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HEARTWARE INTERNATIONAL, INC. - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion and analysis of our financial condition and results of operations should be read together with our consolidated financial statements and related notes appearing elsewhere in this Annual Report on Form 10-K. This discussion and analysis contains forward-looking statements that involve risks, uncertainties, judgments and assumptions. You should review the "Risk Factors" section of this Annual Report on Form 10-K for a discussion of important factors that could cause actual results to differ materially from the results described in or implied by the forward-looking statements contained in the following discussion and analysis. Certain abbreviated key terms have the meanings defined elsewhere in this Annual Report on Form 10-K. 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 all patients at risk of death from refractory, end-stage heart failure. The HVAD System has been implanted in patients at over 230 health care sites in 37 countries. On August 27, 2013, the FDA approved an IDE Supplement allowing HeartWare to commence enrollment in an additional patient cohort for the ENDURANCE clinical trial. In this supplemental cohort, HeartWare intends to enroll up to 286 patients receiving the HVAD System, as well as up to an additional 143 control patients using a randomization scheme consistent with the ENDURANCE protocol. Patients will be followed for 12 months after implant. HeartWare intends 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. CircuLite On December 1, 2013, the Company 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. The SYNERGY Surgical System, which received CE Marking in the European Union in 2012, is designed for long-term support and is intended to reduce the heart's workload while improving blood flow to vital organs. The system is currently undergoing an upgrade to resolve issues that 47 -------------------------------------------------------------------------------- Table of Contents arose after its commercial release and is not presently available for sale at the direction of regulatory authorities. Sales are expected to resume in a controlled fashion following regulatory approval to re-launch the system in Europe and will focus on building experience at a small number of centers of excellence, refining training techniques and implementing additional system upgrades in advance of a full rollout. The next generation endovascular system, which will be implanted collaboratively by cardiologists and surgeons in a hybrid catheterization ("cath") lab setting, offers an interventional approach to circulatory support. While our HVAD® and MVAD® Systems offer minimally invasive treatment to end-stage heart failure patients, the SYNERGY® platform offers even less invasive and ultimately interventional options to earlier-stage heart failure patients. Operations We began generating commercial revenue from sales of the HVAD System in January 2009 and have incurred net losses in each year since our inception. We expect our losses to continue as we expand our pipeline through continued research and development into next generation products, continue our clinical trials, enhance our infrastructure and expand commercial markets both inside and outside of the United States. We have financed our operations primarily through the issuance of convertible notes and the issuance of shares of our common stock. Most recently, in March 2013, we completed a public offering of 1,725,000 shares of our common stock, including the underwriters' exercise of their over-allotment option to purchase 225,000 shares, at an offering price of $86.45 per share for aggregate gross proceeds of approximately $149.1 million. After fees and related expenses, net proceeds from the offering were approximately $141.0 million. The offering was completed pursuant to a prospectus supplement, dated March 12, 2013, to a shelf registration statement on Form S-3 that was previously filed with the SEC and which was declared effective on December 9, 2010. Our corporate headquarters are located in Framingham, Massachusetts. Our principal facilities include our manufacturing and operations facility in Miami Lakes, Florida, our distribution and customer service facility in Hannover, Germany, and our development and operations facility in Aachen, Germany. 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 financial statements included in this report. Our most critical accounting policies and estimates include: revenue recognition, inventory capitalization and valuation, 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. The following is a discussion of our most critical policies, as well as the estimates and judgments involved. Revenue recognition We recognize revenue from product sales in accordance with FASB ASC 605 - Revenue Recognition. Revenue from product sales is recognized when persuasive evidence of an arrangement exists, substantially all the risks and rewards of ownership have transferred to our customers, the selling price is fixed and collection is 48 -------------------------------------------------------------------------------- Table of Contents reasonably assured and there are no further obligations to customers. Sales from products are not subject to rights of return and, historically, actual sales returns have not been significant. We sell products through our direct sales force and through distributors. Sales through distributors are recognized as revenue upon sale to the distributor as these sales are considered to be final and no right of return or price protection exists. Sales to customers, when not made on consignment, are recognized upon shipment. A significant portion of our sales, including sales made through clinical trials in the U.S., are made on a consignment basis. Revenue from products sold on a consignment basis is recognized on the date the consigned product is implanted or otherwise consumed. In limited circumstances, we rent peripheral equipment to patients. We recognize revenue from this arrangement when a contract is entered into with the patient's insurer over the term the equipment is rented. Inventory We expense costs relating to the production of inventories as research and development ("R&D") expense in the period incurred until such time