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ELGX > SEC Filings for ELGX > Form 10-K on 14-Mar-2013All Recent SEC Filings

Show all filings for ENDOLOGIX INC /DE/ | Request a Trial to NEW EDGAR Online Pro

Form 10-K for ENDOLOGIX INC /DE/


14-Mar-2013

Annual Report


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

The following discussion and analysis should be read in conjunction with "Selected Financial Data" and our consolidated financial statements and the related notes included in this Annual Report on Form 10-K. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those anticipated in the forward-looking statements as a result of various factors including the risks we discuss in Item 1A of Part I, "Risk Factors" and elsewhere in this Annual Report on Form 10-K.

Overview
Our Business
Our corporate headquarters and manufacturing facility is located in Irvine, California. We develop, manufacture, market, and sell innovative medical devices for the treatment of aortic disorders. Our principal product is a stent graft and delivery catheter for the treatment of abdominal aortic aneurysms ("AAA") through minimally-invasive endovascular repair.
We sell our products through (i) our direct U.S. and European sales forces and
(ii) third-party distributors in Europe, Asia, Latin America, and in other parts of the world.

See Item 1., "Business," for a discussion of:
• Market Overview and Opportunity

• Our Products

• Manufacturing and Supply

• Marketing and Sales

• Competition

• Clinical Trials and Product Developments

2012 Overview
2012 was an important year of revenue growth, business expansion, and infrastructure development. We continued to gain market share in the U.S., while also building our direct sales operations in Europe. Combined with good results in other international markets, we achieved 27% annual revenue growth. We also made substantial progress with our new product pipeline, positioning us for several product launches in 2013.
Characteristics of Our Revenue and Expenses Revenue
Revenue is derived from sales of our ELG System (including extensions and accessories) to hospitals upon completion of an EVAR procedure, or from sales to distributors upon title transfer (which is typically at shipment), provided our other revenue recognition criteria have been met. Cost of Goods Sold
Cost of goods sold includes compensation (including stock-based compensation) and benefits of production personnel and production support personnel. Cost of goods sold also includes depreciation expense for production equipment, production materials and supplies expense, allocated facilities-related expenses, and certain direct costs such as shipping. Research and Development
Research and development expenses consist of compensation (including stock-based compensation) and benefits for research and development personnel, materials and supplies, research and development consultants, and allocated facilities-related costs. Our research and development activities primarily relate to the development and testing of new devices and methods to treat aortic disorders. Clinical and Regulatory
Clinical and regulatory expenses consist of compensation (including stock-based compensation) and benefits for clinical and regulatory personnel, regulatory and clinical payments related to studies, and allocated facilities-related costs. Our clinical and regulatory activities primarily relate to studies in order to gain regulatory approval for the commercialization of our devices. Sales and Marketing
Sales and marketing expenses primarily consist of compensation (including stock-based compensation) and benefits for our sales force, sales support, and marketing personnel. It also includes costs attributable to marketing our products to our customers and prospective customers. General and Administrative
General and administrative expenses primarily include compensation (including stock-based compensation) and benefits for personnel that support our general operations such as information technology, executive management, financial accounting, customer service, and human resources. General and administrative expenses also include bad debt expense, patent and legal fees, financial audit fees, insurance, recruiting fees, other professional services, and allocated facilities-related expenses.
Critical Accounting Policies and Estimates The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, and the disclosure of contingent assets and liabilities as of the date of the financial statements and the reported amounts of revenue and expenses during the periods presented. While management believes these estimates are reasonable and consistent, they are by their very nature, estimates of amounts that will depend on future events. Accordingly, actual results could differ from these estimates. Our Audit Committee of the Board of Directors periodically reviews our significant accounting policies. Our critical accounting policies arise in conjunction with the following:
•Revenue recognition and accounts receivable
•Inventory - lower of cost or market
•Goodwill and intangible assets - impairment analysis
•Income taxes
•Stock-based compensation
•Contingent consideration for business acquisition
•Litigation accruals Revenue Recognition and Accounts Receivable We recognize revenue when all of the following criteria are met:

