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CRY > SEC Filings for CRY > Form 10-K on 21-Feb-2014All Recent SEC Filings

Show all filings for CRYOLIFE INC

Form 10-K for CRYOLIFE INC


21-Feb-2014

Annual Report


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

Overview

CryoLife, Inc. ("CryoLife," the "Company," "we," or "us") develops, manufactures, and commercializes medical devices for cardiac and vascular applications and preserves and distributes human tissues for transplantation. CryoLife's surgical sealants and hemostats include BioGlue® Surgical Adhesive ("BioGlue"), BioFoam® Surgical Matrix ("BioFoam"), and PerClot®, an absorbable powdered hemostat, which the Company distributes internationally for Starch Medical, Inc. ("SMI"). CryoLife's subsidiary, Cardiogenesis Corporation ("Cardiogenesis"), specializes in the treatment of coronary artery disease using a laser console system and single use, fiber-optic handpieces to treat patients with severe angina. CryoLife and its subsidiary, Hemosphere, Inc. ("Hemosphere"), market the Hemodialysis Reliable Outflow Graft ("HeRO®Graft"), which is a solution for end-stage renal disease ("ESRD") in certain hemodialysis patients. The cardiac and vascular human tissues distributed by CryoLife include the CryoValve® SG pulmonary heart valve ("CryoValve SGPV") and the CryoPatch® SG pulmonary cardiac patch tissue ("CryoPatch SG"), both of which are processed using CryoLife's proprietary SynerGraft® technology.

For the year ended December 31, 2013 CryoLife had record annual revenues of $140.8 million, increasing 7% over the prior year. The Company's cash position was strong as the Company generated $16.8 million in cash flows from operations during 2013 and an additional $15.4 million in cash proceeds from the sale of its investment in Medafor, Inc. ("Medafor") common stock. The Company experienced increases in research and development expenses during 2013 related to the development of PerClot. During the fourth quarter of 2013 the Company recognized a $3.2 million other than temporary impairment of its investment in the preferred stock of ValveXchange, Inc. ("ValveXchange"). See the "Results of Operations" section below for additional analysis of the fourth quarter and full year 2013 results. See Part I, Item 1, "Business," for further discussion of the Company's business and activities during 2013.

Recent Events

C.R. Bard's Acquisition of Medafor

On October 1, 2013 C.R. Bard, Inc. ("Bard") completed its previously announced acquisition of the outstanding shares of Medafor common stock. The Company received an initial payment of $15.4 million for its 2.4 million shares of Medafor common stock and recorded an initial gain of approximately $12.7 million on the sale in the fourth quarter of 2013. The Company could receive additional payments totaling up to an additional $8.4 million upon the release of funds held in escrow and the satisfaction of certain contingent milestones, measurable through June 2015. The first of these additional payments, which the Company believes could be up to approximately $525,000, if released, would be received in late 2014, although this amount is subject to possible offsets. See also Part I, Item 1A, "Risk Factors-Risks Relating To Our Business- Although We May Receive Additional Cash Of Up To $8.4 Million In The Future Related To Medafor's Earnout And Release Of Escrow Funds Related To Bard's Acquisition of Medafor, It Is Possible We May Not Receive Any Additional Monies, Or The Amount Of The Additional Monies Received Could Be Significantly Less Than $8.4 Million." These payments will be recorded as an additional gain when and if received by the Company.

Regulatory Activity

On January 30, 2013 CryoLife received a warning letter ("Warning Letter") dated January 29, 2013 from the U.S. Food and Drug Administration ("FDA"). The Warning Letter followed a Form 483, Notice of Inspectional Observations, from the FDA ("CryoLife Form 483") related to the Company's processing, preservation, and distribution of human tissue and the manufacture of medical devices. The CryoLife Form 483 followed a routine quality system inspection of the Company's facilities by the FDA during the period September 17, 2012 to October 16, 2012. The Warning Letter relates to certain observations from the CryoLife Form 483 that the FDA believes were either inadequately addressed by the Company's responses or for which the FDA required further information to fully assess the Company's corrective actions. The Company responded to the FDA's requests and implemented corrective actions. The Company believes that these corrective actions have adequately addressed the FDA's notice of violations contained in the Warning Letter, however, it is possible that the Company's actions ultimately may not be satisfactory to the FDA.

