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IRIX > SEC Filings for IRIX > Form 10-K on 28-Mar-2013All Recent SEC Filings

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Form 10-K for IRIDEX CORP


28-Mar-2013

Annual Report


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

Overview

IRIDEX Corporation is a leading worldwide provider of therapeutic based laser systems, delivery devices and consumable instrumentation used to treat sight-threatening eye diseases in ophthalmology. In February 2012, we sold our aesthetics business to Cutera, Inc. We view this as a significant step forward in our strategy because it allows us to focus solely on our ophthalmology business which is our core strength. Management believes that this path affords the Company with the best opportunity for long term profitable growth. In accordance with US GAAP we have disclosed the financial results from our aesthetics business as discontinued operations. This discussion and analysis will focus primarily on our ophthalmology business because this is our continuing business and therefore provides more relevant information to the reader of our financial statements both on a retrospective and prospective basis. Our ophthalmology products are sold in the United States predominantly through a direct sales force and internationally through approximately 70 independent distributors into over 100 countries.

We manage and evaluate our business in one segment - ophthalmology. We break down this segment by geography - Domestic (U.S.) and International (the rest of the world). In addition, we review trends by laser system sales (consoles and durable delivery devices) and recurring sales (single use consumable laser probes and other associated instrumentation ("consumables"), service and support).

Our ophthalmology revenues arise primarily from the sale of our IQ and OcuLight laser systems, consumables and service and support activities. Our current family of IQ products includes IQ 532, IQ 577 and IQ 810 laser photocoagulation systems and our OcuLight products include OcuLight TX, OcuLight Symphony (Laser Delivery System), OcuLight SL, OcuLight SLx, OcuLight GL and OcuLight GLx laser photocoagulation systems. Certain of our laser systems are capable of performing traditional continuous wavelength photocoagulation and our patented Fovea-Friendly MicroPulse laser photocoagulation. Towards the end of 2012, we introduced the TxCell Scanning Laser Delivery System which saves significant time in a variety of laser photocoagulation procedures in allowing physicians to deliver the laser in a multi-spot scanning mode, a more efficient method for these procedures than the traditional single spot mode. Our current family of laser probes includes a wide variety of products in 20, 23 and 25 gauge for vitreoretinal surgery and glaucoma surgery.

Sales to international distributors are made on open credit terms or letters of credit and are currently denominated in U.S. dollars and accordingly, are not subject to risks associated with currency fluctuations.


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Cost of revenues consists primarily of the cost of purchasing components and sub-systems, assembling, packaging, shipping and testing components at our facility, direct labor and associated overhead; warranty, royalty and amortization of intangible assets; and depot service costs.

Research and development expenses consist primarily of personnel costs, materials to support new product development and research support provided to clinicians at medical institutions developing new applications which utilize our products; and regulatory expenses. Research and development costs have been expensed as incurred.

Sales and marketing expenses consist primarily of costs of personnel, sales commissions, travel expenses, advertising and promotional expenses.

General and administrative expenses consist primarily of costs of personnel, legal, accounting and other public company costs, insurance and other expenses not allocated to other departments.

Results of Operations - 2012, 2011 and 2010

Our fiscal year ends on the Saturday closest to December 31. Fiscal 2012 ended on December 29, 2012, fiscal 2011 ended on December 31, 2011, and fiscal 2010 ended on January 1, 2011. Fiscal years 2012, 2011 and 2010 each included 52 weeks of operations.

The following table sets forth certain data from continuing operations as a percentage of revenue from continuing operations for the periods indicated.