as we believe future commercialization is considered probable and future economic benefit is expected to be recognized, which generally is reliant upon receipt of regulatory approval. We then begin to capitalize subsequent inventory costs relating to that product. Inventories are stated at the lower of cost or market. Cost is determined on a first-in, first out, or FIFO, method. Work-in-process and finished goods include direct and indirect labor and manufacturing overhead. Finished goods include product which is ready-for-use and which is held by us or by our customers on a consignment basis. We review our inventory for excess or obsolete items and write down obsolete or otherwise unmarketable inventory to its estimated net realizable value. Obsolescence may occur due to product expiring or product improvements rendering previous versions obsolete. The extent to which product improvements will cause obsolescence of existing inventory is difficult to determine as the rate of customer acceptance is dependent on many factors. We make judgments and estimates on matters, including forecasted sales volume. Our estimates and judgments in this area are subject to uncertainty and may differ from our actual experience in the future, which could have a material effect on recorded inventory values. We include in inventory materials and finished goods that are held for sale. Certain materials and finished goods held in inventory may be used in research and development activities and are expensed as part of research and development costs when consumed. Share-Based Compensation We recognize share-based compensation expense in connection with our share-based awards based on the estimated fair value of the awards on the date of grant, net of estimated forfeitures, using an accelerated accrual method over the vesting period. Therefore, we only recognize compensation cost for those awards expected to vest over the service period of the award. We estimate the forfeiture rate based on our historical experience of forfeitures. If our actual forfeiture rate is materially different from our estimate, share-based compensation expense could be significantly different from what we have recorded in the current period. Calculating share-based compensation expense requires the input of highly subjective judgment and assumptions, including forfeiture rates, estimates of expected life of the share-based award, stock price volatility and risk-free interest rates. The assumptions used in estimating the fair value of our share-based awards represent our best estimates, but these estimates involve inherent uncertainties and the application of management judgment. As a result, if factors change and we use different assumptions, our share-based compensation expense could be materially different in the future. We value restricted stock units, or RSUs, at their intrinsic value on the date of grant. We estimate the fair value of our stock options using a Black-Scholes option pricing model. When appropriate, we estimate the expected life of a stock option by averaging the contractual term of the stock option (up to 10 years) with the associated vesting term (typically 4 years). We estimate the volatility of our shares on the date of grant 49-------------------------------------------------------------------------------- Table of Contents considering several factors, including the historical volatility of our publicly-traded shares. We estimate the risk-free interest rate based on rates in effect for United States government bonds with terms similar to the expected lives of the stock options, at the time of grant. We have issued share-based awards with performance-based vesting criteria. Achievement of the milestones must be probable before we begin recording share-based compensation expense. At each reporting period, we review the likelihood that these awards will vest and if the vesting is deemed probable, we begin to recognize compensation expense at that time. In the period that achievement of the performance based criteria is deemed probable, U.S. GAAP requires the immediate recognition of all previously unrecognized compensation since the original grant date. As a result, compensation expense recorded in the period that achievement is deemed probable could include a substantial amount of previously unrecorded compensation expense related to the prior periods. If ultimately performance goals are not met, for any share-based awards where vesting was previously deemed probable, previously recognized compensation cost will be reversed. Fair Value Measurements FASB ASC 820-Fair Value Measurements and Disclosures defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. FASB ASC 820 requires disclosures about the fair value of all financial instruments, whether or not recognized, for financial statement purposes. Disclosures about the fair value of financial instruments are based on pertinent information available to us as of the respective reporting dates. Accordingly, the estimates presented in our financial statements are not necessarily indicative of the amounts that could be realized on disposition of the financial instruments. FASB ASC 820 specifies a hierarchy of valuation techniques based on whether the inputs to those valuation techniques are observable or unobservable. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect market assumptions. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurement) and the lowest priority to unobservable inputs (Level 3 measurement). The three levels of the fair value hierarchy are as follows: Level 1- Quoted prices for identical instruments in active markets. Level 2-Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations whose inputs are observable or whose significant value drivers are observable. Level 3-Instruments with primarily unobservable value drivers. The assumptions used in calculating the fair value of financial instruments represent our best estimates, but these estimates involve inherent uncertainties and the application of management judgment. As a result, the use of different estimates or assumptions would result in a higher or lower fair value and different amounts being recorded in our financial statements. Calculating fair value utilizing Level 3 inputs requires the input of highly subjective judgment and assumptions. Income Taxes We account for income taxes in