During the second quarter of 2013 the Company received verbal communication from the FDA indicating that these corrective actions appear satisfactory in addressing the issues raised in the Warning Letter. On February 18, 2014 the FDA commenced its reinspection of the Company with respect to the Warning Letter to determine whether it is satisfied with the Company's actions and responses. This reinspection will include a quality system inspection of the Company's products, services, and facilities. The Company believes that the Warning Letter and its actions regarding the Warning Letter and CryoLife Form 483 will not have a material effect on the Company. However, it is possible that further actions the Company


may be required to take in response to the reinspection or the quality system inspection could materially, adversely affect the availability of the Company's products and tissues and cost structure, which could affect the Company's revenues, financial condition, profitability, or cash flows.

Following the receipt of the Warning Letter, on March 28, 2013 CryoLife received a letter from the Human Tissue Authority ("HTA") in London, U.K., which governs the distribution of tissues into markets in Europe by the Company's subsidiary, CryoLife Europa, Ltd. ("Europa"). The letter temporarily suspended Europa's license to import human tissue, due to concerns the HTA had related to the FDA Warning Letter, and directed Europa to issue a recall for tissues previously distributed which had not been implanted. The HTA subsequently issued a variance to allow Europa to continue to import tissue into Europe under certain circumstances for critically ill patients. Subsequent to the issuance of the variance, the HTA reinstated Europa's license but placed certain conditions on the processing of tissue, which would generate significant additional costs when compared to the Company's current processes. As a result, the Company plans to cease shipment of tissues into Europe as of March 31, 2014.

On May 23, 2013 CryoLife received a Form 483 related to the Company's subsidiary Cardiogenesis ("Cardiogenesis Form 483"). The Cardiogenesis Form 483 followed a quality system inspection of the Company's facilities by the FDA in May 2013. The Cardiogenesis Form 483 includes observations concerning labeling, complaint handling, and field actions. The Company has responded to the FDA's requests and implemented changes that it believes address the FDA's observations. Subsequent to receipt of the Cardiogenesis Form 483, as discussed above, Cardiogenesis received Premarket Approval ("PMA") supplement approval from the FDA for its redesigned Sologrip and Port Enabled Angina Relief with Laser ("PEARL") handpieces.

On February 14, 2014 CryoLife received a Form 483 related to the Company's subsidiary Hemosphere ("Hemosphere Form 483"). The Hemosphere Form 483 followed a quality system inspection of the Company's facilities by the FDA in February 2014. The Hemosphere Form 483 includes observations concerning nonconformance inspections and manufacturing, the Company's corrective and preventive action procedures, and documentation issues. The Company has already had verification of its implementation of corrective action with respect to one observation and expects to respond to the remaining observations from the Hemosphere Form 483 within 15 business days, as required by law. The Company believes that the changes that it will implement will address the FDA's observations; however, it is possible that the Company may not be able to do so in a manner satisfactory to the FDA, and the FDA could issue a warning letter or take other actions, including requiring a recall or manufacturing hold. The Company believes that the Hemosphere Form 483 will not have a material effect on the Company. However, it is possible that actions it may be required to take in response to the Hemosphere Form 483 could materially, adversely affect the Company's revenues, financial condition, profitability, or cash flows.

See also Part I, Item 1A, "Risk Factors."

Critical Accounting Policies

A summary of the Company's significant accounting policies is included in Part II, Item 8, Note 1 of the "Notes to Consolidated Financial Statements." Management believes that the consistent application of these policies enables the Company to provide users of the financial statements with useful and reliable information about the Company's operating results and financial condition. The consolidated financial statements are prepared in accordance with accounting principles generally accepted in the U.S. which require the Company to make estimates and assumptions. The following are accounting policies that management believes are most important to the portrayal of the Company's financial condition and results of operations and may involve a higher degree of judgment and complexity.

