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HTWR > SEC Filings for HTWR > Form 10-Q on 5-Aug-2014All Recent SEC Filings

Show all filings for HEARTWARE INTERNATIONAL, INC.

Form 10-Q for HEARTWARE INTERNATIONAL, INC.


5-Aug-2014

Quarterly Report


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

The following discussion and analysis of our financial condition and results of operations should be read together with our unaudited interim condensed consolidated financial statements and related notes appearing elsewhere in this Quarterly Report on Form 10-Q. Certain abbreviated key terms have the meanings defined elsewhere in this Quarterly Report on Form 10-Q.

Overview

HeartWare is a medical device company that develops and manufactures miniaturized implantable heart pumps, or ventricular assist devices, to treat patients suffering from advanced heart failure.

The HeartWare Ventricular Assist System (the "HVAD System"), which includes a ventricular assist device ("VAD"), or blood pump, patient accessories and surgical tools, is designed to provide circulatory support for patients in the advanced stage of heart failure. The core of the HVAD System is a proprietary continuous flow blood pump, the HVAD Pump, which is a full-output device capable of pumping up to 10 liters of blood per minute. The HVAD System is designed to be implanted adjacent to the heart, avoiding abdominal surgery, which is generally required to implant similar devices.

In November 2012, we received approval from the United States Food and Drug Administration ("FDA") for the HVAD System as a bridge to heart transplantation in patients with end-stage heart failure. The HVAD System has been available in the European Union since receiving CE marking in 2009. In May 2012, we received an expanded European label for long-term use of the HVAD System in patients at risk of death from refractory, end-stage heart failure. The HVAD System has been implanted in patients at over 240 health care sites in 40 countries.

On August 27, 2013, the FDA approved an Investigational Device Exemption ("IDE") Supplement allowing us to commence enrollment in an additional patient cohort for the ENDURANCE clinical trial. In this supplemental cohort, we intend to enroll up to 310 patients receiving the HVAD System, as well as up to an additional 155 control patients using a randomization scheme consistent with the ENDURANCE protocol. Patients will be followed for 12 months after implant. We intend to incorporate the data from both this supplemental cohort and ENDURANCE into an anticipated PMA Application seeking approval of the HVAD System for the Destination Therapy indication.

MVAD System

Beyond the HVAD System, we are also developing our next generation miniaturized device, known as the MVAD System. The MVAD System is based on the same technology platform as the HVAD System but adopts an axial flow, rather than a centrifugal flow, configuration and is being developed in multiple designs. The MVAD Pump is less than one-half the size of the HVAD Pump and can provide partial or full support. The MVAD platform is designed to allow for a variety of configurations and surgical placements with the goal towards further reduction of surgical invasiveness while producing superior clinical results. We are preparing regulatory submissions seeking approval to commence a CE Mark study at nine international sites, as well as an IDE study in the United States.

CircuLite

On December 1, 2013, we acquired CircuLite, Inc. CircuLite is the developer of the SYNERGY Circulatory Support System, a partial support system designed to treat less sick, ambulatory, chronic heart failure patients who are not yet inotrope-dependent. While our HVAD and MVAD Systems offer minimally invasive treatment to end-stage heart failure patients, the SYNERGY platform offers potentially even less invasive and ultimately interventional options to earlier-stage heart failure patients. The SYNERGY Surgical System, which received CE marking in the European Union in 2012, was designed for long-term support and is intended to reduce the heart's workload while improving blood flow to vital organs. As a result of issues that arose after its commercial release, the SYNERGY system no longer carries the CE marking and is not presently available for sale. We continue to correspond with regulatory authorities regarding adverse events involving the SYNERGY system. The SYNERGY system is currently undergoing a design review with the goal of identifying design modifications that address the issues experienced by the original commercial system. Following design modifications, we intend to determine a strategy for clinical evaluation and eventual return to clinical use of the SYNERGY system.


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We are also developing a next generation endovascular version of the SYNERGY system which offers an interventional approach to circulatory support and is able to be implanted collaboratively by cardiologists and surgeons in a hybrid catheterization ("cath") lab setting.

