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CYBX > SEC Filings for CYBX > Form 10-Q on 19-Nov-2012All Recent SEC Filings

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Form 10-Q for CYBERONICS INC


19-Nov-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;
- 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 obtain insurance coverage and reimbursement for our depression indication;
- 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, including the development of superior or alternative technology or devices by competitors;
- 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;
- Continued volatility in the global market and worldwide economic conditions; and
- Changes in tax laws or exposure to additional income tax liabilities.


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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 27, 2012, ("2012 Form 10-K"), (3) our reports and registration statements filed and furnished from time to time with the U.S. Securities and 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 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 twenty-six weeks ended October 26, 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 2012 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;
- equipment to assist with the implant procedure;
- equipment to assist the treating physician with setting the stimulation parameters for each patient;
- instruction manuals; and
- magnets to temporarily suspend or induce stimulation manually.

The VNS Therapy pulse generator and lead are surgically implanted, 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.

We sell the VNS Therapy System for refractory epilepsy to hospitals and ambulatory surgery centers ("ASCs") on payment terms that are generally 30 days from the shipment date. In addition to maintaining regulatory approval, 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. This coverage allows our customers to invoice and be paid by third-party payers. 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. In November 2012, CMS announced calendar year 2013 final reimbursement rates, which increased over the calendar year 2012 rates by 5.7% for full systems, 7.9% for generator-only replacements and by more than 200% for lead replacement surgeries.

There can be no assurance that future changes to CMS reimbursement will not have an adverse effect on our future operating results. Any decrease in reimbursement rates or change in reimbursement methodology by CMS could have an adverse impact on our business and our future operating results.

We continue to invest in 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 technology, wireless communication technology and improved lead technology. We also continue to fund and develop other devices that support our focus on device solutions for epilepsy management, such as seizure monitoring, logging and notification technology using external heart monitoring and movement-related sensor advancements. In addition, we are investing in a pilot study related to the use of VNS Therapy for the treatment of chronic heart failure.

In August 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 and withdrew the generators from the field.

In December 2011, the FDA approved our re-designed AspireHC generator, and we resumed full 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 April 2011, we commenced a European clinical trial (designated "E-36") to support regulatory approval in Europe of our AspireSR generator. 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; however, we re-submitted the appropriate applications to re-start this trial in June 2012 and we continue to enroll patients. In September 2012, we submitted to the FDA an Investigational Device Exemption ("IDE") request for the purpose of conducting a U.S. pilot study for the AspireSR generator (designated "E-37"). The IDE was conditionally approved in October 2012, and we are initiating study start-up activities, including investigator qualification, clinical study agreements and Institutional Review Board approvals.

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:


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- 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 April 2012, we received notification from the FDA that we had fulfilled all study requirements related to the dosing study. Based on the results of the post-approval dosing study, our objective is to submit a request for reconsideration of the non-coverage decision issued by the CMS in May 2007 with the objective of obtaining coverage and reimbursement in depression, although there can be no assurance that this objective will be met. A determination by CMS not to approve our request for reconsideration or not to reverse its non-coverage decision could have a material negative impact on our stock price.

- 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 were 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, and as a result, we discontinued paying this royalty after the expiration date. As a result of the epilepsy patent expiration in the U.S., it is possible that one or more competitors may enter the U.S. market. The epilepsy patent expired in Europe five years ago; we are aware of five competitive medical devices approved for sale in the European market. We invested in one of the European competitors, Cerbomed GmbH ("Cerbomed"). Cerbomed is a privately-held, development-stage company working on a transcutaneous vagus nerve stimulation device for the treatment of epilepsy. We do not have indication-specific patent coverage for vagus nerve stimulation for epilepsy or for neuropsychiatric disorders (depression) in the U.S. or Europe.

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 investment agreements that may involve substantial future payments; see "Note 16. Commitments and Contingencies - License Agreements" in our condensed consolidated financial statements for additional information.

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, and we currently occupy approximately 80% of this space.

In order to accommodate expected growth of our business, we have created the following subsidiaries: Cyberonics Holdings LLC, CYBX Netherlands C.V., Cyberonics Spain, S.L. and Cyberonics Latam S.R.L. In September 2012, our new subsidiary, Cyberonics, Latam S.R.L., contracted to purchase land and construct a manufacturing facility in Costa Rica. We intend for this facility to manufacture product for our international markets and to be completed in fiscal year 2014 and operational in fiscal year 2015.


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We lease a 19,800 square foot Austin, Texas facility that we utilize for warehousing and distribution. In addition, as part of our planning to move our Brussels, Belgium offices to a new building by the end fiscal year 2013, we committed to a new nine-year lease beginning in March 2013.

During the quarter ended July 27, 2012, we determined that the fair value of our investment in NeuroVista's convertible debt security had fallen below the carrying value. Based upon our fair value review, we recorded an other-than-temporary impairment loss in the condensed consolidated statement of income of $4.1 million.

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 2012 Form 10-K.