                                                             Percentage of Revenue
                                                                  Years Ended
                                             FY 2012                FY 2011                FY 2010
                                          Dec 29, 2012           Dec 31, 2011            Jan 1, 2011
Revenues:
Total revenues                                    100.0 %                100.0 %                100.0 %
Cost of revenues                                   51.7                   50.9                   49.9

Gross margin                                       48.3                   49.1                   50.1

Operating expenses:
Research and development                           13.0                   11.8                   11.6
Sales and marketing                                23.3                   22.4                   21.9
General and administrative                         14.5                   12.8                   12.9
Legal settlement, net of expenses                   0.0                   (3.8 )                  0.0

Total operating expense                            50.8                   43.2                   46.4

(Loss) income from operations                      (2.5 )                  5.9                    3.7
Legal settlement                                    2.3                    2.4                    2.5
Interest and other expense, net                    (0.6 )                 (0.9 )                 (0.1 )

(Loss) income from continuing
operations before income taxes                     (0.8 )                  7.4                    6.1
(Benefit from) provision for
income taxes                                       (0.3 )                  0.9                    1.0

(Loss) income from continuing
operations, net of tax                             (0.5 )                  6.5                    5.1

(Loss) income from discontinued
operations, net of tax                             (0.8 )                  1.4                    4.3
Gain on sale of discontinued
operations, net of tax                              5.5                    0.0                    0.0

Income from discontinued
operations, net of tax                              4.7                    1.4                    4.3

Net income                                          4.2 %                  7.9 %                  9.4 %


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Comparison of 2012 and 2011

Revenues.

Total revenues from continuing operations for 2012 were $33.9 million compared with $33.2 million in 2011, an increase of $0.7 million or 2.1%. The increase was due primarily to our recurring revenues which improved as a result of the onset of revenues from the licensing and distribution agreement with Alcon. Competition for consumable products remains strong with increased price sensitivities amongst customers. Our ophthalmology system revenues remained consistent period to period. Our OEM revenue continued to decline as anticipated because this revenue is generated from a product that is now in its end of life phase.

(in millions)                         FY 2012          FY 2011          Change in $          Change in %
Ophthalmology systems -
domestic                             $     7.1        $     7.2        $        (0.1 )               (1.4 )%
Ophthalmology systems -
international                              9.4              9.3                  0.1                  1.1 %
Ophthalmology recurring
revenues                                  17.1             16.2                  0.9                  5.6 %
Ophthalmology OEM                          0.3              0.5                 (0.2 )              (40.0 )%

Continuing operations -
ophthalmology revenues               $    33.9        $    33.2        $         0.7                  2.1 %

Gross Profit.

Gross profit remained level at $16.3 million in 2012 as a result of a decrease in gross margin to 48.3% in 2012, from 49.1% in 2011. Direct margins for the year were comparable to 2011. The reduction in gross margin was primarily attributable to increased manufacturing and service costs. We have increased our investment in inventory during the year with the future objective of allowing us to run our production lines more linearly throughout any particular quarter and therefore more efficiently.

Research and Development.

Research and development expenses increased $0.5 million or 12.1%, from $3.9 million in 2011 to $4.4 million in 2012. The increase is attributable to increases in headcount and project material costs incurred in engineering development projects, and patent expenses as the Company continues to focus on new product introductions.

Sales and Marketing.

Sales and marketing expenses increased $0.4 million or 5.9%, from $7.5 million in 2011 to $7.9 million in 2012. The increase is primarily attributable to increased personnel costs associated with increased headcount and marketing programs.

General and Administrative.

General and administrative expenses increased $0.7 million or 15.7%, from $4.3 million in 2011 to $4.9 million in 2012. The increase in expenses was primarily attributable to employee severance and related costs taken as part of streamlining the Company's operations in the latter half of the year.

Other Income (expense).

The Company received the final annual installment of $0.8 million from the settlement with Synergetics of legal claims related to patent infringement which was consistent with the amount received in 2011. During 2012, the remeasurement on the fair value of the earn-out liability from prior acquisitions resulted in an expense of $0.2 million.

Income Taxes.

We recorded a benefit for income taxes of $0.1 million for continuing operations for the year ended December 29, 2012 compared to a provision for income taxes of $0.3 million for the year ended December 31,


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2011. The effective tax rate for the year ended December 29, 2012 was 37% compared to an effective tax rate of 12% for the year ended December 31, 2011. Our effective tax rate increased due mainly to the change from 2011 pretax income of $2.5 million to 2012 pretax loss of $0.3 million. As a result of the current year loss, the tax rate had also increased by a larger reduction in valuation allowance in the current year and the anticipated refund claim from carrying back tax loss to 2010 and 2011 for federal income tax purposes.

