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ELGX > SEC Filings for ELGX > Form 10-K on 3-Mar-2014All Recent SEC Filings

Show all filings for ENDOLOGIX INC /DE/

Form 10-K for ENDOLOGIX INC /DE/


3-Mar-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 the related notes included in this Annual Report on Form 10-K. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those anticipated in the forward-looking statements as a result of various factors including the risks we discuss in Item 1A of Part I, "Risk Factors" and elsewhere in this Annual Report on Form 10-K.

Overview
Our Business
Our corporate headquarters and manufacturing facility is located in Irvine, California. We develop, manufacture, market, and sell innovative medical devices for the treatment of aortic disorders. Our principal products are intended for the treatment of abdominal aortic aneurysms ("AAA"). Our AAA products are built on one of two platforms: (1) traditional minimally-invasive endovascular repair ("EVAR") or (2) endovascular sealing ("EVAS"), our innovate solution for sealing the aneurysm sac while maintaining blood flow through two blood flow lumens. We sell our products through (i) our direct U.S. and European sales forces and
(ii) third-party international distributors and agents in other parts of the world.

See Item 1., "Business," for a discussion of:
• Company Overview and Mission

• Market Overview and Opportunity

• Our Products

• Manufacturing and Supply

• Marketing and Sales

• Competition

• Product Development and Clinical Trials

2013 Overview
2013 was an important year of revenue growth, business expansion, and infrastructure development. We continued to gain market share in the U.S., while also building our direct sales operations in Europe. Combined with good results in other international markets, we achieved 25% annual revenue growth. We also made substantial progress with our new product pipeline, positioning us for product launches in 2014.
Characteristics of Our Revenue and Expenses Revenue
Revenue is derived from sales of our EVAR and EVAS products (including extensions and accessories) to hospitals upon completion of AAA repair procedure, or from sales to distributors upon title transfer (which is typically at shipment), provided our other revenue recognition criteria have been met. Cost of Goods Sold
Cost of goods sold includes compensation (including stock-based compensation) and benefits of production personnel and production support personnel. Cost of goods sold also includes depreciation expense for production equipment, production materials and supplies expense, allocated facilities-related expenses, and certain direct costs such as shipping. Research and Development
Research and development expenses consist of compensation (including stock-based compensation) and benefits for research and development personnel, materials and supplies, research and development consultants, outsourced and licensed research and development costs, and allocated facilities-related costs. Our research and development activities primarily relate to the development and testing of new devices and methods to treat aortic disorders. Clinical and Regulatory
Clinical and regulatory expenses consist of compensation (including stock-based compensation) and benefits for clinical and regulatory personnel, regulatory and clinical payments related to studies, regulatory costs related to registration and approval activities, and allocated facilities-related costs. Our clinical and regulatory activities primarily relate to gaining regulatory approval for the commercialization of our devices.
Marketing and Sales
Marketing and Sales expenses primarily consist of compensation (including stock-based compensation) and benefits for our sales force, clinical specialist, internal sales support functions, and marketing personnel. It also includes costs attributable to marketing our products to our customers and prospective customers.
General and Administrative
General and administrative expenses primarily include compensation (including stock-based compensation) and benefits for personnel that support our general operations such as information technology, executive management, financial accounting, and human resources. General and administrative expenses also include bad debt expense, patent and legal fees, financial audit fees, insurance, recruiting fees, other professional services, the federal Medical Device Excise Tax, and allocated facilities-related expenses. Critical Accounting Policies and Estimates The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, and the disclosure of contingent assets and liabilities as of the date of the financial statements and the reported amounts of revenue and expenses during the periods presented. While management believes these estimates are reasonable and consistent, they are by their very nature, estimates of amounts that will depend on future events. Accordingly, actual results could differ from these estimates. Our Audit Committee of the Board of Directors periodically reviews our significant accounting policies. Our critical accounting policies arise in conjunction with the following:
•Revenue recognition and accounts receivable
•Inventory - lower of cost or market
•Goodwill and intangible assets - impairment analysis
•Income taxes
•Stock-based compensation
•Contingent consideration for business acquisition
•Litigation accruals Revenue Recognition and Accounts Receivable We recognize revenue when all of the following criteria are met:

•We have appropriate evidence of a binding arrangement with our customer;
•The sales price for our EVAR and EVAS products (including extensions and accessories) is established with our customer;
•Our EVAR and EVAS product has been used by the hospital in an AAA repair procedure, or our distributor has assumed title with no right of return, as applicable; and
•Collection from our customer is reasonably assured at the time of sale.

