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VOLC > SEC Filings for VOLC > Form 10-K on 28-Feb-2014All Recent SEC Filings

Show all filings for VOLCANO CORP

Form 10-K for VOLCANO CORP


28-Feb-2014

Annual Report


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

The following discussion and analysis should be read in conjunction with "Selected Financial Data" and our consolidated financial statements and notes thereto included elsewhere in this Annual Report. Overview
We design, develop, manufacture and commercialize a broad suite of precision guided therapy tools including intravascular ultrasound, or IVUS, and fractional flow reserve, or FFR, products. We believe that these products enhance the diagnosis and treatment of coronary and peripheral vascular disease by improving the efficiency and efficacy of existing diagnostic angiograms and percutaneous coronary interventional, or PCI, and endovascular procedures in the coronary arteries or peripheral arteries and veins. We are facilitating the adoption of functional PCI, in which our FFR technology is used to help determine whether or not a stent is necessary, and IVUS is used as an adjunct to angiography to guide stent placement and optimization. We market our products to physicians, nurses and technicians who perform a variety of endovascular based coronary and peripheral interventional procedures in hospitals and to other personnel who make purchasing decisions on behalf of hospitals.
Our products consist of consoles that are marketed as stand-alone units or as units that can be integrated into a variety of hospital-based interventional surgical suites called catheterization laboratories, or cath labs. We have developed customized cath lab versions of these consoles and are developing additional functionality options as part of our cath lab integration initiative. Our consoles have been designed to serve as a multi-modality platform for our phased array and rotational IVUS catheters, FFR pressure and flow wires and image-guided therapy catheters, such as the Pioneer Plus reentry device acquired from Medtronic, Inc., or Medtronic, on August 30, 2013.
Our IVUS products include single-procedure disposable phased array and rotational IVUS imaging catheters, and additional functionality options such as ChromaFlo® stent apposition analysis. Our FFR offerings can be accessed through our multi-modality platforms, and we also provide FFR-only consoles. Our FFR disposables are single-procedure disposable pressure and flow guide wires used to measure the pressure and flow characteristics of blood around plaque enabling physicians to gauge the plaque's physiological impact on blood flow and pressure. We have developed additional offerings for integration into the platform, including adenosine-free Instant Wave-Free Ratio FFR, or iFR®. We are currently developing high resolution Focal Acoustic Computed Tomography, or FACT, catheters, co-registration with IVUS and an IVUS-guided Crux VCF system featuring our inferior vena cava, or IVC, filter. Our Valet microcatheter, Visions® PV .035 catheter and Eagle Eye® Platinum ST short tip catheter, or EEP, products received 510(k) clearance and CE Mark approval in 2012 and their commercial launch occurred in 2013. In addition, we initiated the commercial launch of our Verrata pressure guide wire, our fifth new pressure wire in five years, during 2013.
Through Axsun Technologies, Inc., or Axsun, one of our wholly-owned subsidiaries, we also develop and manufacture optical monitors for the telecommunications industry, laser and non-laser light sources, optical engines used in medical optical coherence topography, or OCT, imaging systems and advanced photonic components and sub-systems used in spectroscopy and other industrial applications. We believe Axsun's proprietary OCT technology will provide us competitive advantages in the invasive imaging sector, as well as for applications in ophthalmology and dental.
We have infrastructure in the U.S., Europe, Japan and Costa Rica. Our corporate office is located in California, U.S. Our manufacturing facilities are located in Coyol, Costa Rica, and Rancho Cordova, California. In Costa Rica we manufacture IVUS catheters and FFR guide wires. In California, we produce multi-modality consoles, FFR consoles, IVUS catheters, FFR guide wires and our Crux IVC filters. We are in the process of transitioning all of our disposable manufacturing activities to our Costa Rica facility. In addition, we have a manufacturing facility in Billerica, Massachusetts that produces our optical monitors, laser and non-laser light sources, and optical engines used in OCT imaging systems as well as micro-optical spectrometers and optical channel monitors. We have research and development facilities in U.S. and Israel. We have sales offices in the U.S. and Japan; sales and distribution offices in Belgium and South Africa; and third-party distribution facilities in Japan. At December 31, 2013, we had over 1,800 full time employees worldwide, including over 900 manufacturing employees, over 370 sales and marketing employees and over 170 research and development employees.
We have focused on building our domestic and international sales and marketing infrastructure to market our products to physicians and technicians who perform diagnostic angiography, PCI and endovascular procedures in hospitals and to other personnel who make purchasing decisions on behalf of hospitals. We sell our products directly to customers in the United States, Japan, certain European markets and South Africa. We utilize distributors in other geographic areas, which are also involved in product launch planning, education and training, physician support and clinical study management.