Comparison of 2011 and 2010

Revenues.

Total revenues from continuing operations for 2011 were $33.2 million compared with $32.3 million in 2010, an increase of $0.9 million or 2.8%. Our ophthalmology system revenues grew as a result of a resurgence in appreciation of the benefits of laser photocoagulation as a treatment modality amongst physicians and a recovery in capital spending particularly in the U.S. Competition for consumable products remains strong with increased price sensitivities amongst customers. Our OEM revenue is generated from a long standing relationship, the product is now in end of life and demand has and will continue to decline.

(in millions)                         FY 2011          FY 2010          Change in $          Change in %
Ophthalmology systems -
domestic                             $     7.2        $     6.2        $         1.0                 16.1 %
Ophthalmology systems -
international                              9.3              9.2                  0.1                  1.1 %
Ophthalmology recurring
revenues                                  16.2             16.2                  0.0                  0.0 %
Ophthalmology OEM                          0.5              0.7                 (0.2 )              (28.6 )%

Continuing operations -
ophthalmology revenues               $    33.2        $    32.3        $         0.9                  2.8 %

Gross Profit.

Gross profit increased $0.1 million from $16.2 million in 2010 to $16.3 million in 2011. The increase in gross profits was driven by increased revenues offset by a reduction in gross margins from 50.1% to 49.1%. The reduction in gross margin was primarily attributable to a decrease in direct margins as a result of increased sales of lower margin systems.

Research and Development.

Research and development expenses increased $0.2 million or 4.3%, from $3.8 million in 2010 to $3.9 million in 2011. The increase is attributable to increases in headcount and therefore personnel costs incurred in engineering development projects as the Company continues to focus on new product introductions.

Sales and Marketing.

Sales and marketing expenses increased $0.4 million or 5.1%, from $7.1 million in 2010 to $7.5 million in 2011. The increase is primarily attributable to increased personnel costs associated with increased headcount and marketing programs.

General and Administrative.

General and administrative expenses increased $0.1 million or 2.3%, from $4.2 million in 2010 to $4.3 million in 2011. Expenses were stable across the two periods.

Legal Settlement, net of expenses.

In November 2011, the Company entered into a license and distribution agreement with Alcon for the IRIDEX GreenTip SoftTip Cannula family of products. As part of the agreement Alcon agreed to pay


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$1.5 million at signing as a settlement of past legal claims. The Company has treated this as part of its ongoing business and therefore as part of operating income because the agreement has established on ongoing commercial relationship that will benefit the Company's continuing business in subsequent periods.

Other Income (expense).

Income from the settlement with Synergetics of legal claims related to patent infringement amounted to $0.8 million for both periods. During 2012, the remeasurement on the fair value of the earn-out liability from prior acquisitions resulted in expense of $0.3 million.

Income Taxes.

We recorded a provision for income taxes on continuing operations of $0.3 million and an effective tax rate of 12% for fiscal year 2011 similar to a provision for income taxes of $0.3 million and an effective tax rate of 16% for fiscal year 2010. Our tax rate is benefiting from a reduction in the valuation allowance we currently have booked against our deferred tax asset.

Liquidity and Capital Resources

Comparison of 2012 and 2011

Liquidity is our ability to generate sufficient cash flows from operating activities to meet our obligations and commitments. In addition, liquidity includes the ability to obtain appropriate financing or to raise capital. During 2012, net cash used in continuing operating activities was $1.1 million. The use of cash resulted primarily from a net loss from continuing operations of $0.2 million less changes in working capital of $2.4 million partially offset by certain non-cash items of $1.4 million. This compares to net cash provided by continuing operating activities in 2011 of $2.3 million which was generated from net income from continuing operations of $2.1 million with non-cash items of $1.1 million less changes in working capital of $1.0 million.