FDA Warning Letter

We received a warning letter from the FDA, dated June 2, 2014, following an inspection of our Miami Lakes, Florida facility conducted in January 2014. The FDA letter cited four categories for us to address: (1) procedures for validating device design, including device labeling; (2) procedures for implementing corrective and preventive action (CAPA); (3) maintaining records related to investigations; and (4) validation of computer software used as part of production or quality systems. The warning letter did not require any action by physicians or patients and did not restrict use of HeartWare's devices.

We sent the FDA our initial response to the warning letter within the required fifteen business days of receipt and committed to undertaking certain quality system improvements and providing the FDA with periodic updates. We have begun to implement systemic changes and organizational enhancements to address the four warning letter items and related quality systems. We have established teams to review and address the items cited by the FDA and have engaged external subject matter experts to assist in assessment and remediation efforts.

Recent Urgent Medical Device Corrections and Voluntary Battery Recall

We issued two Urgent Medical Device Corrections in April 2014 and a recall of certain older batteries in July 2014.

The first Correction was announced by us on April 24, 2014 and provides updated information to patients and clinicians with respect to the driveline connector medical device correction distributed to all of our clinical sites in December 2013. A disconnected driveline would result in a temporary pump stop which could cause serious injury or death, depending on the function of a patient's native heart. To ensure full awareness, we are redistributing this information to clinicians and patients. The April 24, 2014 notification requests patients to discuss the correction notice with their physician or VAD Coordinator. Clinicians are asked to inspect the patient's driveline connector for proper locking at implant and at each routine clinic visit to ensure that the connector assembly remains secure. The notification provides instruction to both patients and clinicians should the locking mechanism fail to engage or the driveline becomes disconnected from the controller and advises clinicians to promptly call their HeartWare representative to arrange a permanent repair should these events occur.

The second Correction was announced by us on May 1, 2014. In letters to clinicians and patients, we reported an observed increase in complaints related to earlier-than-expected battery depletion and routine battery handling. This field safety correction action provides information to assist patients and clinicians to monitor battery performance, recognize abnormal behaviors and reinforce proper power management of the HVAD System. In connection with this Correction, we provided for an increase in battery warranty returns likely to be associated with increased battery performance awareness following implementation of the Correction.

In general, we have experienced a higher battery-related complaint rate in Germany than in other territories. Accordingly, following correspondence with BfArM (the Federal Institute for Drugs and Medical devices in Germany), we extended our field safety corrective action on July 30, 2014 to include a voluntary recall of certain older batteries. The recall instructs sites to replace certain older batteries in the field upon patients' routine visits in order to further mitigate the potential risks associated with premature battery depletion. We will continue to monitor complaints and may take further actions as appropriate.

During the quarter ended June 30, 2014, we recorded a $1.7 million charge for estimated costs associated with the battery recall discussed above.

Summary of Recent Financial Performance

Total revenue was $70.1 million for the quarter ended June 30, 2014, reflecting 47% revenue growth in the United States, where our HVAD System is labeled solely for a bridge-to-transplantation indication, and 29% internationally where the HVAD System is more broadly indicated for general long-term heart failure patients. In each case, revenue growth reflected continued market penetration within existing customer accounts and to a lesser extent revenue contributed from newly added customers. As of June 30, 2014, the Company had 103 customers in the United States and 143 customers internationally.


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We realized an improvement in gross margin percentage, to 67.3% in the second quarter compared to 65.5% in the first quarter and 62.9% in the second quarter of 2013. This continued improvement relates primarily to production efficiencies associated with increased manufacturing throughput, net of the $1.7 million second quarter 2014 charge associated with the battery recall.

Operating expenses in the second quarter decreased to $34.2 million, compared to $60.0 million in the first quarter. The $25.8 million decrease included a $16.8 million net change in expense as a result of adjustments to the fair value of contingent consideration. Research and development expenses were approximately $5.7 million lower in the second quarter compared to the first quarter as a result of reduced consumption of parts and supplies and lower project costs. Selling, general and administrative expenses decreased approximately $3.3 million in the second quarter compared to the first quarter primarily as a result of restructuring costs incurred in the first quarter of approximately $3.0 million.

Our financial results are more fully described in Results of Operations below.