accordance with the liability method presented by FASB ASC 740-Income Taxes. Under this method, deferred income taxes are determined based on the estimated future tax effects of differences between the financial statement and tax basis of assets and liabilities given the provisions of enacted tax laws. Deferred income tax provisions and benefits are based on changes to the assets or liabilities from year to year. In providing for deferred taxes, we consider tax regulations of the jurisdictions in which we operate, estimates of future taxable income, and available tax planning strategies. If tax regulations, operating results or 50-------------------------------------------------------------------------------- Table of Contents the ability to implement tax-planning strategies vary, adjustments to the carrying value of deferred tax assets and liabilities may be required. Valuation allowances are recorded related to deferred tax assets based on the "more likely than not" criteria of FASB ASC 740. Through December 31, 2013, we have historically concluded that a full valuation allowance is required to offset our net deferred tax assets. We operate within multiple taxing jurisdictions and are subject to audit in those jurisdictions. Because of the complex issues involved, any claims can require an extended period to resolve. FASB ASC 740 requires that we recognize the financial statement benefit of a tax position only after determining that the relevant tax authority would more likely than not sustain the position following an audit. For tax positions meeting the "more likely than not" threshold, the amount recognized in the financial statements is the largest benefit that has a greater than 50 percent likelihood of being realized upon ultimate settlement with the relevant tax authority. Reserves Management must make estimates and assumptions to determine the amount of reserves to record in the financial statements. If any of these decisions proves incorrect, our consolidated financial statements could be materially and adversely affected. We maintain allowances for doubtful accounts for estimated losses that may result from an inability to collect payments owed to us for product sales. We regularly review the allowance by considering factors such as historical experience, the age of the accounts receivable balances and current economic conditions that may affect a customer's ability to pay. Certain patient accessories sold with the HVAD System are covered by a limited warranty ranging from one to two years. Estimated contractual warranty obligations are recorded as an expense when the related revenue is recognized and are included in cost of revenue on our consolidated statements of operations. Factors that affect estimated warranty liability include the number of units sold, historical and anticipated rates of warranty claims, cost per claim, and vendor supported warranty programs. We periodically assess the adequacy of our recorded warranty liabilities and adjust the amounts as necessary. Long-Lived Assets, Intangible Assets and Goodwill We evaluate the carrying value of our long-lived assets, including purchased intangible assets, whenever events, changes in business circumstances or our planned use of long-lived assets indicate that their carrying amounts may not be fully recoverable or that their useful lives are no longer appropriate. If these facts and circumstances exist, we assess for recovery by comparing the carrying values of long-lived assets with their future undiscounted net cash flows. If the comparison indicates that impairment exists, impairment losses are recorded for the excess of the carrying value over the fair value of the long-lived assets based on discounted cash flows. Significant management judgment is required in the forecast of future operating results that are used in the preparation of expected undiscounted cash flows. We also evaluate the carrying value of intangible assets (not subject to amortization) related to in-process research and development (IPR&D) assets which are considered to be indefinite-lived until the completion or abandonment of the associated research and development projects. Accordingly, amortization of the IPR&D assets does not occur until the product reaches commercialization. During the period the assets are considered indefinite-lived, they are tested for impairment on an annual basis, as well as between annual tests if we become aware of any events occurring or changes in circumstances that indicate that the fair values of the IPR&D assets are less than their carrying amounts. If and when development is complete, which generally occurs when regulatory approval to market the product is obtained, the associated IPR&D assets are deemed definite-lived and are amortized based on their estimated useful lives at that point in time. If the related project is terminated or abandoned, we may have a full or partial impairment related to the IPR&D assets, calculated as the excess of their carrying value over fair value. 51-------------------------------------------------------------------------------- Table of Contents We test goodwill for impairment on an annual basis in the fourth quarter of each fiscal year or more frequently if we believe indicators of impairment exist. The performance of the test involves a two-step process. The first step requires comparing the fair value of the reporting unit to its net book value, including goodwill. A potential impairment exists if the fair value of the reporting unit is lower than its net book value. The second step of the process is only performed if a potential impairment exists, and it involves comparing the aggregate fair value of the reporting unit's net assets other than goodwill to the fair value of the reporting unit as a whole. Goodwill is considered impaired, and an impairment charge is recorded, if the excess of the fair value of the reporting unit over the fair value of the net assets is less than the carrying value of goodwill. During the fourth quarter of 2013, we recorded an impairment charge totaling $3.7 million to write-off goodwill and in-process research and development that was recorded in 2012 in connection with our acquisition of World Heart. Subsequent to an evaluation of the ongoing research and development efforts surrounding the technology, we determined we would discontinue further development