As of December 29, 2012, we had cash and cash equivalents of $11.9 million, no debt outstanding and working capital of $20.7 million compared with cash and cash equivalents of $10.8 million, no debt and working capital of $20.6 million as of December 31, 2011.

Management is of the opinion that the Company's current cash and cash equivalents together with our ability to generate cash flows from operations provide sufficient liquidity to operate for the next 12 months.

Comparison of 2011 and 2010

During 2011, net cash provided by operating activities was $2.3 million which was generated from net income from continuing operations of $2.1 million with non-cash items added back of $1.1 million less changes in working capital of $1.0 million. This compares to net cash provided by continuing operating activities in 2010 of $1.1 million which was generated from $1.7 million of net income from continuing operations with non-cash items added back of $0.8 million less changes in working capital of $1.3 million.


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Contractual Payment Obligations

Our contractual payment obligations that were fixed and determinable as of
December 29, 2012 were as follows (in thousands):



                                                      Payments Due by Period
                                        Total      < 1 year       1-3 years       3-5 years
  Operating leases payments            $ 1,674     $     748     $       925     $         1
  Total contractual cash obligations   $ 1,674     $     748     $       925     $         1

Critical Accounting Policies

Our consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets and liabilities, net sales and expenses, and the related disclosures. We base our estimates on historical experience, our knowledge of economic and market factors and various other assumptions we believe to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. We believe the following critical accounting policies are affected by significant estimates, assumptions, and judgments used in the preparation of our consolidated financial statements.

Discontinued Operations.

Discontinued operations are presented and accounted for in accordance with Accounting Standards Codification ("ASC") 360, Impairment or Disposal of Long-Lived Assets ("ASC 360"). When a qualifying component of the Company is disposed of or has been classified as held for sale, the operating results of that component are removed from continuing operations for all periods presented and displayed as discontinued operations if: (a) elimination of the component's operations and cash flows from the Company's ongoing operations has occurred (or will occur) and (b) significant continuing involvement by the Company in the component's operations does not exist after the disposal transaction.

On December 30, 2011, we entered into an agreement to sell our aesthetics business to Cutera, Inc. The sale of the aesthetics business was completed on February 2, 2012. The operating results of our aesthetics business were therefore classified as discontinued operations, and the associated assets and liabilities were classified as discontinued for all periods presented under the requirements of ASC 360.

Revenue Recognition.

Our revenues arise from the sale of laser consoles, delivery devices, consumables and service and support activities. Revenue from product sales is recognized upon receipt of a purchase order and product shipment provided that no significant obligations remain and collection of the receivables is reasonably assured. Shipments are generally made with Free-On-Board ("FOB") shipping point terms, whereby title passes upon shipment from our dock. Any shipments with FOB receiving point terms are recorded as revenue when the shipment arrives at the receiving point. Cost is recognized as product sales revenue is recognized. The Company's sales may include post-sales obligations for training or other deliverables. For revenue arrangements such as these, we recognize revenue in accordance with ASC 605, Revenue Recognition, Multiple-Element Arrangements. The Company allocates revenue among deliverables in multiple-element arrangements using the relative selling price method. Revenue allocated to each element is recognized when the basic revenue recognition criteria is met for each element. The Company is required to apply a hierarchy to determine the selling price to be used for allocating revenue to deliverables: (i) vendor-specific objective evidence of selling price ("VSOE"),
(ii) third-party evidence of selling price ("TPE") and (iii) best estimate of the selling price ("ESP"). In general, the Company is unable to establish VSOE or TPE for all of the elements in the arrangement; therefore, revenue is allocated to


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these elements based on the Company's ESP, which the Company determines after considering multiple factors such as management approved pricing guidelines, geographic differences, market conditions, competitor pricing strategies, internal costs and gross margin objectives. These factors may vary over time depending upon the unique facts and circumstances related to each deliverable. As a result, the Company's ESP for products and services could change. Revenues for post-sales obligations are recognized as the obligations are fulfilled.