Critical Accounting Policies and Estimates

We prepare our financial statements in accordance with accounting principles generally accepted in the United States. We are required to adopt various accounting policies and to make estimates and assumptions in preparing our financial statements that affect the reported amounts of our assets, liabilities, revenue and expenses. On an ongoing basis, we evaluate our estimates and assumptions. We base our estimates on our historical experience to the extent practicable and on various other assumptions that we believe are reasonable under the circumstances and at the time they are made. If our assumptions prove inaccurate or if our future results are not consistent with our historical experience, we may be required to make adjustments in our policies that affect our reported results. Our significant accounting policies are disclosed in Note 3 to the Consolidated Financial Statements included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2013 ("2013 Annual Report on Form 10-K") filed with the Securities and Exchange Commission on March 3, 2014. During the six months ended June 30, 2014, there were no significant changes to any of our significant accounting policies.

Our most critical accounting policies and estimates include: revenue recognition, inventory capitalization and valuation, reserves, accounting for share-based compensation, measurement of fair value, valuation of tax assets and liabilities, long-lived assets, intangible assets and goodwill, and contingent consideration. We also have other key accounting policies that are less subjective and, therefore, their application is less subject to variations that would have a material impact on our reported results of operations. There have been no material changes to our critical accounting policies and estimates from the information provided in Part II, Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations, included in our 2013 Annual Report on Form 10-K.


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Results of Operations

Three and six months ended June 30, 2014 and 2013

Revenue, net

In the three and six months ended June 30, 2014 and 2013, we generated revenue through commercial sales and clinical trials.

                      Three Months Ended                        Six Months Ended
                           June 30,                                 June 30,
                       2014          2013       Change         2014          2013        Change
                        (in thousands)                           (in thousands)


Revenue, net $ 70,131 $ 50,836 38 % $ 136,603 $ 100,075 36 %

Total revenue was $70.1 million for the quarter ended June 30, 2014, reflecting 47% revenue growth in the United States, where our HVAD System is labeled solely for a bridge-to-transplantation indication, and 29% internationally where the HVAD System is more broadly indicated for general long-term heart failure patients. In each case, revenue growth reflected continued market penetration within existing customer accounts and to a lesser extent revenue contributed from newly added customers.

Our U.S. revenue was $36.9 million for the quarter ended June 30, 2014 compared to $25.1 million during the quarter ended June 30, 2013. A total of 338 pumps were sold in the U.S. during the second quarter of 2014 compared to 235 pumps sold in the same period of 2013. The U.S. revenue increase included 36 HVAD Systems sold under the Company's supplemental patient cohort for the ENDURANCE clinical trial.

Our international revenue was $33.2 million for the quarter ended June 30, 2014 compared to $25.7 million during the quarter ended June 30, 2013. A total of 336 pumps were sold internationally during the second quarter of 2014 compared to 288 pumps sold in the same period of 2013.

Total revenue was $136.6 million for the six months ended June 30, 2014, reflecting 38% revenue growth in the United States and 35% internationally. In each case, revenue growth reflected continued market penetration within existing customer accounts and to a lesser extent revenue contributed from newly added customers.

Our U.S. revenue was $70.7 million for the six months ended June 30, 2014 compared to $51.3 million in the same period of 2013. A total of 651 pumps were sold in the U.S. during the six months ended June 30, 2014 compared to 473 pumps sold in the same period of 2013. The U.S. revenue increase included 71 HVAD Systems sold under the Company's supplemental patient cohort for the ENDURANCE clinical trial.

Our international revenue was $65.9 million for the six months ended June 30, 2014 compared to $48.8 million in the same period of 2013. A total of 688 pumps were sold internationally during the six months ended June 30, 2014 compared to 532 pumps sold in the same period of 2013.

Changes in foreign currency exchange rates favorably impacted net revenue by approximately $1.6 million and $2.6 million, or 3.1% and 2.6%, in the three and six months ended June 30, 2014, compared to the same periods in 2013. In the three and six months ended June 30, 2014, approximately 44% and 46% of our net revenue was denominated in foreign currencies including principally the Euro and British pound compared to 43% and 42% in the same periods in 2013. Movements in foreign currency exchange rates have had an effect on our reported revenue amounts in the past and could have a significant favorable or unfavorable impact on our reported revenue amounts in the future.

