paying this royalty after the expiration date. Also, as a result of the epilepsy patent expiration, it is possible that one or more competitors may enter this market.

We continuously evaluate whether to out-license or to in-license intellectual property rights to optimize our portfolio. This includes identifying our intellectual property rights for indications we do not have plans to develop and determining whether these rights can be licensed or otherwise granted to third parties. It also involves assessing the intellectual property rights owned by third parties to determine whether we should attempt to license or otherwise acquire those rights. We have entered into several license and technology agreements that may involve substantial future payments; see "Note 16. Commitments and Contingencies - License Agreements" in our Consolidated Financial Statements for additional information.

In order to accommodate expected growth of our business, to secure our future in our current manufacturing and headquarters facility and to realize operating efficiencies, we purchased the building in which we are headquartered during the quarter ended October 28, 2011. Our headquarters building is located in Houston, Texas and has approximately 144,000 square feet of manufacturing and office space. We currently occupy approximately 79% of this space. In addition, as part of our disaster contingency plans, we lease a 19,800 square foot Austin, Texas facility that we utilize for warehousing and distribution.

Significant Accounting Policies and Critical Accounting Estimates

For a full discussion of accounting policies that we identified as critical in the preparation of our consolidated results of operations and financial position, please refer to our 2011 Form 10-K.

The preparation of our consolidated financial statements, in conformity with U.S. generally accepted accounting principles ("U.S. GAAP"), requires us to make estimates and assumptions that affect the amounts reported in our consolidated financial statements and the related notes. Actual results could differ from those estimates. Critical estimates that require management's judgment relate to the allowance for doubtful accounts, estimates of any obsolete inventory, useful lives for property and equipment, impairment of any long-lived assets, sales returns and allowances, recognition of licensing revenue, product warranties, stock option expenses and income tax valuation allowances.


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Revenue Recognition

Product revenue: We sell our products through a direct sales force in the U.S. and a combination of direct sales representatives and independent distributors in international markets. We recognize revenue when title to the goods and risk of loss transfers to customers or our independent distributors. We maintain policies for sales returns and exchanges. We estimate sales returns based on historical data and we record a reduction in sales and a return reserve when we sell the initial product. We estimate exchanges based on approved return authorizations. Our increasing business activity, new product introductions and variations in product utilization could cause product returns and exchanges to differ from our estimates

Licensing Revenue: We amortize an upfront payment received under a license agreement over the life of our obligations under the agreement to prosecute the licensed patent applications. Effective in December 2007, we entered into an agreement granting an exclusive license to certain patents and patent applications pertaining to weight reduction, hypertension and diabetes in exchange for an up-front, non-refundable payment of $9.5 million, plus a royalty on future commercial sales of any product covered by the licensed patents. We retain the responsibility to prosecute the licensed patent applications and estimate that our obligation will be satisfied by April 2014. Accordingly, we have recognized revenue of approximately $0.4 million per quarter based on the straight-line amortization of the $9.5 million payment. However, a change in our estimate of the amortization period or a release of our obligation to prosecute the patent applications could materially change the timing of the recognition of the licensing revenue.

Intellectual Property

The intellectual property shown in our consolidated balance sheets consist of purchased licenses of patents and technology that we use in the development of our products. All of our purchased intellectual property has a definite life. We amortize our intellectual property on a straight-line basis over the period beginning with the effective date of the license agreement and ending with the shorter of either the expiration of the license or with the estimated end of the useful life of the intended product. We evaluate our intellectual property each reporting period to determine whether events and circumstances indicate a different amortization period or impairment. If we change our estimate of the useful lives of our intellectual property, we amortize the carrying amount over the revised remaining useful life. If we identify an impairment indicator, we test the intellectual property for recoverability and if the carrying amount is not recoverable and exceeds its fair value, impairment is recognized. Amortization and impairment are subject to a high degree of estimation and management judgment. As of the quarter ended January 27, 2012, the carrying value of our intellectual property was $4.7 million, which has a weighted average amortization period of 8.4 years. During the quarter ended January 27, 2012, we identified and impaired $0.5 million of intellectual property rights that we considered had a remote chance of utilization in our epilepsy product development plans.

Equity Award Incentive Compensation

Our service-based equity award incentive compensation is based on the fair market value of the grants and our estimation of forfeitures. Forfeiture estimates require assumptions regarding employee turnover. Total expected compensation cost, net of estimated forfeiture, is amortized over the grant vesting period. Stock-based compensation expense can differ significantly from our expectations if employee turnover and grant forfeitures differ from our estimates. The estimated annual forfeiture rate used for the quarter ended January 27, 2012 for restricted share awards was 1.5%, for employee stock option awards was 5.9% and for officer stock option awards was 0.6%. Compensation expense for stock-based grants for the thirty-nine weeks ended January 27, 2012 was $8.4 million.