For sales made to a direct customer (i.e., hospitals), we recognize revenue upon completion of an AAA repair procedure, when our EVAR or EVAS product is implanted in a patient. For sales to distributors, we recognize revenue at the time of title transfer, which is typically at shipment. We do not offer any right of return to our customers, other than honoring our standard warranty.

In the event that we enter into a bill and hold arrangement with our customer, which is uncommon for us, though occurred in 2012 (as discussed in Note 13 to accompanying Consolidated Financial Statements), the following conditions must be met for revenue recognition:
(i) The risks of ownership must have passed to our customer;

(ii) The customer must have made a fixed and written commitment to purchase the EVAR or EVAS product;

(iii) The customer must request that the transaction be on a bill and hold basis;

(iv) There must be a fixed schedule for delivery of the EVAR or EVAS product. The date for delivery must be reasonable and must be consistent with the customer's business purpose;

(v) We have no remaining specific performance obligations and our earnings process is complete;

(vi) Our customer's ordered EVAR or EVAS product must be segregated from our inventory and cannot be used to fulfill other customer orders; and

(vii) The EVAR or EVAS product must be complete and ready for shipment.

In addition to the above requirements, we also consider other pertinent factors prior to our recognition of revenue for bill and hold arrangements, such as:
(i) The date by which we expect payment, and whether we have modified our normal billing and credit terms for the customer;

(ii) Our past experiences with, and pattern of, bill and hold transactions;

(iii) Whether the customer has the expected risk of loss in the event of a decline in the market value of the EVAR or EVAS product;

(iv) Whether our custodial risks are insurable and insured; and

(v) Whether extended procedures are necessary in order to assure that there are no exceptions to the customer's commitment to accept and pay for the EVAR or EVAS product (i.e., that the business reasons for the bill and hold have not introduced a contingency to the customer's commitment).

We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to pay amounts due. These estimates are based on our review of the aging of customer balances, correspondence with the customer, and the customer's payment history.
Inventory - Lower of Cost or Market
We adjust our inventory value for estimated amounts of obsolete or unmarketable items. Such assumptions involve projections of future customer demand, as driven by economic and market conditions, and the product's shelf life. If actual demand, or economic or market conditions are less favorable than those projected by us, additional inventory write-downs may be required. Goodwill and Intangible Assets - Impairment Analysis Goodwill and other intangible assets with indefinite lives are not subject to amortization, but are tested for impairment annually as of June 30, or whenever events or changes in circumstances indicate that the asset might be impaired.
We evaluate the possible impairment for goodwill and intangible assets (i) if/when events or changes in circumstances occur that indicate that the carrying value of assets may not be recoverable; or (ii) in the case of goodwill and indefinite lived intangible assets, our annual impairment assessment date of June 30.
Income Taxes
Our consolidated balance sheets reflect net deferred tax assets that primarily represent the tax benefit of net operating loss carryforwards and credits and timing differences between book and tax recognition of certain revenue and expense items, net of a valuation allowance. When it is more likely than not that all or some portion of deferred tax assets may not be realized, we establish a valuation allowance for the amount that may not be realized. Each quarter, we evaluate the need to retain all or a portion of the valuation allowance on our net deferred tax assets. Our evaluation considers historical earnings, estimated future taxable income and ongoing prudent and feasible tax planning strategies. Adjustments to the valuation allowance increase or decrease net income or loss in the period such adjustments are made. If our estimates require adjustments, it could have a significant impact on our consolidated financial statements.
Changes in tax laws and rates could also affect recorded deferred tax assets in the future. Management is not aware of any such changes that would have a material effect on our consolidated financial statements. Stock-Based Compensation
We recognize stock-based compensation expense for employees over the equity award vesting period, based on its fair value at the date of grant. For awards granted to consultants, the award is marked-to-market each reporting period, with a corresponding adjustment to stock-based compensation expense. The fair value of equity awards that are expected to vest is amortized on a straight-line basis over (i) the requisite service period or (ii) the period from grant date to the expected date of the completion of the performance condition for vesting of the award. Stock-based compensation expense recognized is net of an estimated forfeiture rate, which is updated as appropriate.
We use the Black-Scholes option pricing model to value stock option grants. The Black-Scholes option pricing model requires the input of highly subjective assumptions, including the expected volatility of our common stock, expected risk-free interest rate, and the option's expected life. The fair value of our restricted stock is based on the closing market price of our common stock on the date of grant.
A portion of restricted stock vesting is dependent on us achieving certain regulatory and financial milestones. We use significant judgment in estimating the likelihood and timing of achieving these milestones. Each period, we will reassess the likelihood and estimate the timing of reaching these milestones, and will adjust expense accordingly.
Contingent Consideration for Business Acquisition We determine the fair value of contingently issuable common stock related to the Nellix acquisition using a probability-based income approach and an appropriate discount rate. Changes in the fair value of the contingently issuable common stock are determined each period end and recorded in the other income (expense) section of the Consolidated Statements of Operations and Comprehensive Loss and the current and non-current liabilities section of the Consolidated Balance Sheet. The fair value of the contingent consideration liability could be impacted by changes such as: (i) fluctuations in the price of our common stock, or (ii) the timing of achieving the underlining milestones. Litigation Accruals
From time to time we are involved in various claims and legal proceedings of a nature considered normal and
incidental to our business. These matters may include product liability, intellectual property, employment, and other general claims. We accrue for contingent liabilities when it is probable that a liability has been incurred and the amount can be reasonably estimated. The accruals are adjusted periodically as assessments change or as additional information becomes available.

