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CYBX > SEC Filings for CYBX > Form 10-K on 19-Jun-2013All Recent SEC Filings

Show all filings for CYBERONICS INC

Form 10-K for CYBERONICS INC


19-Jun-2013

Annual Report


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

You should read the following discussion and analysis together with Part I of this Form 10-K, including the matters set forth in "Cautionary Statement About Forward-Looking Statements," "Item 1A. Risk Factors" and our consolidated financial statements and the related notes included elsewhere in this Form 10-K.

This item provides material historical and prospective disclosures enabling investors and other users to assess our consolidated financial position and results of operations.

Overview

We are a medical device company incorporated in 1987, engaged in the design, development, sales and marketing of an implantable medical device, the VNS Therapy® System, which provides neuromodulation therapy for the treatment of refractory epilepsy and treatment-resistant depression ("TRD"). We are also investigating neuromodulation therapy for other indications, including chronic heart failure, and developing non-implantable device solutions for the management of epilepsy.

Our proprietary VNS Therapy System includes the following:

- an implantable pulse generator to provide appropriate stimulation to the vagus nerve;
- a lead that connects the pulse generator to the vagus nerve;
- surgical instrument equipment to assist with the implant procedure;
- equipment to enable the treating physician to set the pulse generator stimulation parameters for the patient;
- instruction manuals; and
- magnets to 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 generator model and the stimulation parameters used for each patient. If a physician determines that a patient's battery is at or near the end of its useful life or that the generator should be replaced for clinical reasons, a patient or a patient's caregiver may choose to implant a new generator. The generator may be replaced with or without replacing the original lead.

We sell the VNS Therapy System 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, we have broad coverage, coding and reimbursement for VNS Therapy for the treatment of refractory epilepsy. CMS, which we estimate pays for approximately 25% of the VNS Therapy System implants, issues an annual update to the reimbursement amounts to be received by our customers. The reimbursement rates vary by geographic area. 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 invest in and support the development of future generations of our VNS Therapy System, including generators employing new stimulation paradigms, cardiac-based seizure detection, rechargeable battery technology, wireless communication technology and for the integration of MRI-compatibility with our leads. 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. We also sponsor post-marketing studies in refractory epilepsy and support a variety of studies for our product development efforts or to build clinical evidence for VNS Therapy.


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Following a February 2011 limited commercial release of our AspireHC® generator and then an August 2011 recall of our AspireHC generator and investigational AspireSR™ generator, we received CE Mark approval in November 2011 and FDA approval in December 2011 for our redesigned AspireHC generator, and we resumed our full commercial release in the U.S. and Europe. The AspireHC generator, with its enhanced battery life, is the platform for our AspireSR generator.

In April 2011, we commenced a European clinical study (designated "E-36") to support regulatory approval in Europe of our AspireSR generator. The AspireSR generator employs a cardiac-based seizure detection system and delivers responsive VNS Therapy. We suspended this study with the August 2011 product withdrawal, restarted it in June 2012, and we continue to enroll patients. In September 2012, we submitted an Investigational Device Exemption ("IDE") request to the FDA for the purpose of conducting a U.S. pilot study of the AspireSR generator (designated "E-37"). The IDE was approved in December 2012, and our clinical team is working with research sites and Institutional Review Boards to complete activities necessary to initiate the first implant.

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.

Our epilepsy-related patents have expired in both the U.S. and Europe. We are aware of several neuromodulation-based medical devices approved for the treatment of epilepsy in the European market, and it is possible that one or more companies may enter the U.S. market 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 11. Commitments and Contingencies - License Agreements" in our 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.

In order to accommodate expected growth of our business, during the quarter ended October 26, 2012, we 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 subsidiary, Cyberonics Latam, S.R.L., contracted to purchase land and construct a manufacturing facility in Costa Rica. We have commenced construction, and we intend for this facility to be fully operational for the manufacture of our products for international markets in fiscal year 2015.


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Significant Accounting Policies and Critical Accounting Estimates

We have adopted various accounting policies to prepare the consolidated financial statements in accordance with accounting principles generally accepted in the U.S. ("U.S. GAAP"). Our most significant accounting policies are disclosed in "Note 1. Summary of Significant Accounting Policies and Related Data" in the consolidated financial statements.