Our performance-based restricted stock and phantom share grant compensation is based on the fair market value of the grant and on management estimates of the probability of achieving performance objectives. These estimates require a high degree of management judgment. Compensation may change significantly if, upon review, performance expectations change due to changing business conditions. We estimated total compensation cost for our performance-based restricted stock grants, including the phantom shares, over the life of the grants, to be $10.3 million. If all performance objectives are ultimately achieved, compensation cost over the life of the performance-based grants would increase by $1.9 million.


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Income taxes

Our effective tax rate is based on income, statutory tax rates, and tax planning opportunities available to us in the various jurisdictions in which we operate. We establish reserves when we believe that certain tax positions are likely to be challenged and we may not prevail. If we determine that a tax position is more likely than not of being sustained upon audit, based solely on the technical merits of the position, we recognize the benefit. We measure the benefit by determining the amount that is greater than 50 percent likely of being realized upon settlement. We presume that all tax positions will be examined by a taxing authority with full knowledge of all relevant information. We regularly monitor our tax positions and tax liabilities and reevaluate the technical merits of our tax positions. Our reserve for uncertain tax positions is subject to a high degree of estimation and management judgment. Although we believe that we have adequate reserves in the amount of $6.3 million as of January 27, 2012, positions taken by taxing authorities could have a material impact on our effective tax rate in future periods. We are subject to income tax examinations for our U.S. federal income taxes, non-U.S. income taxes and state and local income taxes for fiscal year 1992 and subsequent years, with certain exceptions.

Tax regulations require certain items to be included in the tax return at different times or at different amounts than required to be recorded in the consolidated financial statements. As a result, tax expense reflected in our consolidated financial statements is different than that reported on our tax returns. Some of these differences are permanent, such as expenses that are not deductible on our tax return, and some are temporary differences, such as depreciation expense. Temporary differences create deferred tax assets and liabilities. Deferred tax assets generally represent items that can be used as a tax deduction or credit in our tax return in future years for which we have already recorded the tax benefit in our consolidated statements of earnings. Deferred tax liabilities generally represent tax expense recognized in our consolidated financial statements for which payment has been deferred or expense has already been taken as a deduction on our tax return but has not yet been recognized as an expense in our consolidated statements of earnings. We periodically assess the recoverability of our deferred tax assets by considering whether it is more likely than not that some or all of the actual benefit of those assets will be realized. To the extent that realization does not meet the "more-likely-than-not" criterion, we establish a valuation allowance. At January 27, 2012, the valuation allowance recorded against our deferred tax asset arising from foreign net operating losses was $13.0 million. Our foreign net operating losses are not expected to be realized and consequently the associated valuation allowance has been created. Our expectations are based on projecting future taxable income which depend on our judgments of the trend and nature of our sales and operating expenses, including an evaluation of the potential effects of new markets, changing technology, patent protection, governmental reimbursement trends and regulatory trends, competition, healthcare reforms, overall economic conditions and the implementation of prudent and feasible tax planning strategies, if any.

Our estimated effective tax rate for the fiscal year ending April 27, 2012 is 40%, which is primarily due to our federal income tax rate of 35%, plus state and foreign income taxes. We expect our effective tax rate to fluctuate through the rest of fiscal year 2012 and fiscal year 2013, due primarily to the potential impact of expected tax benefit "shortfalls," which are driven by the fair value of the option or restricted stock, the strike price of the option, the market price on the exercise date, the number of shares transacted and the number of shares expired or cancelled. Therefore, future shortfalls and our effective tax rate may vary significantly.

Derivatives

We can be exposed to certain foreign currency risks relating to our ongoing business operations. During the quarter ended January 27, 2012, we entered into a €11.5 million foreign currency forward derivative contract with a major international bank. We enter into foreign currency forward contracts to partially limit our exposure to foreign currency exchange gains and losses generated by certain of our foreign currency denominated assets and there can be no assurance that our derivative policy will offset more than a portion of the financial impact resulting from movements in foreign currency exchange rates. Due to the settlement of our primary foreign currency position during the quarter ended January 27, 2012, we do not expect to enter into a new foreign currency forward contract for our quarter ending April 27, 2012.


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Results of Operations

Net Sales

The table below illustrates comparative net product revenue and unit sales by
geographic area and our licensing revenues. Product shipped to destinations
outside the U.S. is classified as "International" sales, (in thousands, except
unit sales and percentages):

                                         For the Thirteen Weeks Ended
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