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HEARTWARE INTERNATIONAL, INC. - 10-Q - 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 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 250 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. We anticipate completion of enrollment in this supplemental cohort in the first half of 2015. 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 of further reducing 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. 28 -------------------------------------------------------------------------------- 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. As we complete this comprehensive review of our quality systems, it is possible that we may need to take additional actions. 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, which are ongoing as of September 30, 2014. The first Correction was announced by us on April 24, 2014 and provides updated information to patients and clinicians with respect to a driveline connector correction previously 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. This notification requests patients to discuss the Correction 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. On July 30, 2014, we extended our field safety corrective action 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 continue to monitor complaints and may take further actions as appropriate. During the second and third quarters of 2014, we recorded charges of $1.7 million and $0.6 million, respectively, for estimated costs associated with the recall. Summary of Recent Financial Performance Revenue was $68.6 million for the quarter ended September 30, 2014 compared to $54.8 million in the same period of 2013. This increase reflects 39% revenue growth in the United States, where our HVAD System is labeled solely for a bridge-to-transplantation indication, and 11% 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 September 30, 2014, the Company had 105 customers in the United States and 151 customers internationally. We realized a slight increase in gross margin percentage to 66.5% in the third quarter compared to 64.4% in the third quarter of 2013 which is primarily attributable to production efficiencies associated with increased manufacturing throughput. 29 -------------------------------------------------------------------------------- Combined selling, general, administrative, research and development expenses in the third quarter increased to $50.0 million, compared to $45.8 million in the third quarter of 2013. The net increase includes expansion of sales and marketing activities, external warning letter remediation costs, and increased clinical activity as we make preparations for human clinical testing for the MVAD System and associated peripherals. 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 nine months ended September 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. 30 -------------------------------------------------------------------------------- Results of Operations Three and nine months ended September 30, 2014 and 2013 Revenue, net In the three and nine months ended September 30, 2014 and 2013, we generated revenue through commercial sales and clinical trials. Three Months Ended Nine Months Ended September 30, September 30, 2014 2013 Change 2014 2013 Change (in thousands) (in thousands) Revenue, net $ 68,608 $ 54,800 25 % $ 205,211 $ 154,875 33 % Revenue was $68.6 million for the quarter ended September 30, 2014, reflecting 39% revenue growth in the United States, where our HVAD System is labeled solely for a bridge-to-transplantation indication, and 11% 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 $39.1 million for the quarter ended September 30, 2014 compared to $28.2 million during the quarter ended September 30, 2013. A total of 361 pumps were sold in the U.S. during the third quarter of 2014 compared to 263 pumps sold in the same period of 2013. The U.S. revenue increase included 62 HVAD Systems sold under the Company's supplemental patient cohort for the ENDURANCE clinical trial. Our international revenue was $29.5 million for the quarter ended September 30, 2014 compared to $26.6 million during the quarter ended September 30, 2013. A total of 314 pumps were sold internationally during the third quarter of 2014 compared to 287 pumps sold in the same period of 2013. Total revenue was $205.2 million for the nine months ended September 30, 2014, reflecting 38% revenue growth in the United States and 26% 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 $109.8 million for the nine months ended September 30, 2014 compared to $79.4 million in the same period of 2013. A total of 1,012 pumps were sold in the U.S. during the nine months ended September 30, 2014 compared to 736 pumps sold in the same period of 2013. The U.S. revenue increase included 133 HVAD Systems sold under the Company's supplemental patient cohort for the ENDURANCE clinical trial. Our international revenue was $95.4 million for the nine months ended September 30, 2014 compared to $75.5 million in the same period of 2013. A total of 1,002 pumps were sold internationally during the nine months ended September 30, 2014 compared to 819 pumps sold in the same period of 2013. Changes in foreign currency exchange rates favorably impacted net revenue by approximately $0.3 million and $2.9 million, or 0.5% and 1.9%, in the three and nine months ended September 30, 2014, compared to the same periods in 2013. In the three and nine months ended September 30, 2014, approximately 40% and 44% of our net revenue was denominated in foreign currencies including principally the Euro and British pound compared to 46% and 45% 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. 