At December 31, 2013, we had a worldwide installed base of over 7,000 consoles, excluding our legacy In-Vision Gold systems. We intend to grow and leverage this installed base to drive recurring sales of our single-procedure disposable catheters and guide wires. In the year ended December 31, 2013, the sale of our single-procedure disposable catheters and guide wires accounted for $306.9 million, or 79.7% of our medical segment revenues, a $6.2 million, or 2.1% increase from the year ended December 31, 2012, in which the sale of our single-procedure disposable catheters and guide wires accounted for $300.7 million, or 81.0% of our medical segment revenues.
Our revenues have increased from $343.5 million in 2011 to $381.9 million in 2012 and to $393.7 million in 2013. We had operating loss of $29.9 million during 2013, and operating income of $19.6 million and $25.4 million during 2012 and 2011, respectively. The 2013 operating loss includes $5.0 million of acquisition-related items and $19.4 million of restructuring charges. The 2012 operating income included $1.9 million of acquisition-related expenses. During 2013, our management approved two restructuring plans: (1) to consolidate and transition our manufacturing resources related to the manufacture of disposables to Costa Rica, (2) to reprioritize and reallocate our resources within our distribution, research and development, and clinical programs that we believe better advance our key strategies. The key elements under the second restructuring plan include the discontinuation of development programs for our Forward-Looking IVUS, or FL.IVUS, Forward-Looking Intra-Cardiac Echo, or FL.ICE, and Optical Coherence Tomography, or OCT, intravascular coronary imaging development programs, the termination of the commercial sale of our ReFLOW Aspiration Catheter, or ReFLOW product line, and a modest reorganization of several functional areas and business units within the Company. We recorded $19.4 million of restructuring charges during 2013. Refer to "Item 8, Financial Statements and Supplementary Data - Notes to Consolidated Financial Statements, Note 3 Financial Statements Details - Restructuring Activity" in this Annual Report on Form 10-K.
In the years ended December 31, 2013, 2012 and 2011, 44.6%, 46.3% and 47.3%, respectively, of our revenues and 19.8%, 22.7% and 22.5%, respectively, of our operating expenses were denominated in various non-U.S. dollar currencies, primarily the Japanese yen and the euro. We expect that a significant portion of our revenue and operating expenses will continue to be denominated in non-U.S. dollar currencies. As a result, we are subject to risks related to fluctuations in foreign currency exchange rates, which could affect our operating results in the future. If our yen or euro denominated sales exceed our yen or euro denominated costs, and the U.S. dollar strengthens relative to the yen or euro, there is an adverse effect on our results of operations. Conversely, if the U.S. dollar weakens relative to the yen or euro, there is a positive effect on our results of operations. For example, the average exchange rate of one U.S. dollar to yen increased 21.5% from 79.3 in 2012 to 96.4 in 2013, which resulted in a net negative impact to our operational results for 2013 in the amount of approximately $14.1 million. The average exchange rate of one euro to U.S. dollar increased 2.8% from 1.29 in 2012 to 1.33 in 2013, which resulted in a net positive impact to our operational results for 2013 in the amount of approximately $1.2 million.
We use third-party manufacturing partners to produce circuit boards and mechanical sub-assemblies used in the manufacture of our consoles. We also use third-party manufacturing partners for certain proprietary components used in the manufacture of our single-procedure disposable products. We perform incoming inspection on these circuit boards, mechanical sub-assemblies and components, assemble them into finished products, and test the final product to assure quality control. We do not carry significant inventory of transducers, substrates or scanner subassemblies. If we had to change suppliers, we expect that it would take 6 to 24 months to identify appropriate suppliers, complete design work and undertake the necessary inspections and testing before the new transducers, substrates and subassemblies would be available. External Factors
In September 2009, published findings from the Fractional Flow Reserve versus Angiography for Multivessel
Evaluation, or FAME, study demonstrated that patients in the study with multi-vessel coronary artery disease who were treated by FFR guidance had a 34% reduction in death and myocardial infarction (heart attack) compared to angiographic guidance alone. In August 2012, the results of the Fractional Flow Reserve-Guided PCI vs. Medical Therapy in Stable Coronary Disease, or FAME 2, study were published in the New England Journal of Medicine. FAME 2 showed that patients receiving PCI with proven ischemia by FFR had 66% fewer primary endpoint events including death, myocardial infarction and urgent revascularization's (e.g. coronary bypass) than those patients treated with optimal medical therapy alone. We believe these findings will continue to drive the growth and adoption of our disposable FFR wire products.
With respect to IVUS, two-year data released in 2013 from the ADAPT-DES study (Assessment of Platelet Therapy with Drug-Eluting Stents), the largest study conducted with IVUS guidance to date, indicated IVUS guidance was associated with reductions in certain serious patient events, including stent thrombosis and myocardial infarction, and that IVUS guidance was associated with a change in procedure 74% of the time. These data suggest that IVUS guidance can play an important role in helping to improve patient outcomes.


