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VSCI > SEC Filings for VSCI > Form 10-K on 25-Jun-2013All Recent SEC Filings

Show all filings for VISION SCIENCES INC /DE/



Annual Report

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

Executive Overview

We design, develop, manufacture, and market products for endoscopy - the science of using an instrument, known as an endoscope - to provide minimally invasive access to areas not readily visible to the human eye. We have two reportable segments, medical and industrial. Each of these operating segments has unique characteristics and faces different opportunities and challenges.

Medical Business Segment

Our medical segment designs, manufactures, and sells our advanced line of endoscopy-based products, including our flexible fiber and video endoscopes and our EndoSheath technology, for a variety of specialties and markets. Our proprietary reusable flexible endoscope is combined with a single-use, sterile protective EndoSheath disposable that is placed over the patient contact area of the scope. Our "always sterile" EndoSheath technology reduces the risks of cross-contamination associated with the reuse (or "reprocessing") of conventional endoscopes, which are difficult, costly, and time-consuming to clean and disinfect or sterilize.

In November 2012, the ECRI Institute listed cross-contamination from flexible endoscopes as the fourth most dangerous hazard on its list of the top-ten health technology hazards for 2012. The use of our EndoSheath technology allows healthcare providers to perform a rapid, simplified reprocessing routine after use, avoiding the elaborate high level disinfection/sterilization routines required by the U.S. Food and Drug Administration (the "FDA") for conventional endoscopes. The FDA requires that all conventional flexible endoscopes be reprocessed according to FDA-cleared manufacturers' regulations and organizational guidelines, whether they are used in hospitals, clinics or office settings. With our EndoSheath technology we are able to reduce the steps needed to reprocess flexible endoscopes from approximately 27 to three, thereby lowering costs and saving time. This design of "always ready" equipment, which allows for a rapid and less damaging cleaning process, provides a multitude of benefits to healthcare practitioners, such as lower capital equipment investment, less service and maintenance costs of capital equipment, less staff exposure to toxic chemicals, increased patient scheduling flexibility and throughput, improved staff productivity and a more practical implementation of endoscopy.

We target six market spaces for our endoscopes and our EndoSheath technology:

? Urology - we supply our cystoscopes, ureteroscopes, and EndoSheath technology to the Endoscopy Division of Stryker Corporation ("Stryker") in North and Latin America, South America, China and Japan. Although Stryker was to receive the exclusive rights for the rest of the world in April 2012, we reached an agreement with Stryker to delay this launch indefinitely. Until we agree with Stryker on the date of such launch, we will continue to manufacture and sell our cystoscopes and EndoSheath technology to our independent distributors for sale in the rest of the world.

? Critical Care / Pulmonology - we manufacture, market, and sell our bronchoscope (an endoscope that allows detailed viewing of the lungs) and EndoSheath technology to intensivists, pulmonologists, thoracic surgeons, and other airway-related physicians.

? Surgery - we manufacture, market, and sell our TNE (trans-nasal esophagoscopy) endoscope and EndoSheath technology to general surgeons, primarily bariatric and gastroesophageal reflux disease ("GERD") surgeons.

? Gastroenterology - we manufacture, market, and sell our TNE endoscopes and EndoSheath technology to gastroenterology ("GI") physicians, ear, nose, and throat ("ENT") physicians and others with a GI focus as part of their practice.

? ENT (ear, nose, and throat) - we manufacture, market, and sell our ENT endoscopes to ENT physicians.

? Spine - we supply our flexible video surgical endoscope systems to SpineView, Inc. for use with SpineView's space creator product.

We believe our technology delivers significant value to our customers - doctors, clinics, and hospitals - through reduced capital, lower staff and service costs, and increased patient throughput, practice revenue, and profitability. Our goal is to become a customer-centric organization with a focus on enhancing stockholder value. We are doing this by:

? Increasing the size and capabilities of our sales force in the U.S. by adding proven medical-surgical device sales professionals in promising territories;

? Targeting acute care facilities and office-based clinics that recognize patient safety and the patient experience as a primary value position;

? Capitalizing on our extensive and relevant library of published clinical studies on the efficacy and safety of our EndoSheath technology; and

? Enhancing our professional educational programs to enable healthcare professionals to teach other healthcare professionals about our EndoSheath technology.

