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CYBX > SEC Filings for CYBX > Form 10-K on 16-Jun-2014All Recent SEC Filings

Show all filings for CYBERONICS INC

Form 10-K for CYBERONICS INC


16-Jun-2014

Annual Report


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

You should read the following discussion and analysis together with Part I of this Form 10-K, including the matters set forth in "Cautionary Statement About Forward-Looking Statements," "Item 1A. Risk Factors" and our consolidated financial statements and the related notes included elsewhere in this Form 10-K.

This item provides material historical and prospective disclosures enabling investors and other users to assess our consolidated financial position and results of operations.

Overview

We are a medical device company incorporated in 1987, engaged in the design, development, sale and marketing of the VNS Therapy® System, that delivers VNS therapy using pulsed electrical signals applied to the vagus nerve for the treatment of refractory epilepsy and 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 System 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 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.

We sell the VNS Therapy System to hospitals and ASCs on payment terms that are generally 30 days from the shipment date. In addition to maintaining and expanding our regulatory approvals, our ability to successfully expand the commercialization of the VNS Therapy System depends on obtaining and maintaining favorable insurance coverage, coding and reimbursement for the device, the implant procedure and follow-up care. This coverage allows our customers to invoice and be paid by third-party payers. Currently, we have broad coverage, coding and reimbursement for the VNS Therapy System for the treatment of refractory epilepsy. We estimate that the CMS pays for approximately 25% to 30% of the VNS Therapy System implants under Medicare and approximately 15% to 20% under Medicaid. CMS issues an annual update to the reimbursement amounts available to our customers under Medicare. The Medicaid reimbursement rates, while based on the CMS rates, vary by state. A decrease in reimbursement rates or a change in reimbursement methodology by CMS could have an adverse impact on our business and our future operating results.

We continue to invest in and support the regulatory approval of the AspireSR generator and the development of future generations of our VNS Therapy System that include generators with wireless communication technology (Centro™ generators), new stimulation paradigms, rechargeable battery technology and the integration of magnetic resonance imaging 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 the ProGuardian™ event monitoring system, capable of seizure monitoring, logging and notification using external heart-monitoring and movement-related sensor advancements. In addition, we are investing in a program to ascertain whether the VNS Therapy System could be utilized for treating patients with CHF. 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 the VNS Therapy System. A description and the status of these studies may be found at www.clinicaltrials.gov.

The AspireSR generator provides the benefits of VNS therapy, with an additional feature: automatic stimulation in response to detection of a seizure. The AspireSR generator is capable of delivering additional stimulation automatically by responding to a patient's relative heart-rate changes that exceed certain variable thresholds. Heart-rate changes accompany seizure activity in certain patients. The thresholds are programed by the patient's physician and can be adjusted to suit the patient's level of physical activity or for other reasons. The AspireSR generator received CE Mark approval from the European regulatory body in February 2014, and we have commenced commercial release in Europe. This technology is under investigation in the U.S. and is not approved by the FDA for commercial use.


In 2011, we commenced a program to ascertain whether VNS therapy could be utilized for treating patients with CHF. This program included an open-label study of 60 patients with chronic symptomatic heart failure with a classification of New York Heart Association class II and III - the ANTHEM-HF pilot study. This study is now complete. The ANTHEM-HF investigators have submitted an abstract for presentation at the meeting of the European Society of Cardiology Meeting in early September 2014. We plan to increase our research and development expenditures in this area in fiscal year 2015. We intend to submit an application to the European regulatory authority for CE Mark approval. We may consider partnering with another company to further develop or commercialize this technology.

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. The patent covering vagus nerve stimulation for the treatment of neuropsychiatric disorders (including depression) expired May 3, 2011. The last of the U.S. patents covering vagus nerve stimulation for movement disorders expired July 16, 2011.

We believe that in the refractory epilepsy and TRD indications, existing and future drug therapies are the primary competition for the VNS Therapy System at present. We also believe that the primary competitive factors within the epilepsy treatment markets are the safety, tolerability and efficacy of the treatment relative to alternative therapies, physician and patient acceptance of the product and procedure, availability of third-party reimbursement, quality of life improvements, and in the case of device-based therapies, product reliability. We believe that the VNS Therapy System compares favorably with competitive products as to these factors.