Results of Operations
Operations Overview - 2013, 2012, and 2011 The following table presents our results of continuing operations and the related percentage of the period's revenue (in thousands):

                                                   Year Ended December 31,
                                   2013                      2012                      2011
Revenue                   $ 132,257      100.0%     $ 105,946      100.0%     $  83,417      100.0%
Cost of goods sold           32,750       24.8%        25,282       23.9%        18,746      22.5%
Gross profit                 99,507       75.2%        80,664       76.1%        64,671      77.5%
Operating expenses:
Research and development     16,199       12.2%        16,571       15.6%        16,738      20.1%
Clinical and regulatory
affairs                       8,679       6.6%          6,343       6.0%          4,439       5.3%
Marketing and sales          63,588       48.1%        53,953       50.9%        44,655      53.5%
General and
administrative               21,409       16.2%        20,266       19.1%        15,525      18.6%
Contract termination and
business acquisition
expenses                          -        -%             422       0.4%          1,730       2.1%
   Settlement costs               -        -%           5,000       4.7%              -        -%
Total operating expenses    109,875       83.1%       102,555       96.8%        83,087      99.6%
Loss from operations        (10,368 )    (7.8)%       (21,891 )    (20.7)%      (18,416 )   (22.1)%
Total other expense          (5,710 )    (4.3)%       (13,352 )    (12.6)%      (10,400 )   (12.5)%
Net loss before income
tax                         (16,078 )    (12.2)%      (35,243 )    (33.3)%      (28,816 )   (34.5)%
Income tax (expense)
benefit                          10        -%            (531 )    (0.5)%            86       0.1%
Net loss                  $ (16,068 )    (12.1)%    $ (35,774 )    (33.8)%    $ (28,730 )   (34.4)%

Year Ended December 31, 2013 versus December 31, 2012 Revenue
Year Ended December 31,
2013 2012 Variance Percent Change

(in thousands)

Revenue $ 132,257 $ 105,946 $ 26,311 24.8%

Our 24.8% revenue increase of $26.3 million over the prior year period resulted from volume increases caused by:

(i) $15.8 million increase in U.S. sales due to the (a) the expansion of our U.S. sales force through the addition of clinical specialists, (b) the continued physician adoption of AFX which was launched in the U.S. in August 2011, and (c) our PEVAR physician training programs;

(ii) $7.7 million increase in Europe due to the expansion of our European sales force (which began direct sales activity in September 2011), and the limited market introduction of our Nellix System in February 2013; and

(iii) $2.8 million increase in ROW sales. ROW sales growth is attributable to a full year of AFX sales in Brazil and Argentina, and increased IntuiTrak orders by our distributor in Japan.
Cost of Goods Sold, Gross Profit, and Gross Margin Percentage

                                                 Year Ended December 31,
                                                  2013              2012         Variance    Percent Change
                                                      (in thousands)
Cost of goods sold                           $     32,750       $    25,282     $ 7,468          29.5%
Gross profit                                       99,507            80,664      18,843          23.4%
Gross margin percentage (gross profit as a
percent of revenue)                                  75.2 %            76.1 %      (0.9 )%

The $7.5 million increase in cost of goods sold was driven by our revenue increase of $26.3 million.