We expect to continue to generate and grow commercial revenue from product sales as we further expand our sales and marketing efforts on a global basis. Future product sales are dependent on many factors, including perception of product performance and market acceptance among physicians, patients, health care payers and the medical community as well as our capacity to meet customer demand by manufacturing sufficient quantities of our products.


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Cost of Revenue

Cost of revenue includes costs associated with manufacturing and distributing our products and consists of direct materials, labor and overhead expenses allocated to the manufacturing process, provisions for excess or obsolete inventory, and shipping costs. Cost of revenue totaled approximately $23.0 million and $18.9 million in the three months ended June 30, 2014 and 2013, respectively. Cost of revenue totaled approximately $45.9 million and $37.6 million in the six months ended June 30, 2014 and 2013, respectively.

Gross profit and gross margin percentage are as follows:

                               Three Months Ended            Six Months Ended
                                    June 30,                     June 30,
                               2014           2013          2014          2013
                                 (in thousands)               (in thousands)
            Gross profit     $  47,176      $ 31,970      $ 90,733      $ 62,429
            Gross margin %        67.3 %        62.9 %        66.4 %        62.4 %

The three month comparative increase in gross margin percentage was primarily a result of production efficiencies driven by increased revenues and manufacturing throughput resulting in 8.7 percentage points of improvement, partially offset by 4.3 percentage points resulting from increases in reserve allowances including the recent battery recall charge recognized in the second quarter of 2014 as described in Note 3 to the condensed consolidated financial statements included in this report.

The six month comparative increase in gross margin percentage was primarily a result of production efficiencies driven by increased revenues and manufacturing throughput resulting in 8.4 percentage points of improvement, partially offset by 4.4 percentage points resulting from increases in reserve allowances including the recent battery recall charge discussed above.

Selling, General and Administrative

Selling, general and administrative expenses include costs associated with selling and marketing our products and the general corporate administration of the Company. These costs are primarily related to salaries and wages and related employee costs, travel, marketing, external consultants and contractors, legal and accounting fees and general infrastructure costs, and include all operating costs not associated with or otherwise classified as research and development costs or cost of revenue.

                                                Three Months Ended June 30,                  Six Months Ended June 30,
                                             2014             2013        Change          2014            2013       Change
                                                (in thousands)                              (in thousands)
Total selling, general and
administrative expenses                   $    20,948       $  17,217          22 %    $    45,180      $ 33,704          34 %

The increase of $3.7 million for the three months ended June 30, 2014 as compared to the same period in 2013 resulted primarily from commercial expansion and included $2.6 million of salaries and related costs associated with headcount growth and $0.8 million of increased travel, conference, tradeshows and other marketing expenditures. We also experienced an increase in non-cash share-based compensation expense of $0.9 million due to an increase in the number of outstanding awards and the increased valuation of those awards, an increase in professional fees of $0.4 million and an increase in medical device excise taxes of $0.4 million. These increases were partially offset by various reductions in certain information technology and facilities expenses of $1.3 million.

The increase of $11.5 million for the six months ended June 30, 2014 as compared to the same period in 2013 included approximately $3.1 million of restructuring charges, primarily related to our acquisition of CircuLite. These expenses included lease exit costs associated with facilities we vacated in Massachusetts and New Jersey, severance costs and asset impairment charges. The remainder of the increase resulted primarily from commercial expansion and included $5.1 million of salaries and related costs associated with headcount growth and $1.9 million of increased travel, conference, tradeshows and other marketing expenditures. We also experienced an increase in non-cash share-based compensation expense of $1.2 million due to an increase in the number of outstanding awards and the increased valuation of those awards


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as well as an increase in professional fees of $1.2 million and an increase in medical device excise taxes of $0.6 million. These increases were partially offset by various reductions in certain information technology and facilities expenses of $1.8 million.

We expect our selling, general and administrative expenses to continue to increase as we continue to expand our sales and distribution capabilities in an effort to increase market penetration on a global basis as well as enhance our administrative capabilities to support our overall corporate growth.