The preparation of our condensed consolidated financial statements, in conformity with U.S. GAAP, requires us to make estimates and assumptions that affect the amounts reported in our condensed 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, inventory valuation, useful lives for property and equipment, sales returns and allowances, and recognition of licensing revenue, as well as the following:

Intangible Assets

Intangible assets, as shown on the condensed consolidated balance sheets, consist of purchased licenses of patents and technology rights that we have acquired to develop and maintain our competitive position. The patent and technology rights we have purchased pertain primarily to seizure detection, wireless communication, rechargeable battery technology, external charging accessory hardware and associated software, a MRI-compatible implantable lead and microprocessor technologies. We amortize our intangible assets on a straight-line basis, over an average period of 11 years, beginning with the effective date of the license agreement and ending with the shorter of either the expiration of the patent or license or the estimated useful life of the product. We evaluate our intellectual property each reporting period to determine whether events and circumstances warrant either a different amortization period or impairment. The intangible asset is impaired if the technology no longer factors into our product commercialization plans or the carrying value exceeds future cash flows. The risks associated with achieving commercialization include, but are not limited to, failure of the acquired technology to function as planned, failure to obtain regulatory approvals, failure of clinical trials, failure to obtain third-party reimbursement and patent litigation. Amortization and impairment are subject to a high degree of estimation and management judgment. 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. The carrying value of our intangible assets amounted to $6.6 million at October 26, 2012.


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Investments in Debt and Equity Securities

We have invested in three privately-held, development-stage medical device companies, with a total carrying value of approximately $8.0 million as of October 26, 2012. The first investment is a convertible debt instrument, which we account for at fair value as an available-for-sale debt security. During the quarter ended July 27, 2012, we determined that the fair value of this investment was below the carrying value and recorded an other-than-temporary impairment loss of $4.1 million in the condensed consolidated statement of income. The second and third investments consist of preferred shares accounted for under the cost method. If we identify events or changes in circumstances that indicate a decrease in value of these cost-method investments that is other-than-temporary, we recognize a loss. Fair value and impairment loss adjustments are subject to a high degree of management judgment as these investments do not have quoted market prices. We cannot guarantee that our investments will be successful or that further impairments will not adversely affect our consolidated balance sheets, statements of income or cash flows. See "Note 6. Long-Term Investments in Debt and Equity Securities" and "Note 15. Fair Value Measurements" for further details of these investments.

Stock-Based Compensation

Market and Performance-Based Restricted Stock and Performance-Based Restricted Stock Units. We grant restricted stock and restricted stock unit awards that vest based on the satisfaction of market or performance conditions. The fair market values of market condition-based awards are determined using the Monte Carlo simulation method. The Monte Carlo simulation method is subject to variability as several factors utilized must be estimated, including the derived service period estimate based on our judgment of likely future performance and our stock price volatility. The fair value of performance-based awards is based on the market closing price of our common stock on the grant date. Compensation expense for performance-based awards is estimated based on our judgment of likely future performance and may be adjusted significantly in future periods, depending on actual performance.

Recognized compensation cost for performance-based and market-based restricted stock and restricted stock unit awards for the twenty-six weeks ended October 26, 2012 and October 28, 2011 was $6.8 million and $5.6 million, respectively.

Income taxes

Our effective tax rate is based on income, statutory tax rates, and permanent differences. 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, 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 the fiscal year 1992 and subsequent years, with certain exceptions. During the quarter ended October 26, 2012, we agreed upon adjustments with the Internal Revenue Service ("IRS") in connection with our fiscal years ended April 24, 2009 and April 30, 2010. These adjustments did not materially impact our financial statements. In addition, during the quarter ended October 26, 2012, we were notified that our European subsidiary, Cyberonics Europe BVBA, is under examination by the Belgium tax authority with respect to transfer pricing. This audit has just begun and we are unable to assess the impact it may have on our consolidated financial statements, but it appears there will be no material impact to our financial statements


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Our effective tax rate for the thirteen and twenty-six weeks ended October 26, 2012 was 36.4% and 37.4%, respectively, which was primarily due to our federal income tax rate of 35%, plus state and foreign income taxes, and permanent differences including the non-taxability of the gain on the warrants, refer to "Note 8. Warrants" in the Notes to Condensed Consolidated Financial Statements for a description of the warrants. This rate does not include the impact of the federal research and development tax credit because the credit has not yet been extended for calendar year 2012.

Restricted stock, restricted stock units and stock options vested or were exercised during the thirteen and twenty-six weeks ended October 26, 2012. The difference between the tax deduction on the vesting or exercise date and the financial statement expense creates an excess tax benefit (windfall) or tax deficiency (shortfall). If a windfall benefit can be utilized to reduce income taxes payable, the windfall benefit will offset the shortfall deficiency; if not, then the shortfall is recognized as a discrete item in the quarter in which it occurs. Due to our net operating losses and the utilization of net operating loss carryforwards, prior to the quarter ended July 27, 2012, we were unable to offset shortfalls with windfalls and were required to recognize shortfalls as a discrete tax expense in the quarter in which they occur. For the fiscal year ending April 26, 2013, we are forecasting the utilization of windfall benefits to offset income taxes payable; therefore, shortfalls should have no impact on the effective tax rate.

As of the quarter ended October 26, 2012, we have not provided for U.S. income taxes for the undistributed earnings of our foreign subsidiaries. These earnings, while not material to our consolidated statement of income, are intended to be permanently reinvested outside the United States.

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
                                         October 26, 2012       October 28, 2011         % Change
Net Product Sales by Geographic Area:
U.S.                                    $        51,503       $           44,684             15.3%
International                                    11,079                    8,638             28.3%
Total net product sales                 $        62,582       $           53,322             17.4%

Unit Sales by Geographic Area:
U.S.                                              2,339                    2,091             11.9%
International                                       891                      693             28.6%
Total unit sales                                  3,230                    2,784             16.0%

Licensing Revenue                       $           373       $              373              0.0%



                                                       For the Twenty-Six Weeks Ended
                                         October 26, 2012        October 28, 2011         % Change
. . .
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