To prepare our consolidated financial statements in conformity with U.S. GAAP, management makes estimates and assumptions that may affect the reported amounts of our assets and liabilities, the disclosure of contingent liabilities as of the date of our consolidated financial statements and the reported amounts of our revenues and expenses during the reporting period. Our actual results may differ from these estimates. We consider estimates to be critical if we are required to make assumptions about material matters that are uncertain at the time of estimation, or if materially different estimates could have been made or it is reasonably likely that the accounting estimate will change from period to period. The following are areas requiring management's judgment that we consider critical:

Intangible Assets

Intangible assets, as shown on the consolidated balance sheets, consisted of purchased licenses of patents and technology rights that are feasible and ready to integrate into our products. The technology rights are purchased from our collaborative partners and pertain primarily to seizure detection, wireless communication, rechargeable battery technology, external charging accessory hardware and associated software, the integration of MRI compatibility with our leads and micro-processor technologies. We amortize our intangible assets on a straight-line basis, over an average period of 12 years, 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 product. We evaluate our intellectual property each reporting period to determine whether events and circumstances indicate either a different amortization period or impairment. The intangible asset is impaired if the technology no longer factors into our product commercialization plans. 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 for clinical trials, failure of clinical trials, failure to obtain regulatory approval to market, failure to obtain insurance 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 $9.2 million at April 26, 2013.

Investments In Equity Securities

We invested in two privately-held start-up entities with a total carrying value of $10.6 million as of April 26, 2013. The investments consist of convertible preferred shares accounted for under the cost method. We own less than 20% of the equity of these entities and do not exercise significant influence. The carrying value of these entities are reviewed each period for impairment. As of April 26, 2013 we have not impaired these investments because there have been no identified events or changes in circumstances that indicate a significant adverse effect on the carrying value. Impairment adjustments are subject to a high degree of management judgment as these investments do not have quoted market prices. We cannot guarantee that such investments will be successful or will not adversely affect our consolidated balance sheet, statement of income or cash flow. See "Note 6. Investments" and "Note 18. Fair Value Measurements," for further details of these investments.


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Investments in Debt Securities

We invested $5.0 million in the convertible debt of a privately-held medical start-up entity in the quarter ended October 28, 2011, which we accounted for at fair value as an available-for-sale debt security. We reviewed this investment for impairment on a reoccurring basis. Impairment of this investment was subject to a high degree of management judgment as this investment did not have a quoted market price. In the quarter ended July 27, 2012, we recorded an impairment loss and reduced the carrying value of this investment in the amount of $4.1 million. In the quarter ended April 26, 2013, we foreclosed on the debt and took possession of assets equal to the carrying value of the debt. See "Note 6. Investments" and "Note 18. Fair Value Measurements," for further details of this investment.

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 and maintain policies for sales returns and exchanges. We estimate sales returns based on historical data and record a reduction in sales and a return reserve when we sell the initial product. The balance of our reserve for sales returns for the fiscal years ending April 26, 2013 and April 27, 2012 was $1.3 million and $1.2 million, respectively. Our increasing business activity, new product introductions and variations in product utilization could cause product returns to differ from our estimates.

License Revenue: We amortize upfront payments received under license agreements over the life of our obligations under the agreements 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 during the fiscal year 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 license revenue.

Stock-Based Compensation

Stock Option Awards

Our stock option award compensation expense is based on the fair market value of our awards. The fair market value of an award is amortized over the award vesting period. We use the Black-Scholes option pricing methodology to estimate the grant date fair market value of stock option award. This methodology takes into account variables such as the future expected volatility of our stock price, the amount of time expected to elapse between the date of grant and the date of exercise and a risk-free interest rate. Fair values of stock options issued in the future may vary significantly from fair values recorded in the current period depending on our estimates of these variables and therefore expense in future periods may differ significantly from current-period stock option compensation expenses. In addition, compensation expense may vary significantly from our estimates if forfeiture rates differ from our expectations. The estimated forfeiture rate used for stock option awards granted during the fiscal year ended April 26, 2013 ranged from 1.1% to 6.6%. Recognized compensation cost for stock option awards for the 52 weeks ended April 26, 2013, April 27, 2012 and April 29, 2011 was $2.9 million, $2.6 million and $2.5 million, respectively.