The Patient Protection and Affordable Care Act and Health Care and Education Affordability Reconciliation Act were enacted into law in the U.S. on March 23, 2010. The legislation imposed on medical device manufacturers a 2.3 percent excise tax on U.S. sales of Class I, II and III medical devices beginning January 1, 2013.
The economic conditions in many countries and regions where we generate our revenues remain uncertain. If our customers do not obtain or do not have access to the necessary capital to operate their businesses, or are otherwise adversely affected by any deterioration in national and worldwide economic conditions, this could result in reductions in the sales of our products, longer sales cycles and slower adoption of new technologies by our customers, which would materially and adversely affect our business. In addition, our customers' and suppliers' liquidity, capital resources and credit may be adversely affected by their relative ability or inability to obtain capital and credit, which could adversely affect our ability to collect on our outstanding invoices and lengthen our collection cycles, or limit our timely access to important sources of raw materials necessary for the manufacture of our consoles and catheters. In addition, the political unrest in certain regions of the world may have adverse consequences to the global economy or to our customers in certain regions, which could negatively impact our business. Uncertainty about future economic conditions may make it more difficult for us to forecast operating results and to make decisions about future investments. For further discussion, see "Risk Factors-General national and worldwide economic conditions may materially and adversely affect our financial performance and results of operations."
Financial Operations Overview
The following is a description of the primary components of our revenue and expenses.
Revenues. We derive our revenues from two reporting segments: medical and industrial. Our medical segment represents our core business, in which we derive revenues primarily from the sale of our consoles and single-procedure disposables. Our industrial segment derives revenues related to the sales of Axsun's micro-optical spectrometers and optical channel monitors to telecommunication and other industrial companies. In the year ended December 31, 2013, we generated $393.7 million of revenues which is comprised of $385.2 million from our medical segment and $8.4 million from our industrial segment. We experienced increases in revenues related to consoles and FFR single-procedure disposables and decrease in revenues related to IVUS single-procedure disposables in 2013 compared with 2012. In the year ended December 31, 2013, 11.3% of our medical segment revenues were derived from the sale of our consoles, 50.4% from IVUS single-procedure disposables and 29.2% from FFR single-procedure disposables as compared with 11.0% from consoles, 55.5% from IVUS single-procedure disposables and 25.6% from FFR single-procedure disposables in the year ended December 31, 2012. Other revenues consist primarily of service and maintenance revenues, shipping and handling revenues, sales of distributed products, sales of medical products manufactured by our Axsun subsidiary, spare parts sales, and license fees.
We expect to continue experiencing variability in our quarterly revenues from console sales due in part to the timing of hospital capital equipment purchasing decisions. Further, we expect variability of our revenues based on the timing of our new product introductions, which may cause our customers to delay their purchasing decisions until the new products are commercially available. Our medical segment sales are generated by our direct sales representatives or through independent distributors and are shipped throughout the world from facilities in the United States, Belgium, Japan and South Africa. Our industrial segment sales are generated by our direct sales representatives or through independent distributors and these products are shipped primarily to telecommunications and industrial companies domestically and abroad from the United States.
Cost of Revenues. Cost of revenues consists primarily of material costs for the products that we sell and other costs associated with our manufacturing process, such as personnel costs, rent, depreciation related to our manufacturing equipment and utilities. In addition, cost of revenues includes depreciation of company-owned consoles, royalty expenses for licensed technologies included in our products, service costs, provisions for warranty, distribution, freight and packaging costs and stock-based compensation expense related to manufacturing employees. We expect a trend of improvement in our gross margin for IVUS and FFR products if we are successful in our ongoing efforts to streamline and improve our manufacturing processes, increase production volumes and transition certain manufacturing operations to Costa Rica.
Selling, General and Administrative. Selling, general and administrative expenses consist primarily of salaries and commissions and other related costs for personnel serving the sales, administrative and marketing functions. Other costs include stock-based compensation expense, professional fees for legal and accounting services, travel and entertainment expenses, facility costs, trade show, training and other promotional expenses. Due to ongoing litigation, legal expenses tend to be somewhat unpredictable in their timing and amount. We expect that our selling, general and administrative expenses will increase as we continue to expand our sales force and marketing efforts and invest in the necessary infrastructure to support our continued growth.