•We have appropriate evidence of a binding arrangement with our customer;
•The sales price for our ELG System (including extensions and accessories) is established with our customer;
•Our ELG System has been used by the hospital in an EVAR procedure, or our distributor has assumed title with no right of return, as applicable; and
•Collection from our customer is reasonably assured at the time of sale. For sales made to a direct customer (i.e., hospitals), we recognize revenue upon completion of an EVAR procedure, when our ELG Device is implanted in a patient. For sales to distributors, we recognize revenue at the time of title transfer, which is typically at shipment. We do not offer any right of return to our customers, other than honoring our standard warranty. In the event that we enter into a bill and hold arrangement with our customer, which is uncommon for us, though occurred in 2012 (as discussed in Note 7 to accompanying Consolidated Financial Statements), the following conditions must be met for revenue recognition:
(i) The risks of ownership must have passed to our customer;

(ii) The customer must have made a fixed and written commitment to purchase the ELG Systems;

(iii) The customer must request that the transaction be on a bill and hold basis;

(iv) There must be a fixed schedule for delivery of the ELG Systems. The date for delivery must be reasonable and must be consistent with the customer's business purpose;

(v) We have no remaining specific performance obligations and our earnings process is complete;

(vi) Our customer's ordered ELG Systems must be segregated from our inventory and cannot be used to fulfill other customer orders; and

(vii) The ELG Systems must be complete and ready for shipment.

In addition to the above requirements, we also consider other pertinent factors prior to our recognition of revenue for bill and hold arrangements, such as:
(i) The date by which we expect payment, and whether we have modified our normal billing and credit terms for the customer;

(ii) Our past experiences with, and pattern of, bill and hold transactions;

(iii) Whether the customer has the expected risk of loss in the event of a decline in the market value of the ELG Systems;

(iv) Whether our custodial risks are insurable and insured; and

(v) Whether extended procedures are necessary in order to assure that there are no exceptions to the customer's commitment to accept and pay for the ELG Systems (i.e., that the business reasons for the bill and hold have not introduced a contingency to the customer's commitment).

We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to pay amounts due. These estimates are based on our review of the aging of customer balances, correspondence with the customer, and the customer's payment history.
Inventory - Lower of Cost or Market
We adjust our inventory value for estimated amounts of obsolete or unmarketable items. Such assumptions involve projections of future customer demand, as driven by economic and market conditions, and the product's shelf life. If actual demand, or economic or market conditions are less favorable than those projected by us, additional inventory write-downs may be required. Goodwill and Intangible Assets - Impairment Analysis Goodwill and other intangible assets with indefinite lives are not subject to amortization, but are tested for impairment annually as of June 30, or whenever events or changes in circumstances indicate that the asset might be impaired.
We evaluate the possible impairment (i) if/when events or changes in circumstances occur that indicate that the carrying value of assets may not be recoverable; or (ii) in the case of goodwill and indefinite lived intangible assets, our annual impairment assessment date of June 30. Income Taxes
Our consolidated balance sheets reflect net deferred tax assets that primarily represent the tax benefit of net operating loss carryforwards and credits and timing differences between book and tax recognition of certain revenue and expense items, net of a valuation allowance. When it is more likely than not that all or some portion of deferred tax assets may not be realized, we establish a valuation allowance for the amount that may not be realized. Each quarter, we evaluate the need to retain all or a portion of the valuation allowance on our net deferred tax assets. Our evaluation considers historical earnings, estimated future taxable income and ongoing prudent and feasible tax planning strategies. Adjustments to the valuation allowance increase or decrease net income or loss in the period such adjustments are made. If our estimates require adjustments, it could have a significant impact on our consolidated financial statements.
Changes in tax laws and rates could also affect recorded deferred tax assets in the future. Management is not aware of any such changes that would have a material effect on our consolidated financial statements. Stock-Based Compensation
We recognize stock-based compensation expense for employees over the equity award vesting period, based on its fair value at the date of grant. For awards granted to consultants, the award is marked-to-market each reporting period, with a corresponding adjustment to stock-based compensation expense. The fair value of equity awards that are expected to vest is amortized on a straight-line basis over (i) the requisite service period or (ii) the period from grant date to the expected date of the completion of the performance condition for vesting of the award. Stock-based compensation expense recognized is net of an estimated forfeiture rate, which is updated as appropriate.
We use the Black-Scholes option pricing model to value stock option grants. The Black-Scholes option pricing model requires the input of highly subjective assumptions, including the expected volatility of our common stock, expected risk-free interest rate, and the option's expected life.
A portion of restricted stock vesting is dependent on us achieving certain regulatory and financial milestones. We use significant judgment in estimating the likelihood and timing of achieving these milestones. Each period, we will reassess the likelihood and estimate the timing of reaching these milestones, and will adjust expense accordingly.
Contingent Consideration for Business Acquisition We determine the fair value of contingently issuable common stock related to the Nellix acquisition using a probability-based income approach using an appropriate discount rate . Changes in the fair value of the contingently issuable common stock are determined each period end and recorded in the other income (expense) section of the Consolidated Statements of Operations and Comprehensive Income (Loss) and the non-current liabilities section of the Consolidated Balance Sheet.
Litigation Accruals

