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CYBX > SEC Filings for CYBX > Form 10-Q on 23-Aug-2013All Recent SEC Filings

Show all filings for CYBERONICS INC

Form 10-Q for CYBERONICS INC


23-Aug-2013

Quarterly Report


ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Cautionary Statement Regarding Forward Looking Statements

This Quarterly Report on Form 10-Q ("Form 10-Q") contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and
Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"). The Private Securities Litigation Reform Act of 1995 provides a "safe harbor" for certain forward-looking statements. The words "believe," "potential," forecast," "project," "expect," "anticipate," "plan," "intend," "foresee," "should," "would," "could," "may," "estimate," "project" or other similar expressions are intended to identify forward-looking statements. These forward-looking statements are based on our current expectations and beliefs concerning future developments and their potential effects on us. There can be no assurance that future developments affecting us will be those that we anticipate. All comments concerning our expectations for future revenues and operating results are based on our forecasts for our existing operations. These forward-looking statements involve significant risks and uncertainties (some of which are beyond our control) and assumptions. They are subject to change based on various factors, including but not limited to the risks and uncertainties summarized below:

changes in our common stock price;
changes in our profitability;
regulatory activities and announcements; effectiveness of our internal controls over financial reporting; fluctuations in future quarterly operating results; failure to comply with, or changes in laws, regulations or administrative practices affecting government regulation of our products, including, but not limited to, United States ("U.S.") Food and Drug Administration ("FDA") laws and regulations;
failure to expand or maintain market acceptance or reimbursement for the use of VNS Therapy or any component which comprises the VNS Therapy System for the treatment of epilepsy and depression; any legislative or administrative reform to the healthcare system, including the U.S. Medicare or Medicaid systems or international reimbursement systems, that significantly reduces reimbursement for procedures using the VNS Therapy System, or any component thereof, or denies coverage for such procedures, as well as adverse decisions by administrators of such systems on coverage or reimbursement issues relating to our products; failure to maintain the current regulatory approvals for our epilepsy and depression indications;
failure to obtain insurance coverage and reimbursement for our depression indication;
failure to develop VNS Therapy for the treatment of indications other than epilepsy and depression;
unfavorable results from clinical studies; variations in sales and operating expenses relative to estimates; our dependence on certain suppliers and manufacturers to provide certain materials, components and contract services necessary for the production of our products;
product liability-related losses and costs; protection, expiration and validity of our intellectual property; changes in technology, including the development of superior or alternative technology or devices by competitors; failure to comply with applicable laws and regulations, including federal and state privacy and security laws and regulations; international operational and economic risks and concerns; failure to attract or retain key personnel; losses or costs from pending or future lawsuits and governmental investigations;
changes in accounting rules that adversely affect the characterization of our consolidated results of income, financial position or cash flows; changes in customer spending patterns; continued volatility in the global market and worldwide economic conditions; and
changes in tax laws or exposure to additional income tax liabilities.


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Other factors that could cause our actual results to differ from our projected results are described in (1) Part II, Item 1A and elsewhere in this Form 10-Q,
(2) our Annual Report on Form 10-K for the period ended April 26, 2013 ("2013 Form 10-K"), (3) our reports and registration statements filed and furnished from time to time with the U.S. Securities and Exchange Commission ("SEC") and
(4) other announcements we make from time to time.

Readers are cautioned not to place undue reliance on forward-looking statements, which speak only as of the date hereof. We undertake no obligation to update or revise any forward-looking statements after the date they are made, whether as a result of new information, future events or otherwise. You should read the following discussion and analysis in conjunction with our unaudited condensed consolidated financial statements and related notes included elsewhere in this report. Operating results for the thirteen weeks ended July 26, 2013 are not necessarily indicative of future results, including the full fiscal year. You should also refer to our Annual Consolidated Financial Statements, Notes thereto, and Management's Discussion and Analysis of Financial Condition and Results of Operations and "Risk Factors" contained in our 2013 Form 10-K.

Business 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, that 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 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; a surgical instrument 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 model and the stimulation parameters and settings used for each patient. At or near the end of the useful life of a battery, a patient may, with the advice of a physician, choose to implant a new generator, with or without replacing the original lead.

