Cyberonics 10-K 2008
Documents found in this filing:
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Commission file number: 0-19806
(Exact name of registrant as specified in its charter)
100 Cyberonics Blvd.
(Address of principal executive offices)
Registrant’s telephone number, including area code:
Securities registered pursuant to Section 12(b) of the Act:
Securities registered pursuant to Section 12(g) of the Act:
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o No þ
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o No þ
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. þ
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ
The aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant as of October 26, 2007, the last business day of the registrant’s most recently completed second fiscal quarter, based upon the last sales price reported for such date on the NASDAQ Global Market was approximately $254.3 million. For purposes of this disclosure, shares of common stock held by persons who hold more than 5% of the outstanding shares of common stock and shares held by officers and directors of the registrant have been excluded as such persons may be deemed to be affiliates.
At June 19, 2008, 26,942,170 shares of common stock were outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the definitive proxy statement of Cyberonics, Inc. for the 2008 Annual Meeting of Stockholders, which will be filed within 120 days of April 25, 2008, are incorporated by reference into Part III of this Annual Report on Form 10-K.
TABLE OF CONTENTS
In this Annual Report on Form 10-K, “Cyberonics,” “we,” “us” and “our” refer to Cyberonics, Inc. and
its consolidated subsidiary (Cyberonics Europe NV).
CAUTIONARY STATEMENT ABOUT FORWARD-LOOKING STATEMENTS
This Annual Report on Form 10-K (this “Form 10-K”) contains forward-looking statements. These statements relate to future events or our future financial performance. We have attempted to identify forward-looking statements by terminology such as “expect,” “may,” “will,” “intend,” “anticipate,” “believe,” “estimate,” “could,” “possible,” “plan,” “project,” “forecast” and similar expressions. Our forward-looking statements generally relate to our growth strategies, financial results, reimbursement programs, product acceptance programs, product development programs, clinical and new indication development programs, regulatory approval programs, manufacturing processes and sales and marketing programs. Forward-looking statements should be carefully considered as involving a variety of risks and uncertainties including, but not limited to, those described in (a) Part I, “Item 1A. Risk Factors” and elsewhere in this Form 10-K; (b) our reports and registration statements filed from time to time with the Securities and Exchange Commission (“SEC”); and (c) other announcements we make from time to time.
No forward-looking statements can be guaranteed to be accurate and actual outcomes may vary materially. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. We will not update any of the forward-looking statements after the date of this Form 10-K to conform these statements to actual results, unless required by law.
Item 1. Business
We are a neuromodulation company incorporated as a Delaware corporation in 1987, engaged in the design, development, sales and marketing of implantable medical devices that provide a unique therapy, vagus nerve stimulation (“VNS”) therapy (“VNS Therapy”), for the treatment of refractory epilepsy and depression.
Our proprietary VNS Therapy™ System (“VNS Therapy System”) includes the following:
The implantation of the generator and lead into patients is generally performed on an outpatient basis. The battery contained in this generator has a finite life, which varies according to the model, the stimulation parameters and settings used for each patient. At or near the end of the useful life of a battery, a patient may, with the advice of a physician, choose to implant a new generator, with or without replacing the original lead.
The United States (“U.S.”) Food and Drug Administration (“FDA”) approved the VNS Therapy System in July 1997 for use as an adjunctive therapy in epilepsy patients over 12 years of age in reducing the frequency of partial onset seizures that are refractory or resistant to antiepileptic drugs. Regulatory bodies in Canada, the European Economic Area, South America, Africa, Australia and certain countries in Eastern Asia have approved VNS Therapy for the treatment of epilepsy, many without age restrictions or seizure-type limitations. In July 2005, the FDA approved the VNS Therapy System for the adjunctive long-term treatment of chronic or recurrent depression for patients 18 years of age or older who are experiencing a major depressive episode and have not had an adequate response to four or more adequate anti-depressant treatments. Regulatory bodies in the European Economic Area and Canada have approved the VNS Therapy System for the treatment of chronic or recurrent depression in patients who are in a treatment-resistant or in a treatment-intolerant depressive episode without age restrictions.