31-------------------------------------------------------------------------------- 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 $19.5 million in the three months ended September 30, 2014 and 2013, respectively. Cost of revenue totaled approximately $68.8 million and $57.2 million in the nine months ended September 30, 2014 and 2013, respectively. Gross profit and gross margin percentage are as follows: Three Months Ended Nine Months Ended September 30, September 30, 2014 2013 2014 2013 (in thousands) (in thousands) Gross profit $ 45,631 $ 35,271 $ 136,365 $ 97,700 Gross margin % 66.5 % 64.4 % 66.5 % 63.1 % The three month comparative increase in gross margin percentage was primarily a result of production efficiencies driven by increased revenue and manufacturing throughput resulting in 3.3 percentage points of improvement, partially offset by 1.2 percentage points resulting from increases in reserve allowances including the recent battery recall charges described in Note 3 to the condensed consolidated financial statements included in this report. The nine month comparative increase in gross margin percentage was primarily a result of production efficiencies driven by increased revenue and manufacturing throughput resulting in 6.5 percentage points of improvement, partially offset by 3.1 percentage points resulting from increases in reserve allowances including the recent battery recall charge noted 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 September 30, Nine Months Ended September 30, 2014 2013 Change 2014 2013 Change (in thousands) (in thousands)Total selling, general and administrative expenses $ 20,584 $ 19,844 4 % $ 65,765 $ 53,548 23 % The increase of $0.7 million for the three months ended September 30, 2014 as compared to the same period in 2013 resulted primarily from commercial expansion and included $2.0 million of salaries and related costs associated with headcount growth, an increase in certain professional fees of $1.2 million and $0.4 million of increased travel, conference, tradeshows and other marketing expenditures. These increases were partially offset by various reductions in certain information technology and facilities expenses of $1.5 million, a reduction in legal fees of $0.9 million and a decrease in non-cash share-based compensation expense of $0.4 million. The increase of $12.2 million for the nine months ended September 30, 2014 as compared to the same period in 2013 included approximately $3.0 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 $7.1 million of salaries and related costs associated with headcount growth and $2.5 million of increased travel, conference, tradeshows and other marketing expenditures. We also experienced an increase in non-cash share-based compensation expense of $0.8 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 professional fees of $2.7 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 $3.2 million and a reduction in legal fees of $1.1 million. 32 -------------------------------------------------------------------------------- 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. Research and development expenses also include costs associated with our compliance with FDA regulations. Additional costs include travel, facilities and overhead allocations. Three Months Ended September 30, Nine Months Ended September 30, 2014 2013 Change 2014 2013 Change (in thousands) (in thousands)Total research and development expenses $ 29,477 $ 25,930 14 % $ 88,981 $ 72,201 23 % The increase of $3.5 million for the three months ended September 30, 2014 as compared to the same period of 2013 was primarily due to a $2.0 million increase in salaries and related costs associated with headcount growth and an increase in preclinical and clinical trial costs of $1.4 million. We also experienced an increase in certain infrastructure costs of $1.6 million. These increases were partially offset by a $0.5 million decrease in development project costs, including consumables, outside engineering, consultants and contractors. The third quarter of 2013 also included a $0.6 million loss on the disposal of assets. This loss primarily related to the sale or disposal of fixed assets when we ceased certain development activities performed at our former Australian facility and relocated those activities to the United States. The increase of $16.8 million for the nine months ended September 30, 2014 as compared to the same period of 2013 was primarily due to a $6.3 million increase in salaries and related costs associated with headcount growth and an increase in preclinical and clinical trial costs of $5.2 million. We also experienced an increase in certain infrastructure costs of $3.5 million, a $1.5 million increase in development project costs, including consumables, outside engineering, consultants and contractors 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. Included in the amounts above for the three and nine months ended September 30, 2014 are incremental expenses of $2.2 million incurred in connection with the warning letter we received from the FDA in June 2014. We expect our warning letter-related expenses to trend higher in the fourth quarter of 2014, and into the first quarter of 2015, but should decrease thereafter as we complete some of the resource intensive activities for which we have contracted external consultants and advisors. 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 September 30, 2014, we recorded a $3.6 million adjustment for the net decrease in the estimated fair value of the contingent consideration from June 30, 2014 to September 30, 2014. Adjustments in revenue projections, due to the anticipated delay in re-launching the SYNERGY Surgical System, resulted in a $6.1 million decrease in the fair value of a component of the contingent consideration related to royalty payments. This decrease in fair value was partially offset by a $2.5 million increase in fair value due to the effect of the passage of time on the fair value measurement. 