Fair Value Measurements

The Company records certain financial instruments at fair value, including: cash equivalents, certain marketable securities, certain restricted securities, contingent consideration, and derivative instruments. The Company may make an irrevocable election to measure other financial instruments at fair value on an instrument-by-instrument basis; although as of December 31, 2013 the Company has not chosen to make any such elections. Fair value financial instruments are recorded in accordance with the fair value measurement framework.

The Company also measures certain non-financial assets at fair value on a non-recurring basis. These non-recurring valuations include evaluating assets such as cost method investments, long-lived assets, and non-amortizing intangible assets for impairment; allocating value to assets in an acquired asset group; and applying accounting for business combinations. The Company uses the fair value measurement framework to value these assets and reports these fair values in the periods in which they are recorded or written down.


The fair value measurement framework includes a fair value hierarchy that prioritizes observable and unobservable inputs used to measure fair values in their broad levels. These levels from highest to lowest priority are as follows:

• Level 1: Quoted prices (unadjusted) in active markets that are accessible at the measurement date for identical assets or liabilities;

• Level 2: Quoted prices in active markets for similar assets or liabilities or observable prices that are based on inputs not quoted on active markets, but corroborated by market data; and

• Level 3: Unobservable inputs or valuation techniques that are used when little or no market data is available.

The determination of fair value and the assessment of a measurement's placement within the hierarchy requires judgment. Level 3 valuations often involve a higher degree of judgment and complexity. Level 3 valuations may require the use of various cost, market, or income valuation methodologies applied to unobservable management estimates and assumptions. Management's assumptions could vary depending on the asset or liability valued and the valuation method used. Such assumptions could include: estimates of prices, earnings, costs, actions of market participants, market factors, or the weighting of various valuation methods. The Company may also engage external advisors to assist in determining fair value, as appropriate.

Although the Company believes that the recorded fair value of its financial instruments is appropriate, these fair values may not be indicative of net realizable value or reflective of future fair values.

Deferred Preservation Costs

By federal law, human tissues cannot be bought or sold, therefore, the tissues the Company preserves are not held as inventory. The costs the Company incurs to procure and process cardiac and vascular tissues are instead accumulated and deferred. Deferred preservation costs are stated at the lower of cost or market value on a first-in, first-out basis and are deferred until revenue is recognized. At each balance sheet date, deferred preservation costs includes costs of tissues available for shipment, tissues currently in active processing, and tissues held in quarantine pending release to implantable status.

Upon shipment of the tissue to an implanting facility, revenue is recognized and the related deferred preservation costs are expensed as cost of preservation services. Cost of preservation services also includes, as applicable, lower of cost or market write-downs and impairments for tissues not deemed to be recoverable, and includes, as incurred, idle facility expense, excessive spoilage, extra freight, and rehandling costs.

The calculation of deferred preservation costs involves judgment and complexity and uses the same principles as inventory costing. Donated human tissue is procured from deceased human donors by organ and tissue procurement organizations ("OTPOs"), which consign the tissue to the Company for processing, preservation, and distribution. Deferred preservation costs consist primarily of the procurement fees charged by the OTPOs, direct labor and materials (including salary and fringe benefits, laboratory supplies and expenses, and freight-in charges), and indirect costs (including allocations of costs from support departments and facility allocations). Fixed production overhead costs are allocated based on actual tissue processing levels, to the extent that they are within the range of the facility's normal capacity.

These costs are then allocated among the tissues processed during the period based on cost drivers, such as the number of donors or number of tissues processed. The Company applies a yield estimate to all tissues in process and in quarantine to estimate the portion of tissues that will ultimately become implantable. Management estimates quarantine yields based on its experience and reevaluates these estimates periodically. Actual yields could differ significantly from the Company's estimates, which could result in a change in tissues available for shipment, and could increase or decrease the balance of deferred preservation costs. These changes could result in additional cost of preservation services expense or could increase per tissue preservation costs, which would impact gross margins on tissue preservation services in future periods.