efforts needed to commercialize the MiFlow technology. Contingent Consideration In connection with the acquisition of CircuLite, we agreed to pay $30 million consisting of approximately $18 million in shares of HeartWare common stock, par value $0.001 per share (the "Common Stock"), equal to approximately 230,000 shares of Common Stock (the "Closing Payment"), and approximately $12 million in cash to repay outstanding CircuLite indebtedness and pay certain transaction liabilities and expenses. We funded the cash payment at closing with our existing cash balances. In accordance with the terms of the Merger Agreement, a volume weighted average of the per share prices of Common Stock during the 60 consecutive trading days ending on (and including) November 27, 2013 was used to determine the number of shares of Common Stock issued in connection with the closing. For accounting purposes, these shares were valued as of closing at approximately $22 million based upon the closing price of our Common Stock on the trading day prior to closing. In addition to the Closing Payment, CircuLite securityholders may be entitled to receive additional shares of Common Stock (or cash, in certain cases, at our discretion) upon the achievement of specified performance milestones (the "Contingent Payments"). The estimated acquisition-date fair value of the Contingent Payments was approximately $67.0 million. Contingent Payments are recorded as a liability and measured at fair value using a discounted cash flow model utilizing significant unobservable inputs including the probability of achieving each of the potential milestones and an estimated discount rate commensurate with the risks of the expected cash flows attributable to the various milestones. The material factors that may impact the fair value of the Contingent Payments, and therefore this liability, are the probabilities of achieving the related milestones and the discount rate. Significant increases or decreases in any of the probabilities of success would result in a significantly higher or lower fair value, respectively, and commensurate changes to this liability. The fair value of the Contingent Payments, and the associated liability relating to the Contingent Payments at each reporting date, will be updated with the changes in fair value reflected in earnings. Results of Operations The results of operations for CircuLite are included in our consolidated statements of operations for the period from the December 1, 2013 date of acquisition to December 31, 2013. The following is a description of significant components of our operations, including significant trends and uncertainties that we believe are important to an understanding of our business and results of operations. 52-------------------------------------------------------------------------------- Table of Contents Fiscal Years 2013 and 2012 Revenue, net In November 2012, we received approval from the FDA for the HVAD System as a bridge to heart transplantation in patients with end-stage heart failure. This approval resulted in substantially increased sales in the United States compared to 2012 sales. 2013 sales reflected commercial activities both in the United States and internationally, while 2012 sales were derived from a mix of clinical trial activities in the United States and ongoing commercial sales of our HVAD system internationally. In 2013, domestic revenue comprised approximately 51% of our net revenue compared to approximately 25% in 2012. Net revenue for the years ended December 31, 2013 and 2012 was as follows: 2013 2012 Change (in thousands) Revenue, net $ 207,929 $ 110,922 87 % In 2013, our U.S. revenue increased approximately $77.7 million, or 281%, to $105.3 million compared to U.S. revenue of approximately $27.6 million in 2012. A total of 978 HVAD pumps were sold in the U.S. in 2013 compared to 292 pumps sold in 2012. International revenue increased in 2013 by approximately $19.3 million, or 23%, to $102.6 million compared to international revenue of approximately $83.3 million in 2012. A total of 1,101 HVAD pumps were sold internationally in 2013 compared to 925 pumps sold internationally in 2012. Changes in foreign currency exchange rates favorably impacted net revenue by approximately $2.0 million, or 1.8%, in 2013 compared to 2012. In 2013, approximately 45% of our net revenue was denominated in foreign currencies including principally the Euro and British pound. 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, including commercial sales in the U.S. following FDA approval of the HVAD System for bridge-to-transplant. 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. 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 $76.5 million and $51.0 million in 2013 and 2012, respectively. Gross profit and gross margin percentage for the years ended December 31, 2013 and 2012 were as follows: 2013 2012 (in thousands) Gross profit $ 131,461 $ 59,899 Gross margin % 63 % 54 % The increase in gross margin percentage for 2013 compared to 2012 was primarily a result of production efficiencies resulting from fixed overhead costs spread over a greater number of units produced and sold, and to a lesser extent an increase in the average per unit selling price in 2013 attributable to the introduction of 53 -------------------------------------------------------------------------------- Table of Contents commercial product in the United States during the fourth quarter of 2012. Compared to 2012 higher unit sales prices contributed 2.2% of the gross margin increase, with the balance of the increase related to the described production efficiencies. 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. 