In international regions, we utilize distributors to market and sell our products. We recognize revenue upon shipment for sales to these independent, third party distributors as we have no continuing obligations subsequent to shipment. Generally our distributors are responsible for all marketing, sales, installation, training and warranty labor coverage for our products. Our standard terms and conditions do not provide price protection or stock retention rights to any of our distributors.

Royalty revenues are typically based on licensees' net sales of products that utilize our technology and are recognized as earned in accordance with the contract terms when royalties from licensees can be reliably measured and collectibility is reasonably assured, such as upon the earlier of the receipt of a royalty statement from the licensee or upon payment by the licensee.

Inventories.

Inventories are stated at the lower of cost or market and include on-hand inventory physically held at the Company's facility, sales demo inventory and service loaner inventory. Cost is determined on a standard cost basis which approximates actual cost on a first-in, first-out ("FIFO") method. Lower of cost or market is evaluated by considering obsolescence, excessive levels of inventory, deterioration and other factors. Adjustments to reduce the cost of inventory to its net realizable value, if required, are made for estimated excess, obsolete or impaired inventory and are charged to cost of revenues. Factors influencing these adjustments include changes in demand, product life cycle and development plans, component cost trends, product pricing, physical deterioration and quality issues. Revisions to these adjustments would be required if these factors differ from our estimates.

Sales Returns Allowance and Allowance for Doubtful Accounts.

The Company estimates future product returns related to current period product revenue. We analyze historical returns, and changes in customer demand and acceptance of our products when evaluating the adequacy of the sales returns allowance. Significant management judgment and estimates must be made and used in connection with establishing the sales returns allowance in any accounting period. Material differences may result in the amount and timing of our revenue for any period if management made different judgments or utilized different estimates. Our provision for sales returns is recorded net of the associated costs. The balance for the provision of sales returns have not historically been material.

Similarly management must make estimates regarding the uncollectability of accounts receivable. We are exposed to credit risk in the event of non-payment by customers to the extent of amounts recorded on the balance sheet. As sales levels increase the level of accounts receivable would likely also increase. In addition, in the event that customers were to delay their payments to us, the levels of accounts receivable would likely also increase. We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. The allowance for doubtful accounts is based on past payment history with the customer, analysis of the customer's current financial condition, the aging of the accounts receivable balance, customer concentration and other known factors.

Warranty.

The Company accrues for estimated warranty costs upon shipment of products. Actual warranty costs incurred have not materially differed from those accrued. The Company's warranty policy is applicable to products which are considered defective in their performance or fail to meet the product specifications. Warranty costs are reflected in the statements of operations as cost of revenues.


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Income Taxes.

We account for income taxes in accordance with ASC 740, Income Taxes ("ASC 740"), which requires that deferred tax assets and liabilities be recognized using enacted tax rates for the effect of temporary differences between the book and tax bases of recorded assets and liabilities. Under ASC 740, the liability method is used in accounting for income taxes. Deferred tax assets and liabilities are determined based on the differences between financial reporting and the tax basis of assets and liabilities, and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. ASC 740 also requires that deferred tax assets be reduced by a valuation allowance if it is more likely than not that some or all of the deferred tax asset will not be realized. We evaluate annually the realizability of our deferred tax assets by assessing our valuation allowance and by adjusting the amount of such allowance, if necessary. The factors used to assess the likelihood of realization include our forecast of future taxable income and available tax planning strategies that could be implemented to realize the net deferred tax assets. In 2012 and 2011, we have recorded a full valuation allowance for our deferred tax assets based on our current year loss and the uncertainty regarding our ability to project future taxable income. In future periods if we are able to generate income we may reduce or eliminate the valuation allowance.

Accounting for Uncertainty in Income Taxes.

We account for uncertain tax positions in accordance with ASC 740. ASC 740 seeks to reduce the diversity in practice associated with certain aspects of measurement and recognition in accounting for income taxes. ASC 740 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax provision that an entity takes or expects to take in a tax return. Additionally, ASC 740 provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosures, and transition. Under ASC 740, an entity may only . . .

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