33 -------------------------------------------------------------------------------- In the nine months ended September 30, 2014, adjustments aggregating $14.2 million were recorded for the net decrease in the estimated fair value of the contingent consideration since December 31, 2013. The net decrease in the estimated fair value of the contingent consideration in the nine months ended September 30, 2014 was primarily due to a $16.6 million reduction as a result of the unlikely probability of achieving the performance milestone conditions related to the re-launch of the SYNERGY Surgical System, which is undergoing redesign following its removal from the market in 2013 and loss of CE marking in the European Union in March 2014. In addition, as noted above, we adjusted our revenue projections for the SYNERGY Surgical System, which resulted in a $6.1 million decrease in the fair value of a component of the contingent consideration related to royalty payments. These decreases in fair value were partially offset by an $8.5 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 as well as revenue and milestone targets as compared to initial projections. Adjustments associated with changes in the estimated fair value of the contingent consideration are presented on a separate line item on our condensed consolidated statements of operations and will be similarly presented in future accounting periods. 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 the three months ended September 30, 2014, our net foreign exchange losses totaled approximately $3.3 million compared to net foreign exchange gains of approximately $2.1 million in the same period of 2013. In the nine months ended September 30, 2014, our net foreign exchange losses totaled approximately $3.1 million compared to net foreign exchange losses of approximately $0.4 million in the same period of 2013. During the third quarter of 2014, the Euro weakened significantly relative to the U.S. dollar. This was the primary contributor to the foreign exchange losses experienced in the third quarter of 2014. In 2014 and 2013, 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. Interest Expense Interest expense in 2014 and 2013 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. In the three months ended September 30, 2014, interest expense was approximately $3.3 million, which included $1.3 million of interest incurred on the principal amount of the convertible notes at the 3.5% coupon rate and $2.0 million of non-cash amortization of the related discount and deferred financing costs. In the three months ended September 30, 2013, interest expense was approximately $3.1 million, which included $1.3 million of interest incurred on the principal amount of the convertible notes at the 3.5% coupon rate and $1.8 million of non-cash amortization of the related discount and deferred financing costs. 34 -------------------------------------------------------------------------------- In the nine months ended September 30, 2014, interest expense was approximately $9.8 million, which included $3.8 million of interest incurred on the principal amount of the convertible notes at the 3.5% coupon rate and $6.0 million of non-cash amortization of the related discount and deferred financing costs. In the nine months ended September 30, 2013, interest expense was approximately $9.1 million, which included $3.8 million of interest incurred on the principal amount of the convertible notes at the 3.5% coupon rate and $5.3 million of non-cash amortization of the related discount and deferred financing costs. Investment Income, net Investment income is primarily derived from investments and cash and short-term deposit accounts held in the U.S. as well as note receivable interest on a strategic investment in a private company. The amortization of premium on our investments is also included in investment income, net. Investment income, net was approximately $0.1 million and $0.5 million in the three and nine months ended September 30, 2014, respectively, compared to $0.1 million and $0.2 million in the same periods in the prior year. 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. For the three and nine months ended September 30, 2014, our tax provision includes estimated foreign taxes in jurisdictions where wholly-owned subsidiaries may be subject to current taxes. Additionally, in accordance with ASC 740 we continue to record and evaluate tax positions for recognition using a more-likely-than-not threshold, and those tax positions eligible for recognition are measured as the largest amount of tax benefit that is greater than 50% likely of being realized upon the effective settlement with a taxing authority that has full knowledge of all relevant information. 