Recent Medical Business Product Launches

In December 2012, we began to exclusively supply to Stryker our first charge-coupled device (CCD) based flexible ureteroscope. This ureteroscope expands our new 7000 Series video endoscopy platform and is the smallest CCD-based video endoscope in the marketplace today. Ureteroscopes are used for diagnostic and therapeutic procedures in the ureter and the kidney, typically performed in a hospital operating room setting.

We also launched our next-generation digital video processor, the DPU-7000. This integrated visualization endoscopy platform is a high-performance, efficient, and easy-to-use system designed to provide expanded benefits across a broader spectrum of users. The DPU-7000 is the first all-in-one endoscopy platform to include audio, video, archiving, and workflow enhancements in a single standalone unit. It is fully compatible with our 5000 Series line of endoscopes that utilize our EndoSheath technology.

Industrial Business Segment

Our industrial segment, through our wholly-owned subsidiary Machida, designs, manufactures, and sells borescopes to a variety of users, primarily in the aircraft engine manufacturing and aircraft engine maintenance industries. A borescope is an instrument that uses optical fibers for the visual inspection of narrow cavities. Our borescopes are used to inspect aircraft engines, casting parts and ground turbines, among other items.

Machida's quality line of borescopes includes a number of advanced standard features normally found only in custom designed instruments. We were the first to offer a flexible borescope with a grinding attachment, allowing users to "blend" or smooth small cracks in turbine blades of jet engines without disassembling the engine, saving our customers significant expense and delay.

Financing Arrangements

Long-Term Debt - Related Party

On September 19, 2012 (the "Effective Date"), we entered into a new $20.0 million convertible promissory note (the "Replacement Note") with our chairman, Lewis C. Pell (the "Lender"). The Replacement Note consolidates and restructures the $15.0 million in aggregate borrowings collectively outstanding under the Original Agreement (as defined below) and the Supplemental Note (as defined below) and provides for an additional $5.0 million available to us (of which $2.0 million has been drawn as of March 31, 2013), for an aggregate of up to $20.0 million. We also terminated the letter agreement dated August 14, 2012, pursuant to which Mr. Pell had agreed to provide financial assistance to us in the amount of up to $3.0 million.

The Replacement Note accrues annual interest, payable annually, and is set at the "applicable federal rate" in effect on the date of the Replacement Note (as defined in the Replacement Note; equal to 0.84%). The Replacement Note must be repaid in full on or before its fifth anniversary (the "Maturity Date"), but may be prepaid by us at any time without penalty. We will be required to repay all amounts outstanding under the Replacement Note upon an event of default, as defined in the Replacement Note.

The outstanding principal amount of the Replacement Note is convertible at any time prior to the Maturity Date, at Mr. Pell's option, into shares of our common stock at a conversion price of $1.20 per share, which was the closing price of our common stock on the Effective Date.

The Replacement Note replaces the original loan agreement between us and Mr. Pell dated September 30, 2011 (the "Original Agreement") pursuant to which we borrowed $10.0 million, and the promissory note dated July 25, 2012 (the "Supplemental Note") pursuant to which we borrowed $5.0 million. The amounts borrowed against the Original Agreement and Supplemental Note accrued interest at an annual rate of 7.5%. Mr. Pell also had received an availability fee equal to an annual rate of 0.5% on the difference between the average annual principal amount of the outstanding balance under the Original Agreement and the maximum amount of $10.0 million.

At March 31, 2013, we had $17.0 million in outstanding borrowings and $3.0 million available under the Replacement Note. The outstanding balance is reflected as convertible debt - related party on our consolidated balance sheet. See Subsequent Event section below.

Equity Purchase Agreement

On April 27, 2012, we entered into a purchase agreement (the "Purchase Agreement") with Lincoln Park Capital Fund, LLC ("LPC"), pursuant to which we have the right to sell to LPC up to $15 million in shares of our common stock from time-to-time over a period of up to three years, subject to certain limitations and conditions set forth in the Purchase Agreement. This total maximum amount of $15 million would increase to $21 million if the aggregate market value of shares of our common stock held by non-affiliates reached at least $75 million during the 36-month term of the Purchase Agreement. The Purchase Agreement contains customary representations, warranties and agreements between us and LPC, limitations (market price of our common stock and LPC's ownership limit) and conditions to completing future sale transactions, indemnification rights and other obligations of the parties. In connection with the initial purchase under the Purchase Agreement, and any future sales under the Purchase Agreement, Mr. Pell waived the repayment requirement under the Loan Agreement. On July 26, 2012, we amended the Purchase Agreement with LPC to, among other things, create a threshold price of $3.00 for the sale of our common stock to LPC, as calculated pursuant to the formula provided in the Purchase Agreement.