2013 2012 Change (in thousands)Total selling, general and administrative expenses $ 76,524 $ 53,945 42 % % of operating expenses 43 % 39 % During 2013, we continued to experience significant growth as we expanded our sales and distribution capabilities, especially in the U.S. in connection with the commercial launch of the HVAD System subsequent to receiving FDA approval in November 2012. We also experienced increased administrative costs as we expanded our administrative capabilities to support overall corporate growth. The increase of $22.6 million resulted primarily from commercial expansion and included $8.0 million of salaries and related costs associated with headcount growth, $5.0 million of increased travel, conferences, tradeshows and other marketing expenditures, $3.5 million of professional fees and $2.0 million of non-cash share-based compensation expense. In addition, we incurred excise taxes of $2.4 million as a result of the Reconciliation Act (discussed below) and $0.6 million in severance costs in connection with the acquisition of CircuLite. In 2010, the Affordable Care Act and the Health Care and Education Reconciliation Act were signed into law. Among other things, these Acts, when taken together, impose a 2.3% excise tax on the U.S. sales of certain medical devices, including our devices, which became effective January 1, 2013. We have included this tax expense in selling, general and administrative expenses on our consolidated statements of operations. We have not invoiced our customers for this tax as a separate charge, and the tax is not included as an element of revenue. The statutory rate of the medical device excise tax is 2.3% of revenue on initial sales of finished medical products sold in the United States. We expect our selling, general and administrative expenses to continue to increase in 2014 compared to 2013 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. 54-------------------------------------------------------------------------------- Table of Contents Research and development expenses for the years ended December 31, 2013 and 2012 were as follows: 2013 2012 Change (in thousands) Total research and development expenses $ 102,483 $ 83,548 23 % % of operating expenses 57 % 61 % The $18.9 million increase was primarily due to a $9.8 million increase in development project costs, including consumables, outside engineering, consultants and contractors. We also experienced a $7.0 million increase in salaries and related costs associated with headcount growth, and an increase in non-cash share-based compensation of $1.7 million. These increases were partially offset by a decrease in costs related to clinical trials of $5.4 million. During the fourth quarter of 2013, we recorded an impairment charge totaling $3.7 million to write-off goodwill and in-process research and development that was recorded in 2012 in connection with our acquisition of World Heart. Subsequent to an evaluation of the ongoing research and development efforts surrounding the technology, we determined we would discontinue further development efforts needed to commercialize the MiFlow technology, other than with respect to certain know-how which has been incorporated into our development of the MVAD System. 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 and certain early research initiatives, new 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. In addition, we anticipate ongoing research and development expenditures with respect to the SYNERGY Surgical System, which received CE Marking in the European Union in 2012. The system is currently undergoing an upgrade to resolve issues that arose after its commercial release and is not presently available for sale at the direction of regulatory authorities. Our efforts will include refining training techniques and implementing additional system upgrades in advance of a full rollout. The next generation endovascular system, which will be implanted collaboratively by cardiologists and surgeons in a hybrid catheterization ("cath") lab setting, offers an interventional approach to circulatory support. Foreign Exchange We generate a substantial portion of our revenue and collect receivables in foreign currencies. Fluctuations in the exchange rate of the U.S. dollar against the Euro, British Pound and Australian dollar can result in foreign currency exchange gains and losses that may significantly affect our financial results. Continued fluctuation of these exchange rates could result in financial results that are not comparable from quarter to quarter. In 2013, our net foreign exchange losses totaled approximately $0.1 million compared to net gains of approximately $1.2 million in 2012. In 2013 and 2012, the majority of our realized and unrealized foreign exchange gains and losses resulted from the settlement of certain balance sheet accounts, primarily accounts receivable that were denominated in foreign currencies, and the remeasurement to U.S. dollars at period end of certain balance sheet accounts, denominated in foreign currencies, primarily the Euro. We expect to continue to realize foreign exchange gains and losses for the foreseeable future as a significant portion of our sales is denominated in foreign currencies. We do not currently utilize foreign currency contracts to manage foreign exchange risks. 55 -------------------------------------------------------------------------------- Table of Contents Interest Expense Interest expense in 2013 and 2012 primarily consists of interest incurred on the principal amount of our convertible senior notes issued in December 2010, amortization of the related discount and amortization of the portion of the deferred financing costs allocated to the debt component. The convertible senior notes bear interest at a rate of 3.5% per annum. The discount on the convertible senior notes and the deferred financing costs are being amortized to interest expense through the December 15, 2017 maturity date of the convertible senior notes using the effective interest method. Interest expense was approximately $12.2 million and $11.4 million in 2013 and 2012, respectively. Interest incurred on the principal amount of the convertible senior notes at the 3.5% coupon rate was approximately $5.0 million in 2013 and 2012. Non-cash amortization of the discount and deferred financing costs totaled approximately $7.2 million and $6.4 million in 2013 and 2012, respectively. Investment Income, net Investment income is primarily derived from investments and cash and short-term deposit accounts held in the U.S. The amortization of premium on our investments is also included in investment income, net. Investment income, net was approximately $0.4 million and $0.2 million in 2013 and 2012, respectively. Due to our public offering of our common stock completed in March 2013, which resulted in net proceeds of approximately $141.0 million, we maintained higher average balances during 2013 compared to 2012. However, we continue to experience low interest rates on our deposits and available-for-sale