From time to time we are involved in various claims and legal proceedings of a nature considered normal and
incidental to our business. These matters may include product liability, intellectual property, employment, and other general claims. We accrue for contingent liabilities when it is probable that a liability has been incurred and the amount can be reasonably estimated. The accruals are adjusted periodically as assessments change or as additional information becomes available.

Results of Operations

Operations Overview - 2012, 2011, and 2010 The following table presents our results of continuing operations and the related percentage of the period's revenue (in thousands):

                                                      Year Ended December 31,
                                     2012                       2011                      2010
Revenue                    $ 105,946       100.0  %   $  83,417       100.0  %   $  67,251      100.0  %
Cost of goods sold            25,282        23.9  %      18,746        22.5  %      15,030       22.3  %
Gross profit                  80,664        76.1  %      64,671        77.5  %      52,221       77.7  %
Operating expenses:
Research and development      16,571        15.6  %      16,738        20.1  %       8,997       13.4  %
Clinical and regulatory
affairs                        6,343         6.0  %       4,439         5.3  %       2,169        3.2  %
Marketing and sales           53,953        50.9  %      44,655        53.5  %      31,869       47.4  %
General and administrative    20,266        19.1  %      15,525        18.6  %      13,410       19.9  %
Contract termination and
business acquisition
expenses                         422         0.4  %       1,730         2.1  %           -          -  %
   Settlement costs            5,000         4.7  %           -           -  %           -          -  %
Total operating expenses     102,555        96.8  %      83,087        99.6  %      56,445       83.9  %
Loss from operations         (21,891 )     (20.7 )%     (18,416 )     (22.1 )%      (4,224 )     (6.3 )%
Total other expense          (13,352 )     (12.6 )%     (10,400 )     (12.5 )%        (160 )     (0.2 )%
Net loss before income tax   (35,243 )     (33.3 )%     (28,816 )     (34.5 )%      (4,384 )     (6.5 )%
Income tax (expense)
benefit                         (531 )      (0.5 )%          86         0.1  %      15,037       22.4  %
Net income (loss)          $ (35,774 )     (33.8 )%   $ (28,730 )     (34.4 )%   $  10,653       15.8  %

Year Ended December 31, 2012 versus December 31, 2011 Revenue
Year Ended December 31,
2012 2011 Variance Percent Change

(in thousands)

Revenue $ 105,946 $ 83,417 $ 22,529 27.0 %

Our 27.0% revenue increase of $22.5 million over the prior year period resulted from:

(i) $15.4 million increase in U.S. sales due to the (a) expansion of our U.S. sales force through the addition of clinical specialists that exclusively provide field support to our sales representatives, having the impact of increasing overall sales force productivity and (b) the continued market traction of AFX, which was launched in the U.S. in August 2011;

(ii) $4.2 million increase in European sales due to our transition from a third-party distributor to a direct sales organization beginning in September 2011; and

(iii) $2.9 million increase in ROW sales. ROW sales growth is attributable to the July 2012 launch of AFX in Brazil and Argentina, and IntuiTrak orders by our distributor in Japan (in anticipation of its Japanese regulatory approval, which was received in December 2012).
Cost of Goods Sold, Gross Profit, and Gross Margin Percentage

                                                 Year Ended December 31,
                                                  2012              2011         Variance     Percent Change
                                                      (in thousands)
Cost of goods sold                           $     25,282       $    18,746     $ 6,536              34.9 %
Gross profit                                       80,664            64,671      15,993              24.7 %
Gross margin percentage (gross profit as a
percent of revenue)                                  76.1 %            77.5 %      (1.4 )%

The $6.5 million increase in cost of goods sold was driven by our revenue increase of $22.5 million.