As consideration for entering into the Purchase Agreement and for their initial purchase of $1.0 million of our common stock, we issued to LPC 175,333 shares of our common stock. As consideration for any remaining future purchases under the Purchase Agreement, we also will also issue to LPC, on a pro rata basis in connection with each purchase of shares by LPC, up to a total of 215,000 additional shares of our common stock. We did not receive any cash proceeds from the issuance of 175,333 shares and will not receive any proceeds upon the issuance of any of the remaining 215,000 shares.

Subsequent Event

Pursuant to a letter agreement dated June 21, 2013, Mr. Pell has agreed to provide financial assistance to us in the amount of up to $5.0 million, if necessary to support our operations, for a period ending on the earlier of (i) July 1, 2014 or (ii) our raising debt or equity capital in the amount of $5.0 million or more. This financial assistance, if drawn by us, would be on the same terms as our existing convertible debt with Mr. Pell. We expect that our cash at March 31, 2013, together with the $3 million of capital available under a convertible note dated September 19, 2012 and $5.0 million of capital to be made available to us, subject to certain conditions, under a letter agreement dated June 21, 2013 from Lewis C. Pell, our Chairman (see Note 13. Subsequent Event for additional information), should be sufficient to fund our operations through at least March 31, 2014. However, if our performance expectations fall short (including our failure to generate expected levels of sales) or our expenses exceed expectations, we will need to reduce our expenses and/or secure additional funding to support our operational needs in the future, and we cannot be certain that such funding will be available on terms acceptable to us, if at all, particularly in light of current economic and capital market conditions for companies of our size. Any capital raising necessary to continue our operations may be through one or a combination of approaches, which could include public or private financing, issuances of equity or debt, sale or partnering of one or more of our assets or other strategic initiatives. Any public or private financings involving issuances of common stock or other classes of our equity would likely dilute existing stockholders' percentage ownership. If we are unable to obtain funding to support operations, we will be forced to curtail our operations and we may be less likely to develop and market products successfully, which would have a material adverse impact on our prospects and financial condition. If required, we believe we would be able to reduce our expenses to a sufficient level to continue to operate as a going concern.

Critical Accounting Policies and Estimates

The preparation of our consolidated financial statements requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Management evaluates these estimates and assumptions on an ongoing basis. Estimates are based on historical experience, when available, and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

Management believes that, of its significant accounting policies, an understanding of the following critical accounting policies is important in obtaining an overall understanding of the consolidated financial statements.

Revenue Recognition

We recognize revenue in accordance with the Financial Accounting Standards Board (the "FASB") Accounting Standards Codification ("ASC") 605 (Topic 605, Revenue Recognition). ASC 605 requires that five basic criteria must be met before revenue can be recognized: (i) persuasive evidence that an arrangement exists;
(ii) delivery has occurred or services were rendered; (iii) the fee is fixed and determinable; (iv) collectability is reasonably assured; and (v) the fair value of undelivered elements, if any, exists. Determination of criterion (iv) above is based on management's judgment regarding the collectability of invoices for products and services delivered to customers. Should changes in conditions cause management to determine this criterion is not met for certain future transactions, revenue recognized for any reporting period could be adversely affected. We recognize revenue when title passes to the customer, generally upon shipment of our products F.O.B. shipping point. Revenue for service repairs of equipment is recognized after service has been completed, and service contract revenue is recognized ratably over the term of the contract.

For products sold to Stryker we recognize revenue in a two-step process. The first step is recognition of revenue for our cost to manufacture these products when title passes to Stryker, generally upon shipment of our products F.O.B. shipping point. The second step is recognition of revenue for our specified margin of Stryker's gross profit after Stryker sells the products to its end customers, based upon reports received from Stryker monthly. There is no minimum amount of scopes and EndoSheath products that Stryker is required to purchase from us.