We do not have indication-specific patent coverage for vagus nerve stimulation for epilepsy or for depression in the U.S. or Europe and we face competition and potential competition from other medical device companies for the treatment of epilepsy. Medtronic, Inc. has received approval from the FDA for its Activa Neurostimulator, a DBS device indicated for the treatment of essential tremor, Parkinson's Disease and severe obsessive compulsive disorder and has submitted a PMA to the FDA for use of the Activa Neurostimulator for the treatment of refractory epilepsy. The device already has approval for marketing in the European countries governed by CE Mark approval, and Medtronic has begun commercial marketing in several European countries. A company based in Europe, Neurotech, SA, now owned by Sorin Group, Italy, has obtained CE Mark approval for a device capable of vagus nerve stimulation for the treatment of epilepsy. However, we do not believe Neurotech has commenced commercialization. Another company, CerebralRx Ltd. based in Israel, developed an implantable device capable of vagus nerve stimulation for the treatment of epilepsy and has CE Mark approval. CerebralRx has initiated commercialization efforts in several European countries. In November 2013, the FDA approved NeuroPace, Inc.'s responsive neurostimulation device for the treatment of refractory epilepsy. This device includes electrodes placed in pre-determined areas in the brain where seizures are thought to originate. NeuroPace has commenced commercial activity in the U.S.

Several non-invasive neurostimulation technologies are emerging, as well. NeuroSigma Inc., based in the U.S., is focused on the development of a trigeminal nerve stimulation device for the treatment of attention deficit hyperactivity disorder, major depressive disorder, and refractory epilepsy. NeuroSigma Inc. received CE Mark approval for this technology for the treatment of refractory epilepsy and has begun commercialization in Europe. Cerbomed GmbH ("Cerbomed"), a privately-held company based in Germany, has developed a transcutaneous vagus nerve stimulation device that is also CE Mark approved for the treatment of epilepsy. Cerbomed has initiated a clinical study in Germany to study outcomes in the treatment of refractory epilepsy. We have invested approximately $3.9 million in Cerbomed.

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 11. Commitments and Contingencies - License Agreements" in our consolidated financial statements for additional information.

We have constructed a second manufacturing facility located in Costa Rica. We intend for this facility to manufacture product for our international markets and expect it to be operational, upon regulatory approval, by approximately December 2014.


Significant Accounting Policies and Critical Accounting Estimates

We have adopted various accounting policies to prepare the consolidated financial statements in accordance with accounting principles generally accepted in the U.S. ("U.S. GAAP"). Our most significant accounting policies are disclosed in "Note 1. Summary of Significant Accounting Policies and Related Data" in the consolidated financial statements.

To prepare our consolidated financial statements in conformity with U.S. GAAP, management makes estimates and assumptions that may affect the reported amounts of our assets and liabilities, the disclosure of contingent liabilities as of the date of our consolidated financial statements and the reported amounts of our revenues and expenses during the reporting period. Our actual results may differ from these estimates. We consider estimates to be critical if we are required to make assumptions about material matters that are uncertain at the time of estimation, or if materially different estimates could have been made or it is reasonably likely that the accounting estimate will change from period to period. The following are areas requiring management's judgment that we consider critical:

Intangible Assets

Intangible assets, as shown on the consolidated balance sheets, consisted primarily of purchased patents and licensed patent and technology rights. The determination of useful lives and impairment is subject to a high degree of estimation and management judgment. The carrying value of our intangible assets amounted to $11.7 million at April 25, 2014, with an average amortization period of 12 years. We estimate the useful lives of our intangible assets based on the shorter of the patent life or the expected technological utility. We evaluate our intangible assets each reporting period to determine whether events and circumstances indicate either a different amortization period or impairment. Impairment indicators include a determination that a patent or technology lacks future utility. See "Note 5. Intangible Assets" for further details of these investments.

Investments in Equity Securities

We invested in the convertible preferred shares of two privately-held start-up entities. The investments are accounted for under the cost-method and have a total carrying value of $15.9 million as of April 25, 2014. The carrying value of these entities is reviewed each reporting period for events or changes in circumstances that indicate an impairment of our investment. Impairment adjustments are subject to a high degree of management judgment, as these investments do not have quoted market prices. Impairment indicators include failed clinical trials, adverse regulatory actions, change in the investees' competitive position or difficulty in raising funds. We have not recorded any impairment of these investments. See "Note 6. Investments" and "Note 18. Fair Value Measurements," for further details.

Revenue Recognition

Product Revenue. We recognize product revenue when persuasive evidence of a sales arrangement exists, title to the goods and risk of loss transfers to customers or to independent distributors, the selling price is fixed or determinable and collectability is reasonably assured. We record a sales return reserve, which is accounted for as a reduction of sales. Sales returns are estimated based on historical sales and returns information. Management judgment is required to estimate the effects of unusual sales or return patterns, product recalls, customer's acceptance of new products and variations in product utilization. The balance of our reserve for sales returns for the fiscal year ended April 25, 2014 and April 26, 2013 was $0.5 million and $1.3 million, respectively.