Gross margin for the year ended December 31, 2013 decreased to 75.2% from 76.1% for the twelve months ended December 31, 2013. This decrease is primarily due to our product mix and the greater proportion of our total revenue being derived from international sales, as well as inventory obsolescence charges in 2013, aggregating to $1.6 million.

Operating Expenses
                                            Year Ended December 31,
                                             2013             2012          Variance     Percent Change
                                                (in thousands)
Research and development                $      16,199     $    16,571     $     (372 )       (2.2)%
Clinical and regulatory affairs                 8,679           6,343          2,336         36.8%
Marketing and sales                            63,588          53,953          9,635         17.9%
General and administrative                     21,409          20,266          1,143          5.6%
Contract termination and business
acquisition expenses                                -             422           (422 )      (100.0)%
Settlement costs                                    -           5,000         (5,000 )       100.0%

Research and Development. The $0.4 million decrease in research and development expenses was primarily driven by a decrease in Ventana development activities, given the suspended enrollment in the Ventana U.S. IDE clinical trial and the planned limited market introduction of Ventana in Europe, partially offset by a new exclusive license agreement of $0.9 million for the future design of our Nellix System.
Clinical and Regulatory Affairs. The $2.3 million increase in clinical and regulatory affairs was primarily driven by increased personnel, the start-up costs associated with the EVAS Forward clinical studies, our ongoing clinical trials, in addition to an increase in FDA and CE regulatory activities. Marketing and Sales. The $9.6 million increase in marketing and sales expenses was primarily related to (i) increased variable compensation in the U.S. due to our sales growth of 18%, (ii) costs related to the continued growth and development of our direct sales force and clinical personnel worldwide; and
(iii) increased marketing costs to support our business. General and Administrative. The $1.1 million increase in general and administrative expenses is attributable to (i) additional personnel to support our business growth; (ii) the federal Medical Device Excise Tax (which took effect January 1, 2013); and (iii) increased stock-based compensation expense.

Contract Termination and Business Acquisition Expenses. Prior period expense of $0.4 million is associated with professional fees incurred as part of the July 2012 acquisition of our Italian distributor's business. This transaction allowed us to begin selling our products through the acquired Italian sales force, and to directly contract with sub-dealers in Italy.

Settlement Costs. Settlement costs of $5.0 million in the prior period represents our payment to settle a patent dispute with Cook Incorporated.

Other income (expense), net
                                  Year Ended December 31,
                                  2013                 2012      Variance   Percent Change
                                       (in thousands)
Other income (expense), net  $     (5,710 )         $ (13,352 )     7,642      (57.2)%

Other income (expense), Net. The other expense variance of $7.6 million between the twelve months ended December 31, 2013 and 2012 is primarily related to the fair value adjustment of contingent payment of $8.5 million associated with our acquisition of Nellix (see Note 9). Partially offsetting these fair value adjustments is $1.3 million in other income from a distribution from our former product liability carrier in the first quarter of 2013, and the remeasurement of certain assets and liabilities that were not transacted in the functional currency of the corresponding operating entity.

Provision for Income Taxes
                                    Year Ended December 31,
                                        2013               2012     Variance   Percent Change
                                        (in thousands)
Income tax (expense) benefit  $       10                 $ (531 )  $     541      (101.9)%

For the twelve months ended December 31, 2013, our provision for income taxes was a $10 thousand benefit and our effective tax rate was 0.06% for the year ended December 31, 2013. During the twelve months ended December 31, 2013, we had operating legal entities in the U.S., Italy, New Zealand, and The Netherlands (plus registered sales branches of our Dutch entity in certain countries in Europe). We have certain minimum tax liabilities attributable to our operations in these countries and in the U.S.