Research and Development

Research and development expenses are the direct and indirect costs associated with developing our products prior to commercialization, including the costs of operating clinical trials, and are expensed as incurred. These expenses fluctuate based on project level activity and consist primarily of salaries and wages and related employee costs of our research and development, clinical and regulatory staffs, external research and development costs, and materials and expenses associated with clinical trials. Additional costs include travel, facilities and overhead allocations.

Three Months Ended June 30, Six Months Ended June 30, 2014 2013 Change 2014 2013 Change

(in thousands) (in thousands)

Total research and development expenses $ 26,913 $ 24,188 11 % $ 59,504 $ 46,330 28 %

The increase of $2.7 million for the three months ended June 30, 2014 as compared to the same period of 2013 was primarily due to a $1.7 million increase in salaries and related costs associated with headcount growth and an increase in animal study and clinical trial costs of $1.4 million. We also experienced an increase in non-cash share-based compensation expense of $0.7 million due to an increase in the number of outstanding awards and the increased valuation of those awards as well as an increase in certain infrastructure areas of $0.5 million. These increases were partially offset by a $1.6 million decrease in development project costs, including consumables, outside engineering, consultants and contractors.

The increase of $13.2 million for the six months ended June 30, 2014 as compared to the same period of 2013 was primarily due to a $2.5 million increase in development project costs, including consumables, outside engineering, consultants and contractors. We also experienced a $4.3 million increase in salaries and related costs associated with headcount growth, an increase in animal study and clinical trial costs of $3.8 million, an increase in certain infrastructure costs of $1.0 million and $0.5 million in fees related to the cancellation of a development agreement. In connection with our acquisition of CircuLite, we recorded restructuring charges aggregating $1.1 million, including contract termination fees and severance costs.

We expect that research and development expenses will continue to represent a significant portion of our operating expenses for the foreseeable future as we continue to incur substantial development costs related to our next generation products, including the Pal controller, the MVAD System, the SYNERGY system and certain early research initiatives, clinical trial expenses related to clinical trials for the HVAD System in new markets and expanded indications and for the MVAD System both in Europe and the United States, as well as ongoing clinical trial expenses associated with bridge-to-transplant post-approval study requirements and ongoing patient follow-up related to the ENDURANCE clinical trial.

Change in Fair Value of Contingent Consideration

On December 1, 2013, we acquired CircuLite, Inc. using a combination of cash and stock. In addition to initial consideration paid at closing, the former CircuLite securityholders may be entitled to receive additional shares of HeartWare common stock (or cash, in certain cases, at our discretion) upon the achievement of six specified performance milestones. The estimated fair value of the contingent consideration is calculated on a quarterly basis by management. In the three months ended June 30, 2014, we recorded a $13.7 million adjustment for the decrease in the estimated fair value of the contingent consideration. The decrease in the estimated fair value of the contingent consideration was primarily due to a $16.3 million reduction as a result of the probable unlikelihood of achieving the performance milestone conditions related to the re-launch of the SYNERGY Surgical System, which is undergoing redevelopment following its removal from the market in 2013 and loss of CE marking in the European Union in March 2014. This decrease in fair value was partially offset by a $2.6 million increase in fair value due to the effect of the passage of time on the fair value measurement.


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In the six months ended June 30, 2014, we recorded a $10.6 million adjustment for the decrease in the estimated fair value of the contingent consideration. The decrease in the estimated fair value of the contingent consideration was primarily due to a $16.6 million reduction as a result of the probable unlikelihood of achieving the performance milestone conditions related to the re-launch of the SYNERGY Surgical System as noted above. This decrease in fair value was partially offset by a $6.0 million increase in fair value due to the effect of the passage of time on the fair value measurement.

The estimated fair value of the contingent consideration requires significant management judgment or estimation and is calculated using the income approach. We utilize significant inputs, including various revenue assumptions, discount rates and apply a probability to each outcome. Potential valuation adjustments will be made as additional information becomes available, including the progress toward achieving re-launch of the SYNERGY Surgical System, revenue and milestone targets as compared to initial projections. The effect of these adjustments will be recorded in our condensed consolidated statement of operations.

Foreign Exchange

We generate a substantial portion of our revenue and collect receivables in . . .

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