The Company regularly evaluates its deferred preservation costs to determine if the costs are appropriately recorded at the lower of cost or market value. The Company also evaluates its deferred preservation costs for costs not deemed to be recoverable, including tissues not expected to ship prior to the expiration date of their packaging. Lower of cost or market value write-downs are recorded if the tissue processing costs incurred exceed the estimated market value of the tissue services, based on recent average service fees at the time of the evaluation. Impairment write-downs are recorded based on the book value of tissues deemed to be impaired. Actual results may differ from these estimates. Write-downs of deferred preservation costs are expensed as cost of preservation services, and these write-downs are permanent impairments that create a new cost basis, which cannot be restored to its previous levels if the Company's estimates change.


The Company recorded write-downs to its deferred preservation costs totaling $448,000, $195,000, and $270,000 for the years ended December 31, 2013, 2012, and 2011, respectively.

Deferred Income Taxes

Deferred income taxes reflect the net tax effect of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and tax return purposes. The Company periodically assesses the recoverability of its deferred tax assets, as necessary, when the Company experiences changes that could materially affect its determination of the recoverability of its deferred tax assets. Management provides a valuation allowance against the deferred tax asset when, as a result of this analysis, management believes it is more likely than not that some portion or all of its deferred tax assets will not be realized.

Assessing the recoverability of deferred tax assets involves judgment and complexity. Estimates and judgments used in the determination of the need for a valuation allowance and in calculating the amount of a needed valuation allowance include, but are not limited to, the following:

• Projected future operating results,

• Anticipated future state tax apportionment,

• Timing and amounts of anticipated future taxable income,

• Timing of the anticipated reversal of book/tax temporary differences,

• Evaluation of statutory limits regarding usage of certain tax assets, and

• Evaluation of the statutory periods over which certain tax assets can be utilized.

Significant changes in the factors above, or other factors, could materially, adversely affect the Company's ability to use its deferred tax assets. Such changes could have a material, adverse impact on the Company's operations, financial condition, and cash flows. The Company will continue to assess the recoverability of its deferred tax assets, as necessary, when the Company experiences changes that could materially affect its prior determination of the recoverability of its deferred tax assets.

The Company believes that the realizability of its acquired net operating loss carryforwards will be limited in future periods due to a change in control of its subsidiaries Hemosphere and Cardiogenesis, as mandated by Section 382 of the Internal Revenue Code of 1986, as amended. The Company believes that its acquisition of Hemosphere constituted a change in control and that prior to the Company's acquisition, Hemosphere had experienced other equity ownership changes that should be considered a change in control. The Company also believes that its acquisition of Cardiogenesis constituted a change in control. The deferred tax assets recorded on the Company's Consolidated Balance Sheets do not include amounts that it expects will not be realizable due to these changes in control. A portion of the acquired net operating loss carryforwards is related to state income taxes for which management believes it is more likely than not that these deferred tax assets will not be realized. Therefore, the Company recorded a valuation allowance against these state net operating loss carryforwards.

Valuation of Acquired Assets or Businesses

As part of its corporate strategy, the Company is seeking to identify and evaluate acquisition opportunities of complementary product lines and companies. The Company evaluates and accounts for acquired patents, licenses, distribution rights, and other tangible or intangible assets as the purchase of an asset or asset group or as a business combination, as appropriate. The determination of whether the purchase of a group of assets should be accounted for as an asset group or as a business combination requires significant judgment based on the weight of available evidence.

For the purchase of an asset group, the Company allocates the cost of the asset group, including transaction costs, to the individual assets purchased based on their relative estimated fair values. In-process research and development acquired as part of an asset group is expensed upon acquisition. The Company accounts for business combinations by allocating the purchase price to the assets and liabilities acquired at their estimated fair value. Transaction costs related to a business combination are expensed as incurred. In-process research and development acquired as part of a business combination is accounted for as an indefinite-lived intangible asset until the related research and development project gains regulatory approval or is discontinued.