Stock-Based Compensation

We account for stock-based awards issued to employees in accordance with the provisions of ASC 718 (Topic 718, Compensation - Stock Compensation). We recognize stock-based compensation expense on a straight-line uniform basis over the service period of the award, which is generally four years for employees. We use historical data to estimate expected employee behaviors related to option exercises and forfeitures and include these expected forfeitures as a part of the estimate of stock-based compensation expense as of the grant date. For stock-based awards with performance-based vesting conditions, we are also required to estimate the probability of the vesting conditions being met. Stock-based awards issued to consultants are accounted for in accordance with the provisions of ASC 718 and ASC 505-50 (Subtopic 50 "Equity-Based Payments to Non-Employees" of Topic 505, Equity). Options granted to consultants are periodically revalued as the options vest, and are recognized as an expense over the related period of service or the vesting period, whichever is longer.

Warranty Obligations

We provide for the estimated cost of warranties at the time the related revenue is recognized based on the number of units sold, historical and anticipated rates of warranty claims, and cost per claim. We periodically assess the adequacy of our recorded warranty liabilities and adjust the amounts as necessary. Warranty expense is recorded in cost of sales in our consolidated statement of operations.

Income Taxes

We account for income taxes in accordance with ASC 740 (Topic 740, Income Taxes). ASC 740 prescribes that the use of the liability method be used for income taxes. Under this method, deferred tax assets and liabilities are determined based on differences between the financial reporting and tax basis of assets and liabilities and are measured using enacted tax rates and laws that are expected to be in effect when the differences reverse. Any resulting net deferred tax assets are evaluated for recoverability and, accordingly, a valuation allowance is provided when it is more likely than not that all or some portion of the deferred tax asset will not be realized.

ASC Topic 740 also clarifies the accounting for uncertainty in income taxes recognized in the financial statements. This interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken, or expected to be taken, in a tax return.

Additionally, ASC Topic 740 provides guidance on the recognition of interest and penalties related to income taxes. We have elected to treat interest and penalties, to the extent they arise, as a component of selling, general, and administrative expenses in our consolidated statement of operations.

Results of Operations (Dollars in thousands, except per share amounts)

Net Sales

In the medical segment, we track sales of our endoscopes and EndoSheath technology by market. We also track sales of peripherals and accessories that can be sold to more than one market. Net sales by operating segment and by market/category for fiscal years 2013 and 2012 were as follows:

                                           Fiscal Year Ended March 31,
Market/Category                              2013                2012              Change
Urology                                 $         5,439     $        7,167                 -24 %
ENT                                               1,896              1,922                  -1 %
Surgery / GI                                      1,019                952                   7 %
Critical Care / Pulmonology                         789                895                 -12 %
Spine                                               440                837                 -47 %
Repairs, peripherals, and accessories             2,047              1,962                   4 %
Total medical sales                     $        11,630     $       13,735                 -15 %
Borescopes                                        2,745              2,204                  25 %
Repairs                                             912                747                  22 %
Total industrial sales                  $         3,657     $        2,951                  24 %
Net sales                               $        15,287     $       16,686                  -8 %

Net sales decreased $1.4 million, or 8%, in fiscal 2013 to $15.3 million compared to $16.7 million in fiscal 2012. During fiscal 2013, our medical segment's net sales of $11.6 million decreased by $2.1 million, or 15%, primarily attributable to lower sales of our endoscopes and EndoSheath disposables to Stryker in the urology market ($1.2 million). Our industrial segment's net sales of $3.7 million increased by $0.7 million, or 24%, primarily attributable to higher demand for our 2.0 mm video-based borescopes, engine turning tools, and custom blending scopes. Although we achieved growth in fiscal 2013 in our industrial segment, we expect future industrial sales to remain relatively flat given the maturity of our products.