The FDA approved our VNS Therapy System in July 1997 for use as an adjunctive therapy in epilepsy patients over 12 years of age in reducing the frequency of partial onset seizures that are refractory or resistant to antiepileptic drugs. Regulatory bodies in Canada, the European Economic Area, certain countries in Eastern Europe, Russia, South America, Africa, Australia and certain countries in Asia, including Japan, China and Taiwan, have approved the VNS Therapy System for the treatment of epilepsy, many without age restrictions or seizure-type limitations. In July 2005, the FDA approved the VNS Therapy System for the adjunctive long-term treatment of chronic or recurrent depression for patients 18 years of age or older who are experiencing a major depressive episode and have not had an adequate response to four or more adequate anti-depressant treatments. Regulatory bodies in the European Economic Area, Canada and Israel have approved the VNS Therapy System for the treatment of chronic or recurrent depression in patients who are in a treatment-resistant or treatment-intolerant depressive episode without age restrictions.

We sell the VNS Therapy System for refractory epilepsy to hospitals and ambulatory surgery centers ("ASCs"). Our ability to successfully expand the commercialization of the VNS Therapy System depends on maintaining regulatory approval and favorable insurance coverage. This coverage allows our customers to invoice and be paid by third-party payers. Currently, there is broad coverage, coding and reimbursement for VNS Therapy for the treatment of refractory epilepsy.

In May 2007, the Centers for Medicare and Medicaid Services ("CMS") issued a national determination of non-coverage with respect to reimbursement of VNS Therapy for patients with TRD, significantly limiting access to this therapeutic option for many patients. Following this determination, we have not engaged in active commercial efforts with respect to TRD in any of our markets. As a result of new clinical evidence, including the completion of a post-approval dosing study and publication in four peer-reviewed journals, we submitted a formal request to CMS for reconsideration of its determination and requested coverage for VNS Therapy for TRD for a sub-population of Medicare beneficiaries that is estimated to represent approximately 0.2% of CMS's patient population. CMS declined our request for reconsideration on May 28, 2013.


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We believe reimbursement or payment rates from private insurers were largely unchanged over the past year. In November 2012, CMS announced calendar year 2013 final Ambulatory Payment Classification (APC) reimbursement rates, which were increased over the calendar year 2012 rates by 5.7% for full systems and 7.9% for generator-only replacements. For calendar year 2014, CMS has proposed a new hospital outpatient rule that creates "comprehensive" APCs for our products. The new comprehensive APCs are designed to package reimbursement for all items incurred within a period of up to 30 days into a single payment. This means that costs associated with services having nothing to do with our device-related procedures may be reimbursed from our comprehensive APCs. In July 2013, CMS announced calendar year 2014 proposed rates for our new comprehensive APCs. The proposed comprehensive APC rates are increased as compared to the calendar year 2013 APC final rates by 5% for full systems and 29% for generator-only replacements. We believe that the proposed comprehensive APC for generator-only replacements will also include full-system replacements, but we continue to analyze the proposed comprehensive APCs to determine how they differ from the calendar year 2013 APCs.

Any decrease in reimbursement rates or change in reimbursement methodology by CMS, including the proposed new comprehensive APCs, 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, and wireless communication technology and the integration of magnetic resonance imaging ("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. A description and the status of these studies may be found at www.clinicaltrials.gov.

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.

We periodically 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 9. Commitments and Contingencies - Investment Agreements" in our condensed consolidated financial statements for additional information.

Significant Accounting Policies and Critical Accounting Estimates

We have adopted various accounting policies in preparing the consolidated financial statements in accordance with U.S. generally accepted accounting principles. Our significant accounting policies are disclosed in Note 1 to the Consolidated Financial Statements included in our Annual Report on Form 10-K for the fiscal year ended April 26, 2013 ("2013 Annual Report on Form 10-K").

Preparation of our consolidated financial statements in conformity with U.S. generally accepted accounting principles requires us to adopt various accounting policies and to make estimates and assumptions that affect the reported amounts in such financial statements and accompanying notes. On an ongoing basis, we evaluate our estimates and assumptions, including those related to sales return reserves, amortization periods for and impairment of intangible assets, income taxes and stock-based compensation. We base our estimates on historical experience and various other assumptions that are believed to be reasonable under the circumstances, and the results form the basis for making judgments about the reported value of assets, liabilities, revenues and expenses. Actual results may differ from these estimates. There have been no material changes to our critical accounting policies from the information provided in Part II, Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations included in our 2013 Annual Report on Form 10-K.


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Deferred Licensing Revenue

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 retained the responsibility to prosecute the licensed patent applications and estimated that our obligation would be satisfied during the quarter ended April 27, 2014. However, during the quarter ended July 26, 2013, our obligations under the contract ended, and we amortized the remaining balance of our deferred revenue resulting in recognition of licensing revenue in the consolidated statement of income of $1.5 million for the thirteen weeks ended July 26, 2013, as compared to $0.4 million for the thirteen weeks ended July 27, 2012.