Gross margin for the year ended December 31, 2012 decreased to 76.1% from 77.5% for the twelve months ended December 31, 2011. This decrease is primarily due to
(i) a greater proportion of the total revenue being derived from international sales in 2012 (which have an average sales price below the U.S. sales price);
(ii) royalty expenses which were not present for the full prior year period; and
(iii) a decline in the average value of the Euro relative to the U.S. dollar in 2012 from 2011. These unfavorable gross margin items were partially offset by a greater proportion of our current period revenue derived from direct sales, as opposed to distributor sales, which typically have a higher average sales price.

Operating Expenses
                                            Year Ended December 31,
                                             2012             2011          Variance     Percent Change
                                                (in thousands)
Research and development                $      16,571     $    16,738     $     (167 )         (1.0 )%
Clinical and regulatory affairs                 6,343           4,439          1,904           42.9  %
Marketing and sales                            53,953          44,655          9,298           20.8  %
General and administrative                     20,266          15,525          4,741           30.5  %
Contract termination and business
acquisition expenses                              422           1,730         (1,308 )        (75.6 )%
Settlement costs                                5,000               -          5,000          100.0  %

Research and Development. The $0.2 million decrease in research and development expenses was primarily driven by decreasing Ventana development activities, as this device reaches the final stages of development and progresses towards production and commercialization. This decrease was partially offset by a $1.0 million purchase in the current period of an exclusive license to patents covering the polymer used in our Nellix System.
Clinical and Regulatory Affairs. The $1.9 million increase in clinical affairs was primarily driven by the continued enrollment and follow-up costs associated with our PEVAR and Ventana clinical trials and our efforts to achieve CE Mark approval of Ventana and the Nellix System.
Marketing and Sales. The $9.3 million increase in marketing and sales expenses was primarily related to marketing costs to support the growth of our U.S. business, costs related to our direct sales force in Europe (which was largely not present in the prior year period), and an increase in variable compensation expense of $1.2 million, driven by an increase in U.S. revenue of 21%. General and Administrative. The $4.7 million increase in general and administrative expenses is attributable to (i) additional personnel to support our business growth; (ii) increased travel expenses associated with the expansion of our European operations; and (iii) professional service fees to develop our global legal structure.

Contract Termination and Business Acquisition Expenses. Current period expense of $0.4 million is associated with professional fees incurred as part of the July 2012 acquisition of our Italian distributor's business. In the prior year period we early terminated a distribution agreement with two former European distributors for aggregate termination fees of $1.7 million. These actions allowed us to begin selling our products through our direct sales force in most of western Europe, beginning September, 2011, and in Italy, beginning July, 2012.

Settlement Costs. Settlement costs of $5.0 million in the current period represents our payment in full to settle a patent dispute with Cook Incorporated.

Provision for Income Taxes
                                   Year Ended December 31,
                                    2012              2011        Variance
                                       (in thousands)
Income tax (expense) benefit          (531 )       $       86    $    (617 )

For the twelve months ended December 31, 2012, our provision for income taxes was $0.5 million and our effective tax rate was 1.5% for the year ended December 31, 2012. During the twelve months ended December 31, 2012, we had operating legal entities in the U.S., Italy, and The Netherlands (plus registered sales branches of our Dutch entity in certain countries in Europe). We had a single operating legal entity in the U.S. during the prior year period until September 2011, when we formed operating legal entities in The Netherlands to begin direct sales activity in Europe. Accordingly, we have certain minimum tax liabilities attributable to our operations in these countries in 2012 that were not present in 2011.