The following table summarizes net sales by market/category and by product for our medical operating segment for fiscal years 2013 and 2012:

                            Fiscal Year Ended March 31, 2013                      Fiscal Year Ended March 31, 2012
Market/Category        U.S.            International         Total           U.S.            International         Total
Endoscopes          $     1,883       $           642      $    2,525     $     2,737       $         1,226      $    3,963
disposables                 973                 1,941           2,914           1,489                 1,715           3,204
Total urology
market                    2,856                 2,583           5,439           4,226                 2,941           7,167

Endoscopes                1,334                   562           1,896           1,478                   444           1,922

Surgery / GI
Endoscopes                  804                    67             871             823                    36             859
disposables                 145                     3             148              91                     2              93
Total surgery /
GI markets                  949                    70           1,019             914                    38             952

Critical Care /
Endoscopes                  277                   369             646             482                   272             754
disposables                  34                   109             143              27                   114             141
Total critical
care /
markets                     311                   478             789             509                   386             895

Endoscopes                  440                     -             440             837                     -             837

peripherals, and
accessories               1,377                   670           2,047           1,306                   656           1,962
Total medical
sales               $     7,267       $         4,363      $   11,630     $     9,270       $         4,465      $   13,735

Endoscopes          $     4,738       $         1,640      $    6,378     $     6,357       $         1,978      $    8,335
disposables               1,152                 2,053           3,205           1,607                 1,831           3,438
peripherals, and
accessories               1,377                   670           2,047           1,306                   656           1,962
Total medical
sales               $     7,267       $         4,363      $   11,630     $     9,270       $         4,465      $   13,735

Net sales to the urology market in fiscal 2013 decreased by $1.7 million, or 24%, as compared to fiscal 2012. The year-over-year decline was primarily attributable to the lower sales of our cystoscopes and related EndoSheath technology products to Stryker stemming from initial stocking of product in fiscal 2012 to support their April 2011 launch efforts. Net sales to Stryker were down $1.2 million, or 29%, in fiscal 2013.

Net sales to the ENT market in fiscal 2013 decreased by $26 thousand, or 1%, as compared to fiscal 2012. The nominal decrease was primarily attributable to lower sales of our ENT fiberscopes in the U.S. as our domestic sales force concentrated their selling efforts in the surgical and critical care markets ($229 thousand). Partially offsetting this decline was growth of our ENT fiberscopes in the international markets ($195 thousand), primarily Israel.

Net sales to the surgery and GI markets in fiscal 2013 increased by $67 thousand, or 7%, as compared to fiscal 2012. An increase in demand for our EndoSheath technology contributed to the year-over-year growth ($55 thousand). Our effort to drive awareness of the efficacy and safety of our EndoSheath technology and increase utilization resulted in the 49% unit volume increase in fiscal 2013.

Net sales to the pulmonology and critical care markets in fiscal 2013 decreased by $0.1 million, or 12%, as compared to fiscal 2012. The year-over-year decline was primarily attributable to lower sales of our video platform (video-based bronchoscope and digital processing unit) in the U.S. ($0.2 million), partially offset by higher demand for our video-based bronchoscopes in the international markets, primarily Italy and Switzerland ($0.1 million). Our focus remains on increasing our installed base in the U.S. to drive further adoption of our EndoSheath technology.

Net sales to SpineView in fiscal 2013 decreased by $0.4 million, or 47%, as compared to fiscal 2012. We fulfilled the remaining balance of the initial stocking order of fifty (50) 2.0mm video-based surgical endoscope systems in the second quarter of fiscal 2013. In December 2012, SpineView received 510(k) clearance from the Food and Drug Administration ("FDA") to use our system for spine applications. With this clearance and the units supplied from the initial stocking order, SpineView has been conducting clinical preference trials for minimally invasive spine surgeries.

Net sales of all repairs, peripherals, and accessories in fiscal 2013 increased by $85 thousand, or 4%, as compared to fiscal 2012. The year-over-year growth was primarily attributable to an increase in our repairs business, which increased 12% in fiscal 2013.

Gross Profit (Net Sales Less Cost of Sales)

Gross profit by operating segment for fiscal years 2013 and 2012 was as follows:

                                Fiscal Year Ended March 31,
Gross Profit                     2013                2012           Change
Medical                      $       3,102       $       4,064          -24 %
As percentage of net sales              27 %                30 %         -3 %
Industrial                           1,240               1,021           21 %
As percentage of net sales              34 %                35 %         -1 %
Gross profit                 $       4,342       $       5,085          -15 %
Gross margin percentage                 28 %                30 %         -2 %
. . .
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