License 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 and responsibility to prosecute the licensed patent applications. We recorded the license fee as deferred revenue and amortized the fee over the estimated period that we were obligated to prosecute the patent applications. This estimation is subject to a high degree of management judgment. We originally estimated the amortization period would end by April 25, 2014; whereas, during the fiscal year 2014, we determined that our obligation was completed by July 26, 2013. As a result of this process, we included $1.5 million of revenue in the quarter ended July 26, 2013, as compared to $1.5 million for the fiscal year 2013. During the fiscal year 2014, all deferred revenue was amortized, and unless we license additional patents, we will not have license revenue in fiscal year 2015.

Stock-Based Compensation

Stock Option Awards

Our stock option award compensation expense is based on the fair market value of our awards. The fair market value of an award is amortized ratably over the award vesting period. We use the Black-Scholes option pricing methodology to estimate the grant date fair market value of stock option awards. This methodology takes into account variables such as the future expected volatility of our stock price, the amount of time expected to elapse between the date of grant and the date of exercise and a risk-free interest rate. Fair values of stock options issued in the future may vary significantly from fair values recorded in the current period depending on our estimates and judgments regarding these variables and therefore expense in future periods may differ significantly from current-period expense.


Restricted Stock and Restricted Stock Unit Awards

Service-Based Restricted Stock. We grant restricted stock and restricted stock units at no purchase cost to the grantee. The fair market values of serviced-based restricted stock and restricted stock units are determined using the market closing price on the grant date and compensation is expensed ratably over the vesting period. Calculation of compensation for service-based restricted share awards requires estimation of, and depends upon, forfeiture rates. Compensation expense may vary significantly from our estimates if employee turnover rates differ from our expectations.

Market and Performance-Based Restricted Stock and Performance-Based Restricted Stock Units. We grant restricted stock and restricted stock unit awards subject to market or performance conditions that vest based on the satisfaction of the conditions of the award. The fair market values of market condition-based awards are determined using the Monte Carlo simulation method. The Monte Carlo simulation method is subject to variability as several factors utilized must be estimated, including the derived service period estimate based on our judgment of likely future performance and our stock price volatility. The fair value of performance-based awards is based on the market closing price on the grant date. The amount of compensation expense recognized depends on management's estimates of likely future performance. If performance differs from management's estimates, compensation expense could be significantly different from our expectations.

Income Taxes

We are subject to federal, state and foreign income taxes, and we use significant judgment and estimates in accounting for our income taxes. This involves assessing changes in temporary differences resulting from differing treatment of events for tax and accounting purposes. These assessments result in deferred tax assets and liabilities, which are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Actual tax expense may significantly differ from our expectations if, for example, judicial interpretations of tax law, tax regulations or tax rates change.

We are required to periodically assess the recoverability of our deferred tax assets by considering whether it is more likely than not that some or all of the actual benefit of those assets will be realized. To the extent that realization does not meet the "more-likely-than-not" criterion, we establish a valuation allowance. We periodically review the adequacy and necessity of the valuation allowance by considering significant positive and negative evidence relative to our ability to recover deferred tax assets and to determine the timing and amount of valuation allowance that should be released. Changes in our assessment of the factors related to the recoverability of our deferred tax assets could result in materially different income tax provisions.

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 our fiscal year 1992 and subsequent years, with certain exceptions. Tax authorities may disagree with certain positions we have taken and assess additional taxes and as a result, we establish reserves for uncertain tax positions, which require a significant degree of management judgment. We regularly assess the likely outcomes of our tax positions in order to determine the appropriateness of our reserves for uncertain tax positions; however, the actual outcome of an audit can be significantly different than our expectations, which could have a material impact on our tax provision. The total amount of unrecognized tax benefit, as of April 25, 2014, if recognized, would reduce our income tax expense by approximately $7.1 million.

Our effective tax rate for the fiscal year ended April 25, 2014 was approximately 31.3%, and our effective tax rate for the fiscal year ended April 26, 2013 was approximately 38.4%. This reduction in the effective tax rate was partially due to a higher than expected U.S. Research & Development ("R&D") tax credit and to the Texas R&D tax credit, which was enacted during fiscal year 2014 and applied to our tax year ended April 26, 2013. During fiscal year 2014 and prior years, we reviewed the activity of Cyberonics Europe BVBA in order to determine if the balance of the net operating loss carryforwards ("NOL") is more likely than not recoverable. After considering all the available positive and negative evidence, management concluded in the quarter ended April 25, 2014, that the NOL was more likely than not recoverable, and as a result, we released the valuation allowance. The positive evidence, which outweighed the negative evidence, included: (i) positive results for the rolling 12 fiscal quarters for the period ended April 25, 2014, using cumulative pre-tax book income as adjusted for permanent differences; while all prior rolling 12 fiscal quarters resulted in cumulative pre-tax book losses as adjusted for permanent differences, (ii) confidence in forecasts of profitability in future years and,
(iii) no limitations on the carry-forward period for net operating losses under Belgium tax law. The release of the valuation allowance reduced our tax provision for the fiscal year 2014 by $3.5 million, which reduced our effective tax rate by 4.4%.