Year Ended December 31, 2011 versus December 31, 2010 Revenue
Year Ended December 31,
2011 2010 Variance Percent Change

(in thousands)

Revenue $ 83,417 $ 67,251 $ 16,166 24.0 %

Our 24% revenue increase primarily resulted from an increase in U.S. sales due to (i) the expansion of our sales force, (ii) the successful market introduction of additional ELG Device sizes and extensions (beginning in the second half of 2010), and (iii) the successful launch of AFX in August 2011. Though our overall revenue growth was driven by U.S. sales, it was partially offset by our decrease in European sales.
From January 1, through August 31, 2011 (and all prior periods), our European sales were solely derived from independent distributors. From September 1, 2011 through December 31, 2011, our European sales were derived from (i) our developing direct European sales force serving the markets of Austria, Belgium, the Czech Republic, Denmark, France, Germany, Luxemburg, The Netherlands, Romania, Sweden, Switzerland, and the United Kingdom (excluding Northern Ireland), and (ii) four independent distributors serving the markets in Italy, Greece, Turkey, and Ireland.
Cost of Goods Sold, Gross Profit, and Gross Margin Percentage

                                                 Year Ended December 31,
                                                   2011             2010        Variance     Percent Change
                                                      (in thousands)
Cost of goods sold                            $     18,746       $  15,030     $ 3,716              24.7 %
Gross profit                                        64,671          52,221      12,450              23.8 %
Gross margin percentage (gross profit as a
percent of revenue)                                   77.5 %          77.7 %      (0.2 )%

The $3.7 million increase in cost of goods sold was driven by an increase in revenue of $16.2 million. Gross margin for twelve months ended December 31, 2011 remained consistent with the prior year.

Operating Expenses
                                               Year Ended December 31,
                                                 2011             2010         Variance      Percent Change
                                                    (in thousands)
Research and development                    $      16,738     $    8,997     $    7,741             86.0 %
Clinical and regulatory affairs                     4,439          2,169          2,270            104.7 %
Marketing and sales                                44,655         31,869         12,786             40.1 %
General and administrative                         15,525         13,410          2,115             15.8 %
Contract termination and business
acquisition expenses                                1,730              -          1,730            100.0 %

Research and Development. The $7.7 million increase in research and development expenses was primarily driven by development activities related to the Nellix System, which represented an increase of $7.1 million of total research and development expenses for the year ended December 31, 2011. The remaining increase in research and development, as compared to 2010, is related to services and materials for general research and development activities for our other projects, including Ventana.
Clinical and Regulatory Affairs. The $2.3 million increase in clinical affairs expenses was primarily driven by the continued enrollment and follow up costs associated with our PEVAR clinical trial.
Marketing and Sales. The $12.8 million increase in marketing and sales expenses for the twelve months ended December 31, 2011 as compared to 2010 was primarily related to additional sales personnel related costs. We experienced an increase in variable compensation expense associated with our 29% increase in U.S. revenue for the twelve months ended December 31, 2011, as compared to the prior year. We also had an increase in marketing costs associated with driving U.S. sales growth, and incurred $1.2 million of incremental expenses in 2011 to build our direct sales force in Europe.
General and Administrative. The $2.1 million increase in general and administrative expenses was primarily related to an increase of (i) $1.2 million in legal costs associated with patent disputes; (ii) $0.2 million in consulting and professional services; (iii) $0.1 million in bank fees; (iv) $0.4 million increase in various costs to enhance our information technology infrastructure; and (v) $2.1 million increase in additional personnel costs, including recruitment and relocation expenses to support our U.S. and European business growth. These increases were partially offset by $3.0 million of Nellix acquisition costs that only arose in the prior year.
Contract termination and business acquisition expenses. Upon mutual agreement, we terminated a European distribution agreement, effective September 1, 2011. In connection therewith, we were contractually required to pay this distributor $1.3 million in order to start directly marketing and selling our products within certain Western European countries. Additionally, upon mutual agreement, we early terminated a distribution agreement with an Italian distributor, effective March 31, 2011. We were contractually required to pay this distributor $0.4 million as part of the transfer of distribution rights to another Italian distributor.

Liquidity and Capital Resources
The chart provided below summarizes selected liquidity data and metrics as of December 31, 2012 and December 31, 2011:

                                                        December 31, 2012      December 31, 2011
                                                         (in thousands, except financial metrics
                                                                          data)
Cash and cash equivalents                               $         45,118     $            20,035
Accounts receivable, net                                $         22,600     $            15,542
Total current assets                                    $         87,567     $            55,104
Total current liabilities                               $         17,194     $            13,949
Working capital surplus (a)                             $         70,373     $            41,155
Days sales outstanding ("DSO") (b)                                    71                      61
Current ratio (c)                                                    5.1                     4.0

. . .

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