Year Ended December 31, 2012 versus December 31, 2011 Revenue
Year Ended December 31,
2012 2011 Variance Percent Change

(in thousands)

Revenue 105,946 83,417 22,529 27.0%

Our 27.0% revenue increase of $22.5 million over the prior year period resulted from volume increases caused by:

(i) $15.4 million increase in U.S. sales due to the (a) expansion of our U.S. sales force through the addition of clinical specialists that exclusively provide field support to our sales representatives, having the impact of increasing overall sales force productivity and (b) the continued market traction of AFX, which was launched in the U.S. in August 2011;

(ii) $4.2 million increase in European sales due to our transition from a third-party distributor to a direct sales organization beginning in September 2011; and

(iii) $2.9 million increase in ROW sales. ROW sales growth is attributable to the July 2012 launch of AFX in Brazil and Argentina, and IntuiTrak orders by our distributor in Japan (in anticipation of its Japanese regulatory approval, which was received in December 2012).
Cost of Goods Sold, Gross Profit, and Gross Margin Percentage

                                                 Year Ended December 31,
                                                                                           Percent
                                                   2012            2011        Variance     Change
                                                     (in thousands)
Cost of goods sold                            $     25,282      $  18,746     $ 6,536       34.9%
Gross profit                                        80,664         64,671      15,993       24.7%
Gross margin percentage (gross profit as a
percent of revenue)                                   76.1 %         77.5 %      (1.4 )%

The $6.5 million increase in cost of goods sold was driven by our revenue increase of $22.5 million.

Gross margin for the year ended December 31, 2013 decreased to 76.1% from 77.5% for the twelve months ended December 31, 2011. This decrease is primarily due to
(i) a greater proportion of the total revenue being derived from international sales in 2012 (which have an average sales price below the U.S. sales price);
(ii) royalty expenses which were not present for the full prior year period; and
(iii) a decline in the average value of the Euro relative to the U.S. dollar in 2012 from 2011. These unfavorable gross margin items were partially offset by a greater proportion of our current period revenue derived from direct sales, as opposed to distributor sales, which typically have a higher average sales price.

Operating Expenses
                                               Year Ended December 31,
                                                                                            Percent
                                                 2012             2011         Variance      Change
                                                    (in thousands)
Research and development                    $      16,571     $   16,738     $     (167 )    (1.0)%
Clinical and regulatory affairs                     6,343          4,439          1,904      42.9%
Marketing and sales                                53,953         44,655          9,298      20.8%
General and administrative                         20,266         15,525          4,741      30.5%
Contract termination and business
acquisition expenses                                  422          1,730         (1,308 )   (75.6)%
Settlement costs                                    5,000              -          5,000      100.0%

Research and Development. The $0.2 million decrease in research and development expenses was primarily driven by decreasing Ventana development activities, as this device reached the final stages of development and testing. This decrease was partially offset by a $1.0 million purchase in 2012 of an exclusive license to patents covering the polymer used in our Nellix System.
Clinical and Regulatory Affairs. The $1.9 million increase in clinical affairs was primarily driven by the continued enrollment and follow-up costs associated with our PEVAR and Ventana clinical trials and our efforts to achieve CE Mark approval of Ventana and the Nellix System.
Marketing and Sales. The $9.3 million increase in marketing and sales expenses was primarily related to marketing costs to support the growth of our U.S. business, costs related to our direct sales force in Europe (which was largely not present in the prior year period), and an increase in variable compensation expense of $1.2 million, driven by an increase in U.S. revenue of 21%. General and Administrative. The $4.7 million increase in general and administrative expenses is attributable to (i) additional personnel to support our business growth; (ii) increased travel expenses associated with the expansion of our European operations; and (iii) professional service fees to develop our global legal structure.

Contract Termination and Business Acquisition Expenses. During 2012 expense of $0.4 million is associated with professional fees incurred as part of the July 2012 acquisition of our Italian distributor's business. In the prior year period we early terminated a distribution agreement with two former European distributors for aggregate termination fees of $1.7 million. These actions allowed us to begin selling our products through our direct sales force in most of western Europe, beginning September, 2011, and in Italy, beginning July, 2012.

Settlement Costs. Settlement costs of $5.0 million in 2012 represents our payment in full to settle a patent dispute with Cook Incorporated.

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