Results of Operations

Net Sales

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

                             For the Thirteen Weeks Ended
                          July 26, 2013        July 27, 2012    % Change
U.S.                      $      56,358        $      50,884      10.8%
International                    11,046                9,064      21.9%
Total net product sales   $      67,404        $      59,948      12.4%

Unit Sales (1)
U.S.                              2,455                2,311       6.2%
International                       899                  745      20.7%
Total unit sales                  3,354                3,056       9.8%

Licensing Revenue         $       1,468        $         373     293.6%

(1) Sales volume increases are based on unit sales, which are the number of generators sold.

U.S. net product sales for the thirteen weeks ended July 26, 2013 increased by $5.5 million, or 10.8%, as compared to the thirteen weeks ended July 27, 2012, due to a sales volume of 6.2% and increased average selling prices of 4.6%. The average selling price increased due to continued market penetration of our higher-priced AspireHC generator and price increase effective January 1, 2013.

International net product sales for the thirteen weeks ended July 26, 2013 increased by $2.0 million, or 21.9%, as compared to the thirteen weeks ended July 27, 2012, due primarily to increased sales volume of 20.7% and a higher average selling price of 1.2%. Sales volume increased due to higher sales in almost all international markets. The average selling price increased slightly due to higher market penetration of our higher-priced AspireHC in certain countries. We experienced a favorable foreign currency impact of $0.1 million. On a constant currency basis, international sales increased by 20.2%.

Licensing revenues for the thirteen weeks ended July 26, 2013 increased by $1.1 million as compared to the thirteen weeks ended July 27, 2012, due to the amortization of the remaining balance of deferred revenue. 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. Due to our obligations under the agreement we recorded the up-front payment as deferred revenue and have been amortizing the balance at approximately $0.4 million per quarter. However, during the quarter ended July 26, 2013, our obligations under the contract ended and we amortized the remaining balance.


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Cost of Sales and Expenses

The table below illustrates our cost of sales and major expenses as a percent of net sales:

                                       For the Thirteen Weeks Ended
                                       July 26, 2013   July 27, 2012
Cost of sales                                  9.5%            8.3%
Selling, general and administrative           42.6%           47.0%
Research and development                      17.4%           16.1%
Litigation settlement                         10.8%            0.0%

Cost of Sales

Cost of sales consists primarily of direct labor, allocated manufacturing overhead and the acquisition cost of raw materials and components and the new medical device excise tax ("MDET"). Our cost of sales as a percent of net sales for the thirteen weeks ended July 26, 2013 increased by 1.2 percentage points to 9.5% when compared to the quarter ended July 27, 2012. This increase was primarily due to the 2.3% MDET on medical devices sold domestically that added $0.9 million to cost of sales for the quarter ended July 26, 2013 as compared to the quarter ended July 27, 2012.

Selling, General and Administrative ("SG&A") Expenses

SG&A expenses are comprised of sales, marketing, general and administrative activities. SG&A expenses for the thirteen weeks ended July 26, 2013 decreased as a percentage of net sales by 4.4 percentage points to 42.6% as compared to the thirteen weeks ended July 27, 2012. This decrease is due primarily to more efficient use of our sales and marketing expenditures and a reduction in cash-based and share-based compensation.

Research and Development ("R&D") Expenses

R&D expenses consist of expenses related to our product and process development, product design efforts, clinical trial programs and regulatory activities. R&D expense increased 1.3 percentage points to 17.4% as a percentage of sales for the thirteen weeks ended July 26, 2013, as compared to the thirteen weeks ended July 27, 2012. R&D spending increased primarily due to an increase in our product development and clinical study efforts with respect to the AspireSR generator, the ProGuardian event monitoring system, rechargeable battery and wireless communication technology and the treatment of chronic heart failure with Autonomic Regulation Therapy.

Litigation Settlement

We executed a letter agreement with Dr. Zabara settling a dispute regarding our 1988 patent license agreement, resulting in a $7.4 million charge, before a tax benefit of $2.7 million, recorded in our consolidated statement of income for the quarter ended July 26, 2013. For a description of this matter, see "Note 9. Commitments and Contingencies - Litigation" in the notes to our condensed consolidated financial statements.

Impairment of Investment

During the quarter ended July 27, 2012, we determined that the fair value of our investment in a convertible debt instrument of NeuroVista, a privately-held, development-stage medical device company, was below the carrying value and recorded an other-than-temporary impairment loss of $4.1 million.