investments. Income Taxes We are subject to taxation in the United States and jurisdictions outside of the United States. These jurisdictions have different marginal tax rates. Foreign earnings are considered to be permanently reinvested in operations outside the U.S. and therefore we have not provided for U.S. income taxes on these unrepatriated foreign earnings. We have incurred significant U.S. losses since inception, however, changes in issued capital and share ownership, as well as other factors, may limit our ability to utilize any net operating loss carry-forwards, and therefore a 100% valuation allowance has been recorded against our net deferred tax assets. As of December 31, 2013, we did not have earnings which would be sufficient to allow any portion of our deferred tax assets to be recorded. We intend to monitor closely whether to record a deferred tax asset as we expand the commercialization of our products. Fiscal Years 2012 and 2011 Revenue, net In 2012 and 2011, we generated revenue through clinical trials and commercial sales. The increase in revenue from 2011 to 2012 is due to increased commercial market penetration outside of the U.S. resulting in 53% international revenue growth. Revenue from the commercial launch of the HVAD System offset by a decrease in U.S. clinical trial revenues led to a 2% decrease in total U.S. revenues. Net revenue for the years ended December 31, 2012 and 2011 was as follows: 2012 2011 Change (in thousands) Revenue, net $ 110,922 $ 82,764 34 % During 2012, our net revenue denominated in foreign currencies was $68.6 million, an increase of $19.9 million, or 41%, compared to 2011. Changes in foreign currency exchange rates unfavorably impacted total revenue by approximately $4.6 million, or 6%, for 2012. 56-------------------------------------------------------------------------------- Table of Contents Cost of Revenue Cost of revenue totaled approximately $51.0 million for the year ended December 31, 2012 and approximately $32.9 million for the year ended December 31, 2011. Gross profit and gross margin percentage for the years ended December 31, 2012 and 2011 were as follows: 2012 2011 (in thousands) Gross profit $ 59,899 $ 49,832 Gross margin % 54 % 60 % The decrease in gross margin percentage for 2012 compared to 2011 is due primarily to an increase in manufacturing overhead costs per unit as a result of increased overhead costs including costs associated with larger production capabilities and an increase in certain inventory reserves. Selling, General and Administrative Selling, general and administrative expenses for the years ended December 31, 2012 and 2011 were as follows: 2012 2011 Change (in thousands)Total selling, general and administrative expenses $ 53,945 $ 42,314 27 % % of operating expenses 39 % 46 % During 2012, we continued to experience significant growth as we expanded sales and distribution capabilities internationally and in the U.S. later in 2012 in anticipation of commercially launching the HVAD System after receiving FDA approval. We also experienced increased administrative costs as we expanded our administrative capabilities to support overall corporate growth. The increase of $11.6 million was a result of an increase in employee costs, including salaries and wages and related costs of approximately $4.4 million and share-based compensation of $2.8 million, primarily due to increased headcount, and increases in consultant expenses of $1.1 million, travel expenses of $0.9 million, other taxes of $0.7 million, insurance expenses of $0.6 million and marketing expenses of $0.6 million. Research and Development Research and development expenses for the years ended December 31, 2012 and 2011 were as follows: 2012 2011 Change (in thousands) Total research and development expenses $ 83,548 $ 50,149 67 % % of operating expenses 61 % 54 % The increase of $33.4 million was due to an increase in costs associated with development projects of $16.8 million, including $10.3 million of outside engineering, $5.1 million in consultants and contractors and $1.4 million in consumables. These costs were primarily related to furthering our product pipeline, including development of our next generation heart pump system, MVAD, a fully implantable VAD system, and continuous improvement on patient peripherals. In addition, we also experienced an increase in our clinical trial costs of $7.6 million, an increase in employee costs, including salaries and wages and related costs, of approximately $5.7 million and an increase in share-based compensation of $1.9 million. 57-------------------------------------------------------------------------------- Table of Contents Foreign Exchange In 2012, our net foreign exchange gains totaled approximately $1.2 million compared to a $2.3 million loss in 2011. In 2012 and 2011, the majority of our realized and unrealized foreign exchange gains and losses were experienced upon the collection of certain accounts receivable that were denominated in foreign currencies, and the translation to U.S. dollars at period end of certain balance sheet accounts, denominated in foreign currencies, primarily the Euro. We expect to continue to realize foreign exchange gains and losses for the foreseeable future as the majority of our sales denominated in foreign currencies are settled in Euros. We do not currently utilize foreign currency contracts to manage foreign exchange risks. Interest Expense Interest expense in 2012 and 2011 primarily consists of interest incurred on the principal amount of our convertible senior notes issued in December 2010, amortization of the related discount and amortization of the portion of the deferred financing costs allocated to the debt component. The convertible senior notes bear interest at a rate of 3.5% per annum. The discount on the convertible senior notes and the deferred financing costs are being amortized to interest expense through the December 15, 2017 maturity date of the convertible senior notes using the effective interest method. Interest expense was approximately $11.4 million and $10.7 million in 2012 and 2011, respectively. Interest incurred on the principal amount of the convertible senior notes at the 3.5% coupon rate was approximately $5.0 million in 2012 and 2011. Non-cash amortization of the discount and deferred financing costs totaled approximately $6.4 million and $5.7 million in 