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Restricted Stock and Restricted Stock Unit Awards

Service-Based Restricted Stock. We grant restricted stock and restricted stock units at no purchase cost to the grantee. The fair market values of serviced-based restricted stock and restricted stock units are determined using the market closing price on the grant date and compensation is expensed ratably over the vesting period. Calculation of compensation for service-based restricted share awards requires estimation of employee turnover and forfeiture rates. Compensation expense may vary significantly from our estimates if employee turnover rates differ from our expectations. The estimated forfeiture rates used for restricted share awards and share unit awards during the fiscal year ended April 26, 2013 ranged from 1.6% to 2.0%.

Market and Performance-Based Restricted Stock and Performance-Based Restricted Stock Units. We grant restricted stock and restricted stock unit awards subject to market or performance conditions that vest based on the satisfaction of the conditions of the award. 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 on the grant date. Derived service periods and the periods charged with compensation expense for performance-based awards are 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 service-based, performance-based and market-based restricted stock and restricted stock unit awards for the 52 weeks ended April 26, 2013, April 27, 2012 and April 29, 2011 was $8.8 million, $8.5 million and $3.9 million, respectively.

Income Taxes

We are subject to federal, state and foreign income taxes, and we use significant judgment and estimates in accounting for our income taxes. This involves assessing the changes in temporary differences resulting from differing treatment of events for tax and accounting purposes. These assessments result in deferred tax assets and liabilities which are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Income tax expense compared to pre-tax income yields an effective tax rate. Actual tax expense may significantly differ from our expectations if, for example, judicial interpretations of tax law or tax rates change. Cumulative adjustments to the tax provision are recorded in the interim period in which a change in the estimated annual effective rate is determined.

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. We periodically review the adequacy and necessity of the valuation allowance by considering significant positive and negative evidence relative to our ability to recover deferred tax assets and to determine the timing and amount of valuation allowance that should be released. This evidence includes:
a) profitability in the most recent fiscal years, b) internal forecasts for the current and next two future fiscal years, c) size of the deferred tax asset relative to estimated profitability, d) the potential effects on future profitability from increasing competition, healthcare reforms and overall economic conditions, e) limitations and potential limitations on the use of our net operating losses due to ownership changes, pursuant to Internal Revenue Code ("IRC") Section 382, and f) the implementation of prudent and feasible tax planning strategies, if any. Projecting future taxable income requires significant judgment about the trend and nature of our sales and operating expenses, which include an evaluation of the potential effects of new markets, changing technology, patent protection, governmental and private insurance reimbursement trends and regulatory trends. Changes in our assessment of the factors related to the recoverability of our deferred tax assets could result in materially different income tax provisions.


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During fiscal year 2013 we released valuation allowance of $12.4 million related to our U.S. net operating losses ("NOL") carryforward deferred tax asset based upon usage of our federal and state NOL. This reduction in the valuation allowance was recorded as a tax benefit in additional paid-in capital on our consolidated balance sheet due to the nature of the NOL, which was created with excess tax benefits on exercise of options prior to adoption of Statement of Financial Accounting Standard No. 123 (revised 2004) "Share-Based Payments" on April 29, 2006. During fiscal year 2011, based on our evaluation of the recoverability of our U.S. deferred tax assets, we reduced our valuation allowance by $19.9 million, of which $8.9 million was recorded as a tax benefit on our consolidated statement of income and $11.0 million was recorded as a benefit in additional paid-in capital on our consolidated balance sheet. During fiscal year 2010, based on our evaluation of the recoverability of our U.S. deferred tax assets, we reduced our valuation allowance by $40.5 million. This reduction in the valuation allowance was recorded as a tax benefit in our consolidated statement of income. In addition, during fiscal year 2013, we released valuation allowance of $0.6 million related to the utilization and adjustment of NOL from foreign operations. The remaining valuation allowance related to foreign operations has not been released as it is not considered more-likely-than-not that the net operating losses will be able to be utilized. We will continue to evaluate whether to release the cumulative valuation allowance related to foreign NOL during fiscal year 2014.