The Company typically engages external advisors to assist it in determining the fair value of acquired asset groups or business combinations, using valuation methodologies such as: the excess earnings, the discounted cash flow, or the relief


from royalty methods. The determination of fair value in accordance with the fair value measurement framework requires significant judgments and estimates, including, but not limited to: timing of product life cycles, estimates of future revenues, estimates of profitability for new or acquired products, cost estimates for new or changed manufacturing processes, estimates of the cost or timing of obtaining regulatory approvals, estimates of the success of competitive products, and discount rates. Management, in consultation with its advisor(s), makes these estimates based on its prior experiences and industry knowledge. Management believes that its estimates are reasonable, but actual results could differ significantly from the Company's estimates. A significant change in management's estimates used to value acquired asset groups or business combinations could result in future write-downs of tangible or intangible assets acquired by the Company and, therefore, could materially impact the Company's financial position and profitability. If the value of the liabilities assumed by the Company, including contingent liabilities, is determined to be significantly different from the amounts previously recorded in purchase accounting, the Company may need to record additional expenses or write-downs in future periods, which could materially impact the Company's financial position and profitability.

New Accounting Pronouncements

In January 2013 the Company adopted Accounting Standards Update ("ASU"), 2012-02, Intangibles-Goodwill and Other (Topic 350): Testing Indefinite-Lived Intangible Assets for Impairment, which gives entities testing indefinite-lived intangible assets for impairment the option of performing a qualitative assessment before performing the quantitative impairment test as well as the option to bypass the qualitative assessment in any period and proceed directly to performing the quantitative impairment test. The adoption of ASU 2012-02 did not have a material effect on the Company's financial condition, profitability, or cash flows.

In February 2013 the Company adopted ASU 2013-02, Comprehensive Income (Topic 220): Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income, which requires separate presentation of the components that are reclassified out of accumulated other comprehensive income either on the face of the financial statements or in the notes to the financial statements. This update also requires companies to disclose the income statement line items affected by any significant reclassifications. The adoption of ASU 2013-02 did not have a material effect on the Company's financial disclosures.


Results of Operations

(In thousands)

     Year Ended December 31, 2013 Compared to Year Ended December 31, 2012

Revenues



                                                                               Revenues as a Percentage of
                                           Revenues for the Three                Total Revenues for the
                                                Months Ended                       Three Months Ended
                                                December 31,                          December 31,
                                            2013              2012             2013                   2012
Products:
BioGlue and BioFoam                     $     14,766        $ 13,353                 42 %                   41 %
PerClot                                          808           1,009                  2 %                    3 %
Revascularization technologies                 2,128           1,985                  6 %                    6 %
HeRO Graft                                     1,668           1,106                  5 %                    3 %

Total products                                19,370          17,453                 55 %                   53 %
Preservation services:
Cardiac tissue                                 7,488           7,094                 21 %                   22 %
Vascular tissue                                8,599           8,138                 24 %                   25 %

Total preservation services                   16,087          15,232                 45 %                   47 %
Other                                             -              115                 -  %                   -  %

Total                                   $     35,457        $ 32,800                100 %                  100 %

                                                                                Revenues as a Percentage of
                                           Revenues for the Twelve                Total Revenues for the
                                                Months Ended                        Twelve Months Ended
                                                December 31,                           December 31,
                                            2013              2012              2013                   2012
Products:
BioGlue and BioFoam                     $     58,004        $  53,211                 41 %                   41 %
PerClot                                        3,494            3,078                  3 %                    2 %
Revascularization technologies                 8,965            8,092                  6 %                    6 %
HeRO Graft                                     5,731            3,115                  4 %                    2 %

Total products                                76,194           67,496                 54 %                   51 %
Preservation services:
Cardiac tissue                                29,523           29,756                 21 %                   23 %
Vascular tissue                               34,975           33,847                 25 %                   26 %

Total preservation services                   64,498           63,603                 46 %                   49 %
Other                                             71              619                 -  %                   -  %

Total                                   $    140,763        $ 131,718                100 %                  100 %

Revenues increased 8% and 7% for the three and twelve months ended December 31, 2013, respectively, as compared to the three and twelve months ended December 31, 2012, respectively. A detailed discussion of the changes in product revenues and preservation services revenues for the three and twelve months ended December 31, 2013 is presented below.

Products

Revenues from products increased 11% and 13% for the three and twelve months ended December 31, 2013, respectively, as compared to the three and twelve months ended December 31, 2012, respectively. These increases were primarily due to an increase in BioGlue revenues, and to a lesser extent due to the addition of HeRO Graft revenues as a


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