2012 and 2011, respectively. Investment Income, net Investment income is primarily derived from investments and cash and short-term deposit accounts held in the U.S. The amortization of premium on our investments is also included in investment income, net. Investment income, net was approximately $0.2 million in 2012, compared to $0.5 million in 2011. We had lower cash and investments balances during 2012 and have experienced lower interest rates compared to 2011. Income Taxes In 2012, income tax expense relates primarily to income earned by a foreign subsidiary. Foreign earnings were considered to be permanently reinvested in operations outside the U.S. and as such we have not provided for U.S. income taxes. As of December 31, 2012, we did not have ongoing profit which would be sufficient to allow any portion of our domestic or foreign deferred tax assets to be recorded. Liquidity and Capital Resources As of December 31, 2013, our cash and cash equivalents were approximately $162.9 million as compared to $85.9 million at December 31, 2012. In addition, our short term investments as of December 31, 2013 were approximately $37.6 million as compared to $16.9 million as of December 31, 2012. Following is a summary of our cash flow activities for the years ended December 31, 2013, 2012 and 2011: 2013 2012 2011 (in thousands) Net cash used in operating activities $ (22,223 ) $ (59,862 ) $ (39,392 ) Net cash (used in) provided by investing activities (46,321 ) 72,825 (82,459 ) Net cash provided by financing activities 145,649 2,509 1,055 Effect of exchange rate changes on cash and cash equivalents (146 ) (808 ) (95 ) Net increase (decrease) in cash and cash equivalents $ 76,959 $ 14,664 $ (120,891 ) 58 -------------------------------------------------------------------------------- Table of Contents Cash Used in Operating Activities Cash used in operating activities for the year ended December 31, 2013 included a net loss of approximately $59.3 million and non-cash adjustments to net loss totaling approximately $40.9 million, which primarily consisted of $21.9 million of share-based compensation, $6.8 million for the amortization of the discount on our convertible senior notes, $6.5 million of depreciation and amortization on long-lived assets, and $3.7 million related to impairment of goodwill and intangible assets. Also included in cash used in operating activities in 2013 are approximately $4.9 million in increased prepaid expenses, $4.3 million for the purchase and manufacture of inventories and $2.4 million in increased trade accounts receivables. These amounts were partially offset by an increase in other accrued liabilities of $4.0 million and an increase in trade accounts payable of $3.6 million. Cash used in operating activities for the year ended December 31, 2012 included a net loss of approximately $87.7 million and non-cash adjustments to net loss totaling approximately $31.8 million, which primarily consisted of $18.8 million of share-based compensation, $6.0 million for the amortization of the discount on our convertible senior notes and $5.0 million of depreciation and amortization on long-lived assets. Also included in cash used in operating activities in 2012 are approximately $10.4 million in increased trade accounts receivable, $7.9 million for the purchase and manufacture of inventories and $0.9 million for prepaid expenses. These amounts were partially offset by an increase in trade accounts payable of $7.0 million, an increase in other accrued liabilities of $7.6 million and an increase in deferred rent of $0.7 million. Cash used in operating activities for the year ended December 31, 2011 included a net loss of approximately $55.1 million and non-cash adjustments to net loss totaling approximately $23.0 million, which primarily consisted of $13.2 million of share-based compensation, $5.4 million for the amortization of the discount on our convertible notes and $2.6 million of depreciation and amortization on long-lived assets. Also included in cash used in operating activities in 2011 are approximately $17.6 million for the purchase and manufacture of inventories and $2.1 million for prepaid expenses. These amounts were partially offset by net collections of trade accounts receivable of $3.6 million, an increase in other accrued liabilities of $5.4 million, an increase in deferred rent of $2.2 million and an increase in trade accounts payable of $1.1 million. Cash (Used in) Provided by Investing Activities In 2013, net cash used by investing activities included $22.6 million for the purchase (net of maturities) of available-for sale securities, $20.0 million used for our acquisition of CircuLite and other strategic investments, $3.4 million used to acquire property, plant and equipment and $0.7 million received upon the sale of certain property, plant and equipment in connection with the closure of our Australian facility. Other investing activities in 2013 used cash of approximately $1.1 million. In 2012, net cash provided by investing activities included $75.3 million received upon maturity (net of purchases) of available-for sale securities, $3.7 million received upon the acquisition of World Heart, $4.6 million used to acquire property, plant and equipment, $1.0 million used to acquire patents and $0.8 million paid for a security deposit on a facility lease. In 2011, net cash used in investing activities included $67.7 million for the purchase (net of maturities) of available-for sale securities. Other investing activities in 2011 used cash of approximately $14.8 million. This included approximately $12.8 million to acquire property, plant and equipment, primarily for the build-out of our manufacturing facility located in Miami Lakes, Florida. Cash Provided by Financing Activities On March 12, 2013, we entered into an Underwriting Agreement (the "Underwriting Agreement") with J.P. Morgan Securities LLC, as representative of the several underwriters named in the Underwriting Agreement (the "Underwriters"), pursuant to which we agreed to sell and the Underwriters agreed to purchase, subject to and upon terms and conditions set forth therein, an aggregate of 1,500,000 shares of our common stock at a net sales price of $81.9114 per share (the public offering price of $86.45 per share minus the underwriting discount). We 59 -------------------------------------------------------------------------------- Table