Results of Operations

Net Sales

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

                                                                               Fiscal Year   Fiscal Year
                                         52 Weeks Ended                          2013 to       2012 to
                                                                               Fiscal Year   Fiscal Year
                      April 25, 2014     April 26, 2013     April 27, 2012        2014          2013
                                                                                % Change      % Change
U.S.                 $       225,455    $       208,859    $       181,436            7.9%         15.1%
International                 55,091             43,967             35,548           25.3%         23.7%
Total net product
sales (1)            $       280,546    $       252,826    $       216,984           11.0%         16.5%

Unit Sales
U.S.                           9,714              9,340              8,455            4.0%         10.5%
International                  4,268              3,598              2,939           18.6%         22.4%
Total unit sales
(2)                           13,982             12,938             11,394            8.1%         13.5%

Licensing Revenue    $         1,468    $         1,494    $         1,519            -1.7%         -1.6%

(1) Net product sales represent revenue from sales of generators, leads and other items related to our device.
(2) Unit sales are based on the number of generators sold.

U.S. net product sales for the 52 weeks ended April 25, 2014 increased $16.6 million, or 7.9%, as compared to the 52 weeks ended April 26, 2013, due to increased unit sales of 4.0% and an increased average selling price of 3.9%. The average selling price increased due to continued higher market penetration of our higher-priced AspireHC™ generator and price increases effective January 1, 2013 and January 1, 2014. The unit sales increase in the U.S. was 4.0%, which was less than the equivalent prior period growth rate of 10.5%, due in part to certain circumstances occurring in the third quarter, which ended January 24, 2014. These circumstances included a combination of holidays that fell in the middle of the week, inclement weather that disrupted hospital and patient schedules and the disruptive effects of health insurance coverage changes. The approval by the FDA of a competitive implantable neuromodulation device for the treatment of epilepsy in November 2013 may have contributed to the decrease in the growth rate. Our generator replacement growth rates have declined as compared to the prior fiscal year and were slightly less than our expected mid-single digit growth rate. We expect mid-single digit growth rate for generator replacements during fiscal year 2015.

U.S. net product sales for the 52 weeks ended April 26, 2013 increased $27.4 million, or 15.1%, as compared to the 52 weeks ended April 27, 2012, due to increased unit sales of 10.5% and an increased average selling price of 4.7%. The average selling price increased due to higher market penetration of our higher priced AspireHC generator and price increases January 1, 2013 and January 1, 2012.

International net product sales for the 52 weeks ended April 25, 2014 increased by $11.1 million, or 25.3%, as compared to the 52 weeks ended April 26, 2013, due to increased unit sales of 18.6% and an increased average selling price of 6.7%. Unit sales increased in the majority of our international markets and the average selling price increased due to the mix of sales by country; however, two related shipments to one customer accounted for a significant part of our international growth. Without this one customer, our international unit growth was 12.3%, and our average selling price increased 2.2%. In addition, we experienced a favorable foreign currency impact on international revenues of $1.0 million due to the strengthening of the euro against the U.S. dollar and British pound. Our international sales increased by 12.1% on a constant currency basis.

International net product sales for the 52 weeks ended April 26, 2013 increased by $8.4 million, or 23.7%, as compared to the 52 weeks ended April 27, 2012, due to increased unit sales of 22.4% and an increased average selling price of 1.3%. Unit sales increased due to higher sales in almost all international markets. The average selling price increased due to the mix of sales by country. We experienced an unfavorable foreign currency impact of $1.3 million. On a constant currency basis, international sales increased by 27.3%.


Our license revenue has consisted of the amortization of deferred license revenue. The deferred revenue consisted of a one-time up-front payment of $9.5 million in December 2007 for the licensing of certain of our patent and patent applications. During the fiscal year 2014, all deferred revenue was amortized, and unless we license additional patents, we will not have license revenue in fiscal year 2015.

Cost of Sales and Expenses

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

                                                                               Change in %
                                                                       Fiscal Year     Fiscal Year
                                    52 Weeks Ended                       2013 to         2012 to
                                                                       Fiscal Year     Fiscal Year
                   April 25, 2014   April 26, 2013   April 27, 2012       2014            2013
Cost of sales               9.7%             8.6%             9.0%            1.1%            -0.4%
Selling, general
and
administrative             42.8%            44.2%            46.9%            -1.4%           -2.7%
Research and
development                16.5%            16.3%            16.2%            0.2%            0.1%

Cost of Sales

Cost of sales consisted primarily of direct labor, allocated manufacturing . . .

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