Included in selling, general and administrative expense is the U.S. medical device excise tax on the sale of medical devices that was effective January 1, 2013. The statutory rate of the medical device excise tax is 2.3% of revenues on initial sales of finished medical products sold in the United States. Our medical device excise tax is 0.71% of our total revenue for 2013. Our effective rate for this excise tax is less than the statutory rate which is primarily due to international sales.
Research and Development. Research and development expenses consist primarily of salaries and related expenses for personnel, consultants, prototype materials, clinical studies, depreciation, regulatory filing fees, certain legal costs related to our intellectual property and stock-based compensation expense. We expense research and development costs as incurred. Due to product development timelines, research and development costs tend to be distributed unevenly between the periods. We expect our research and development expenses to increase as we continue to develop our products and technologies.
Amortization of Intangibles. We amortize intangible assets, consisting of our developed technology, licenses, customer relationships, patents and trademarks, and covenants-not-to-compete, using the straight-line method over their estimated useful lives of up to 20 years. These assets are regularly tested for impairment and abandonment.
Acquisition-related items. Acquisition-related items consists of acquisition transaction costs, subsequent accretion of and revision, if any, to the fair value of the contingent consideration related to acquisitions and other expenses directly associated with acquisitions.
Restructuring Charges. Restructuring charges consist of employee termination benefits, asset impairments and other related charges associated with restructuring activities.
In-process Research and Development. In-process Research and Development, or IPR&D, consists of our projects acquired in connection with acquisitions that had not reached technological feasibility and had no alternative future uses as of each acquisition date. Certain additional payments that may be required in connection with our acquisitions could result in future charges to IPR&D. OCT. In December 2007, we acquired certain OCT IPR&D assets in connection with our acquisition of CardioSpectra, Inc., or CardioSpectra, which were valued at $26.3 million. At the acquisition date, the estimated costs to complete the project were $7.2 million. We incurred a total of $31.3 million for the OCT project since acquisition.
FL.IVUS. In May 2008, we acquired the FL.IVUS IPR&D assets in connection with our acquisition of Novelis, which was valued at $12.2 million. At the acquisition date, the estimated costs to complete the project were $3.9 million. We incurred a total of $19.6 million for the FL.IVUS project since acquisition. FL.ICE. In August 2010 we acquired the FL.ICE project in connection with our acquisition of Fluid Medical Inc., or Fluid Medical. This project was recorded as an IPR&D asset and was valued at $4.1 million. At the acquisition date, the estimated costs to complete the project were $5.9 million. We incurred a total of $8.5 million for the FL.ICE project since acquisition.
During 2013, our management evaluated various development projects, product lines and functional areas in an effort to reprioritize and reallocate our resources within our distribution, research and development, and clinical programs to focus on development and commercial efforts that we believe better advance our key strategies. The key elements under this restructuring plan include the discontinuation of development programs for our FL.IVUS, FL.ICE and OCT intravascular coronary imaging development programs. Refer to "Item 8, Financial Statements and Supplementary Data - Notes to Consolidated Financial Statements, Note 3 Financial Statements Details - Restructuring Activity" in this Annual Report on Form 10-K.
CO-REGISTRATION. In November 2012, in connection with our acquisition of Sync-Rx Ltd, or Sync-Rx, we acquired Sync-Rx's co-registration technology, which was still under development. This technology was recorded as an IPR&D asset and was valued at $1.3 million. At the acquisition date, the estimated costs to complete the project were approximately $4.4 million. At December 31, 2013, this project is substantially completed and we incurred a total of $3.2 million of expenses related to this project.
IVC FILTER & RETRIEVAL KIT. In December 2012, in connection with our acquisition of Crux Biomedical, Inc., or Crux, we acquired Crux's IVC filter and retrieval kit technologies, which were still under development at acquisition. These technologies were recorded as IPR&D assets and were valued at $28.4 million, of which $24.1 million was for the IVC filter technology and $4.3 million was for the IVC retrieval kit technology. At the acquisition date, the estimated costs to complete the development of the IVC filter were $4.7 million and the estimated costs to complete the development of the IVC retrieval kit were $1.7 million with estimated completion during 2014.
During the fourth quarter of 2013, we substantially completed the IVC filter development and launched the product to a limited market. The $24.1 million IPR&D associated with the IVC filter was transfered to developed technology and we began


amortizing this developed technology in December 2013. We incurred a total of $2.2 million of expenses related to the IVC filter project since acquisition. We are continuing the development of the IVC retrieval kit and the following table summarizes this IPR&D project (in millions) at December 31, 2013:

                                                                                                                                        Total Estimated
                                               As of Acquisition Date                                          Estimated Cost to       Costs to Complete
                                                                                        Costs Incurred          Complete, as of        since Acquisition
Project Name                        Fair Value        Estimated Cost to Complete       Since Acquisition       December 31, 2013              Date
IVC retrieval kit                 $         4.3     $                        1.7     $               1.0     $               0.7     $                1.7

Interest Income. Interest income is comprised of interest income earned from our cash and cash equivalents and our short-term and long-term available-for-sale investments.
Interest Expense. Interest expense is comprised of interest expense related to our convertible senior notes, including coupon interest, accretion of debt discount, and amortization of issuance costs, and interest expense related to the long-term debt acquired with Sync-Rx, offset by interest capitalization related to the Costa Rica plant construction, before the plant was placed into service in the second quarter of 2012, and our global Enterprise Resource Planning, or ERP, system implementation, before the ERP system was placed into service in the fourth quarter of 2013.
Exchange Rate Gain (Loss). Exchange rate gain (loss) is comprised of foreign currency transaction and remeasurement gains and losses, and the effect of changes in value and net settlements of our foreign exchange forward contracts. Provision for Income Taxes. Our effective tax rate is a blended rate resulting from the composition of taxable income in the global jurisdictions in which we conduct business. We apply the "with and without method-direct effects only", in accordance with authoritative guidance, with respect to recognition of stock option excess tax benefits within stockholders equity (additional paid in capital). Therefore, the provision for domestic income taxes is determined utilizing projected federal and state taxable income before the application of deductible excess tax benefits attributable to stock option exercises. For the years ended December 31, 2013, 2012 and 2011, the provision for income taxes is comprised of federal, foreign and various state and local income taxes. Our tax rate is affected by recurring items, such as tax rates in foreign jurisdictions and the relative amount of income we earn in jurisdictions, which we expect to continue to fluctuate as we increase foreign manufacturing and distribution operations. It is also affected by discrete items that may occur in any given year, but are not consistent from year to year. In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income by jurisdiction during the periods in which those temporary differences become deductible. To the extent we establish or change the valuation allowance in a period, the tax effect will generally flow through the statement of operations. In the case of an acquired or merged entity, we will record a valuation allowance on a deferred asset through purchase accounting as an adjustment to goodwill at the acquisition date if it is more likely than not that all or a portion of the acquired deferred tax assets will not be recognized in the future. Any subsequent change to a valuation allowance established during purchase accounting within the measurement period of the acquisition (not to exceed twelve months) will also be recorded as an adjustment to goodwill, provided that such change relates to new information about the facts and circumstances that existed on the acquisition date.
During the fourth quarter of 2013, we concluded that it was more likely than not that we would not be able to realize a $3.8 million benefit related to our state and select foreign deferred tax assets. Further, in 2013, we completed our purchase accounting analysis and concluded that it was more likely than not that $1.4 million of foreign deferred tax assets related to the Sync-Rx, Ltd. acquisition and $1.1 million of state deferred tax assets related to the Crux Biomedical, Inc. acquisition are not realizable. This resulted in a net increase in valuation allowance against these deferred tax assets, which was recorded as a reduction to goodwill.
During the fourth quarter of 2012, we concluded that it was more likely than not that we would be able to realize the benefit of a significant portion of our foreign deferred tax assets in the future. We expect that our operations in the respective foreign jurisdictions will generate sufficient taxable income in future periods to realize the tax benefit associated with the related deferred tax assets. As a result, we released $4.9 million of the valuation allowance on our foreign deferred tax assets.
During the fourth quarter of 2011, we concluded that it was more likely than not that we would be able to realize the benefit of a significant portion of our federal and state deferred tax assets in the future as a result of cumulative profitability and expected future taxable income. Therefore, we reversed $22.0 . . .

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