At April 26, 2013, we had a total valuation allowance of $26.2 million against our deferred tax asset based on the NOL's from our foreign operations, our excess tax benefits from stock-based awards and other tax attributes.

We operate in Europe with a subsidiary, Cyberonics Europe BVBA/SPRL ("Cyberonics Europe BVBA"). Cyberonics Europe BVBA, based in Belgium, is the successor organization arising from the restructuring of Cyberonics, NV/SA, which was also based in Belgium. We made an election to treat Cyberonics Europe BVBA as a disregarded entity for U.S. federal tax purposes during fiscal year 2011. In conjunction with this transaction, we recognized a net $9.0 million income tax benefit resulting from claiming a worthless stock deduction with respect to the shares we own in Cyberonics Europe BVBA. The Internal Revenue Service ("IRS") could challenge the characterization of this type of transaction. The resolution of any challenge could result in reversal of all, part or none of the benefit recorded during fiscal year 2011. Consequently, we have estimated and recorded a $2.3 million liability for uncertain tax benefits, which increased our fiscal year 2011 income tax provision. Changes in our assessment of the factors related to sustainability of this deduction would have resulted in a materially different income tax provision.

Our effective tax rate for fiscal year 2013 was approximately 38.4%, including the impact of federal tax rate of 35%, state and foreign income taxes, the impact of the retroactive enactment of the Research & Development Tax Credit covering the period January 1, 2012 through April 26, 2013, which includes four months from the prior fiscal year 2012, the non-taxability of the gain on the warrant's liability, meals & entertainment expenditures, an uncertain tax position associated with the NeuroVista debt obligation impairment and other permanent differences. The federal R&D Tax Credit was enacted into law on January 2, 2013 by The American Taxpayer Relief Act of 2012, which retroactively extended the R&D Tax Credit for two years, from January 1, 2012 to December 31, 2013.

Our effective tax rate for fiscal year 2012 was approximately 40.3%, including the impact of federal tax rate of 35%, state and foreign income taxes, and the impact of shortfalls resulting from stock option exercises or cancellations and restricted stock vesting. We estimate that our effective tax rate for fiscal year 2014 will be approximately 36.5%. Our cash payments for income taxes for fiscal year 2013 and fiscal year 2012 were approximately 3% and 2% of income before tax, respectively. We estimate increased cash tax payments of approximately 4% to 6% in fiscal year 2014 due to the full utilization of our tax net operating losses during fiscal year 2014.

Tax authorities may disagree with certain positions we have taken and assess additional taxes. We regularly assess the likely outcomes of our tax positions in order to determine the appropriateness of our reserves for uncertain tax positions. However, there can be no assurance that we will accurately predict the outcome of these audits and the actual outcome of an audit could have a material impact on our consolidated results of income, financial position or cash flows.

During the 52 weeks ended October 26, 2012, we finalized the IRS audit in connection with our fiscal years ended April 24, 2009 and April 30, 2010. The audit adjustments did not materially impact our consolidated statements of income or consolidated balance sheets.


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In addition, during the 52 weeks ended April 26, 2013, we were notified that our European subsidiary, Cyberonics Europe BVBA, is under examination by the Belgium tax authority with respect to transfer pricing for fiscal years 2011 and 2010. We are unable to assess the impact the examination may have on our consolidated financial statements, on our cumulative Belgium tax losses through fiscal year 2012 of €25.7 million, and on our U.S. tax position.

Results of Operations

Net Sales

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

                                                                                                  Fiscal year
                                                                                                    2011 to
                 52 Weeks Ended     52 Weeks Ended     52 Weeks Ended     Fiscal year 2012 to     Fiscal year
                 April 26, 2013     April 27, 2012     April 29, 2011       Fiscal year 2013         2012
                                                                                % Change           % Change
U.S.            $      208,859     $      181,436     $      161,224                15.1 %            12.5 %
International           43,967             35,548             27,736                23.7 %            28.2 %
Total net
product sales   $      252,826     $      216,984     $      188,960                16.5 %            14.8 %

Unit
Sales: (1)
U.S.                     9,340              8,455              7,906                10.5 %             6.9 %
International            3,598              2,939              2,480                22.4 %            18.5 %
. . .
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