of Contents also granted the Underwriters an option to purchase 225,000 additional shares of our common stock at the public offering price less the underwriting discount, which the Underwriters exercised in full on March 13, 2013. The closing of the offering occurred on March 18, 2013. After fees and related expenses, net proceeds from the offering were approximately $141.0 million. The offering was completed pursuant to a prospectus supplement, dated March 12, 2013, to a shelf registration statement on Form S-3 that was previously filed with the SEC and which was declared effective on December 9, 2010. In 2013, 2012 and 2011, we received approximately $4.9 million, $2.7 million and $1.1 million, respectively, from the exercise of stock options. Operating Capital and Capital Expenditure Requirements We have incurred operating losses to date and anticipate that we will continue to consume cash and incur substantial net losses as we expand our sales and marketing capabilities, develop new products and seek regulatory approvals for expanded indications of the HVAD System in the U.S. In 2014, cash on hand is expected to primarily be used to fund our ongoing operations, including: • expanding our sales and marketing capabilities on a global basis; • growing market penetration particularly in U.S.; • continued product development, including development of the MVAD Pump and PAL controller, and clinical trials related to expanded indications of the HVAD System; • pre-clinical cost relating to prospective first human implants of the MVAD Pump; • development and relaunch efforts with respect to the SYNERGY Surgical System including refining training techniques and implementing additional system upgrades in advance of a full rollout; • development of the next generation endovascular system with respect to the SYNERGY platform; • regulatory and other compliance functions; • expand work in process and finished goods inventory to support ongoing operations; • planned investments in infrastructure to support our growth; and • general working capital. Our convertible notes bear interest at a rate of 3.5% per annum, payable semi-annually in arrears on June 15 and December 15 of each year. To date, all interest payments have been paid on a timely basis. Based on the outstanding principal amount of our convertible senior notes at December 31, 2013, the semi-annual interest payments due on June 15 and December 15, 2014 will be approximately $2.5 million each. These amounts are expected to be paid from cash on hand. We believe cash on hand and investment balances as of December 31, 2013 are sufficient to support our planned operations for at least the next twelve months. At December 31, 2013, approximately $3.6 million of our cash on hand was held in foreign locations, including Australia, Germany and the United Kingdom. To date, the Company has not had unremitted foreign earnings and has not incurred U.S. federal and state income taxes related to repatriated earnings. As our operations in our foreign subsidiaries grow, we may generate foreign earnings and repatriation of those earnings to the U.S. could result in us incurring federal and state income taxes. Because of the numerous risks and uncertainties associated with the development of medical devices, we are unable to estimate the exact amounts of capital outlays and operating expenditures necessary to maintain regulatory approvals, fund commercial expansion, and develop and obtain regulatory approvals for new products. Our future capital requirements will depend on many factors, including but not limited to the following: • commercial acceptance of our products; • reimbursement of our products by governmental agencies and third party payers; 60 -------------------------------------------------------------------------------- Table of Contents • costs to manufacture our products; • expenses required to operate multiple clinical trials; • further product research and development for next generation products and expanding indications for our products as well as efforts to sustain and implement incremental improvements to existing products; • expanding our sales and marketing capabilities on a global basis; • broadening our infrastructure in order to meet the needs of our growing operations, including regulatory compliance; • expenses related to funding and integrating strategic investments, acquisitions and collaborative arrangements; • payment of the 2.3% excise tax on gross revenue from the sale of our medical devices in the U.S. imposed by the Patient Protection and Affordable Care Act; • payment of our convertible notes on maturity if not converted or repurchased; and • complying with the requirements related to being a public company in the U.S. Contractual Obligations At December 31, 2013, our contractual financial obligations and commitments by due dates were as follows: Less than Total 1 year 1-3 years 3-5 years Thereafter (in thousands) Convertible senior notes $ 163,875 $ 5,031 $ 10,063 $ 148,781 $ - Operating lease obligations 25,403 2,386 6,686 7,043 9,288 Purchase obligations 40,499 39,279 592 628 - Other 1,868 363 213 203 1,089 Total $ 231,645 $ 47,059 $ 17,554 $ 156,655 $ 10,377 From time to time we invest in certain development stage entities in connection with research activities. The above table does not reflect certain contingent milestone payments in connection with these arrangements as the amounts are indeterminate at this time. 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 above table does not reflect these milestone payments, which may be payable over the next 10 years as the timing and amount of certain milestone payments are indeterminate at this time. The maximum amount of the aggregate milestone payments could be $320 million. As of December 31, 2013, the fair value of the contingent payments was $67.0 million. As of December 31, 2013, our potential liability for uncertain tax positions was approximately $3.6 million, including interest. Due to the degree of uncertainty regarding these liabilities, we are unable to make a reasonably reliable estimate of the amount and period in which these liabilities might be realized. Off-Balance Sheet Arrangements The Company has no off-balance sheet arrangements. 61-------------------------------------------------------------------------------- Table of Contents |