Other Income (Expense), Net

Other income (expense), net consisted of foreign currency transaction gains and losses. For the thirteen weeks ended July 26, 2013, our FX transaction losses were $131,000, as compared to FX transaction gains of $67,000 for the thirteen weeks July 27, 2012. We operate in a number of international markets and are exposed to the impact of foreign currency exchange rate movements on earnings, particularly with respect to the U.S. dollar versus the euro.


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Income Taxes

Our effective tax rates were 35.8% and 39.1% for the thirteen weeks ended July 26, 2013 and July 27, 2012, respectively. The rates were primarily due to our federal income tax rate of 35%, plus state and foreign income taxes and permanent differences. The 3.3% reduction in the tax rate between the two quarters is primarily due to the Texas R&D tax credit, which was enacted during the thirteen weeks ended July 26, 2013 and applies to our tax year ended April 26, 2013 and subsequent years. The rate reduction is also due to the domestic manufacturing tax deduction under Internal Revenue Code Section 199, which became available to us during the quarter ended July 26, 2013, because we expect to report federal taxable income after utilization of net operating loss carryforwards for fiscal year 2014. As of the quarter ended July 26, 2013, we have not provided for U.S. income taxes for the undistributed earnings of our foreign subsidiaries. These earnings, while not material to our consolidated statements of income, are intended to be permanently reinvested outside the United States.

We are subject to income tax examinations for our U.S. federal income taxes, non-U.S. income taxes and state and local income taxes for the fiscal year 1992 and subsequent years, with certain exceptions. Our European subsidiary, Cyberonics Europe BVBA, is currently under examination by the Belgium tax authority with respect to transfer pricing. We are unable to assess the impact the examination may have on our consolidated financial statements, at this time. The Belgium tax losses of Cyberonics, BVBA are subject to a full valuation allowance.

Liquidity and Capital Resources

Cash, Cash Equivalents

Cash Flows

Net cash provided by (used in) operating, investing and financing activities for the thirteen weeks ended July 26, 2013 and July 27, 2012 was as follows (in thousands):

                                         For the Thirteen Weeks Ended
                                     July 26, 2013         July 27, 2012          Change
Operating activities                $        9,488        $        14,932      $   (5,444)
Investing activities                       (17,084)                (3,665)        (13,419)
Financing activities                        (6,813)                (5,385)         (1,428)
Effect of exchange rate changes
on cash and cash equivalents                    22                   (244)            266
Net increase (decrease)             $      (14,387)       $         5,638      $  (20,025)

Operating Activities

Cash provided by operating activities during the thirteen weeks ended July 26, 2013 was $9.5 million and was primarily due to net income of $8.7 million, plus non-cash income and expense items of $2.5 million, offset by cash used in operating assets and liabilities of $1.7 million. Non-cash item expense items consisted primarily of stock-based compensation expense of $3.2 million and depreciation of $1.0 million. Non-cash income consisted of the amortization of the remaining balance of deferred license revenue of $1.5 million. Cash used for operating assets and liabilities included a decrease in accounts payable and accrued liabilities of $9.2 million due to reduced compensation accruals based on timing of payments, offset by an increase in the accrued liability for the litigation settlement of $7.1 million. Refer to "Litigation Settlement" above.

Investing Activities

Cash used in investing activities during the thirteen weeks ended July 26, 2013 was $17.1 million, which consisted primarily of net purchases of certificates of deposit of $5.0 million, purchases of commercial paper of $5.0 million, investment in land, plant and equipment of $5.5 million, and intangible asset purchases of $1.3 million focused on the integration of MRI compatibility with our leads and the development of a neurostimulation device with cardiac-based seizure detection capabilities. Plant and equipment investment consisted of Houston facilities and equipment of $4.6 million and construction costs for our manufacturing facility in Costa Rica of $0.9 million. We expect to expend approximately $17 million for capital development during fiscal year 2014, including the Costa Rica project. The construction of the Costa Rica manufacturing facility is expected to be completed in fiscal year 2014 and operational in fiscal year 2015.


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Financing Activities

Cash used in financing activities during the thirteen weeks ended July 26, 2013 was $6.8 million primarily due to purchases of treasury stock of $13.0 million offset by proceeds from the exercise of stock options of $2.6 million and excess tax benefits from exercises of stock options and restricted stock of $4.5 million. Our Board of Directors authorizes purchases of our common stock on the open market, and the volume and timing of such purchases depend on market conditions and other factors. During the thirteen weeks ended July 26, 2013, we repurchased shares of our stock on the open market at a cost of $10.7 million and from our employees for withholding tax obligations on the vesting of restricted stock at a cost of $2.3 million.

Liquidity

We believe our current liquidity and capital resources will be adequate to fund anticipated business activities for the next 12 months. Our liquidity could be . . .

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