35 -------------------------------------------------------------------------------- Liquidity and Capital Resources As of September 30, 2014, our cash and cash equivalents were approximately $113.6 million as compared to $162.9 million at December 31, 2013. Following is a summary of our cash flow activities: Nine Months Ended September 30, 2014 2013 (in thousands) Net cash used in operating activities $ (15,046 ) $ (19,624 ) Net cash used in investing activities (36,860 ) (22,913 ) Net cash provided by financing activities 837 144,356 Effect of exchange rate changes on cash and cash equivalents 1,837 166 Net (decrease) increase in cash and cash equivalents $ (49,232 ) $ 101,985 Cash Used in Operating Activities For the nine months ended September 30, 2014, cash used in operating activities consisted of a net loss of $18.5 million, adjustments for non-cash items of $17.7 million and cash used in working capital of $14.3 million. The net loss was driven by normal operating activities including the sale of the HVAD System in the U.S. and abroad, increased expenditures on research and development as well as increased administrative costs. Adjustments for non-cash items primarily consisted of $17.3 million of share-based compensation, $6.2 million of depreciation and amortization of long-lived assets, $5.7 million for the amortization of the discount on our convertible notes, $1.0 million loss on an equity investment and $0.6 million for the impairment of fixed assets, which were partially offset by an adjustment of $14.2 million from the decrease in fair value of contingent consideration. The decrease in cash from changes in working capital included $10.4 million in increased trade accounts receivable, $13.1 million for the purchase and manufacture of inventories and $2.3 million for the payment of trade accounts payable. These amounts were partially offset by a decrease in prepaid expenses and other assets of $2.4 million and an increase in accrued liabilities of $7.1 million. For the nine months ended September 30, 2013, cash used in operating activities consisted of a net loss of $37.3 million and non-cash adjustments to net loss totaling approximately $28.1 million. Non-cash adjustments include $16.4 million of share-based compensation, $5.0 million for the amortization of the discount on our convertible notes and $5.2 million of depreciation and amortization on long-lived assets. Also included in cash used in operating activities in the nine months ended September 30, 2013 was approximately $4.8 million in increased trade accounts receivable, $2.7 million for the payment of trade payables and $5.6 million for prepaid expenses and other current assets. Cash Used in Investing Activities In the nine months ended September 30, 2014, net cash used in investing activities included $29.7 million for the purchase (net of maturities) of available-for sale securities, $6.0 million to acquire property, plant and equipment and $1.2 million for intellectual property. In the nine months ended September 30, 2013, net cash used by investing activities included $20.7 million for the purchase (net of maturities) of available-for sale securities, $2.1 million used to acquire property, plant and equipment and $0.6 million for intellectual property. These amounts were partially offset by $0.7 million received upon the sale of certain property, plant and equipment in connection with the closure of our Australian facility. 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 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. 36 -------------------------------------------------------------------------------- The exercise of stock options in the nine months ended September 30, 2014 and 2013 resulted in cash proceeds of approximately $0.8 million and $3.4 million, respectively. Operating Capital and Capital Expenditure Requirements We have incurred substantial operating losses to date and anticipate that we will continue to consume cash and incur 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 United States. For the remainder of 2014, cash on hand is expected to be used primarily to fund our ongoing operations, including: • expanding our sales and marketing capabilities on a global basis; • growing market penetration particularly in United States; • continued product development, including development of the MVAD Pump and Pal controller; • pre-clinical and clinical costs relating to prospective first human implants of the MVAD Pump, and clinical trials related to expanded indications of the HVAD System; • development and relaunch efforts with respect to the SYNERGY Surgical System; • development of the next generation endovascular system with respect to the SYNERGY platform; • regulatory and other compliance functions, including activities to enhance our quality systems in response to the warning letter we received from the FDA in June 2014; • expanding 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 September 30, 2014, the semi-annual interest payment due on December 15, 2014 will be approximately $2.5 million. This amount is expected to be paid from cash on hand. We believe cash on hand and investment balances as of September 30, 2014 are sufficient to support our planned operations for at least the next twelve months. At September 30, 2014, approximately $5.9 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. Any repatriation of those earnings to the United States would likely result in us incurring federal and state income taxes. We currently plan to permanently reinvest any earnings of our foreign subsidiaries. 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: • implementation of systemic improvements necessary to satisfactorily address the observations cited in the June 2, 2014 warning letter we received from the FDA; • commercial acceptance of our products; • reimbursement of our products by governmental agencies and third party payers; • costs to manufacture and ensure regulatory compliance of 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; 37 -------------------------------------------------------------------------------- • payment of the 2.3% excise tax on gross revenue from the sale of our medical devices in the United States 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 United States. Contractual Obligations In the nine months ended September 30, 2014, there were no material changes outside the ordinary course of business to our contractual obligations 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 filed with the SEC on March 3, 2014. 38-------------------------------------------------------------------------------- |