Our ability to successfully expand the commercialization of the VNS Therapy System depends on obtaining and maintaining favorable insurance coverage, coding and reimbursement for the device, the implant procedure and follow-up care. Currently, we have broad coverage, coding and reimbursement for VNS Therapy for the treatment of refractory epilepsy. Because there are currently no favorable national coverage policies and only a few regional coverage policies for VNS Therapy for depression, we have assisted physicians and patients with obtaining case-by-case approvals since FDA approval in July 2005. Any long-term growth in sales for the treatment of depression is dependent on obtaining favorable national and regional coverage policies for VNS Therapy for depression. In May 2007, the Centers for Medicare and Medicaid Services (“CMS”) (formerly, the Healthcare Financing Administration) issued a final determination of non-coverage with respect to reimbursement of VNS Therapy for depression.
In February 2008, we announced that, after consulting with clinical and reimbursement experts, we have developed a plan, including the conduct of an additional randomized clinical trial, or possibly more than one such clinical trial, to obtain reimbursement coverage for our depression indication. We also announced a plan to transfer our depression business to a separate entity, in which we expect to maintain at least a minority interest. We have engaged an investment bank to assist us in identifying a financial partner to provide the funding necessary to execute this plan.
Our clinical development program has included pilot and pivotal studies in using VNS Therapy (a) as an adjunctive therapy for reducing the frequency of seizures in patients over 12 years of age with partial onset seizures that are refractory to antiepileptic drugs and (b) as an adjunctive treatment of patients 18 years of age and older with chronic or recurrent depression who are in a major depressive episode. We have also conducted or provided support for small pilot studies for the use of VNS Therapy in the treatment of Alzheimer’s disease, anxiety, bulimia, fibromyalgia, obesity, obsessive-compulsive disorder, multiple sclerosis and other indications. These studies have been conducted to determine the safety and effectiveness of VNS Therapy in these new indications and to determine which new indications might be considered for pivotal studies and, therefore, are an important component of our clinical research activities.
Proprietary protection for our products is important to our business. We maintain a policy of seeking U.S. and foreign patents on selected inventions, acquiring licenses under selected patents of third parties, and entering into invention and confidentiality agreements with our employees, vendors and consultants with respect to technology that we consider important to our business. We also rely on trade secrets, unpatented know-how and continuing technological innovation to develop and maintain our competitive position.
We are actively engaged in determining how we can license intellectual property rights to third parties in order to optimize our portfolio. This includes the assessment and determination of which of our intellectual property rights for particular indications we do not have immediate plans to develop and identifying whether these rights should be licensed to third parties. It also involves the assessment of the intellectual property rights of third parties in order to determine whether we should attempt to acquire those rights through a license. We recently granted rights to Ethicon Endo-Surgery, Inc. to use our technology to treat obesity.
Since inception, we have incurred substantial expenses, primarily for research and development activities that include product and process development and clinical trials and related regulatory activities, sales and marketing activities, manufacturing start-up costs and systems infrastructure. We have also made significant investments in recent periods in connection with sales and marketing activities in the U.S. and clinical research costs associated with new indications development, most notably depression. As of April 25, 2008, we had incurred an accumulated deficit of approximately $269.2 million. We are focused on advancing the clinical foundation as a basis for establishing, maintaining and extending reimbursement for VNS Therapy. This may involve increased investment in clinical trials.
VNS Therapy Epilepsy Indication Overview
Epilepsy is a disorder of the brain characterized by recurrent seizures that are categorized as either partial or generalized at onset. Patients who continue to have unsatisfactory seizure control or intolerable side effects after treatment with appropriate antiepileptic therapies for a reasonable period of time are said to suffer from refractory epilepsy. For reasons that are not clear, partial onset seizures are generally more refractory to existing therapies than generalized seizures. Epilepsy is the second most prevalent neurological disorder in the world. It is estimated that approximately 2.7 million individuals in the U.S. have epilepsy, with approximately 125,000 new cases diagnosed each year, and we estimate that there are in excess of 3.0 million individuals with epilepsy in Western Europe with over 150,000 new cases diagnosed each year. In addition, it is estimated that approximately 50% of patients with epilepsy suffer from partial onset seizures and that over 30% of these patients continue to suffer from seizures in spite of treatment with antiepileptic drugs. There are three standard types of treatment available to persons with epilepsy: anti-epileptic drug therapy, VNS Therapy and surgery. Antiepileptic drugs serve as a first-line treatment and are prescribed for virtually all individuals being treated for epilepsy. When drug therapy is not effective, VNS Therapy may be considered. Surgery may also be an option for some patients. There are a number of other treatments under development for the treatment of epilepsy, including direct deep brain stimulation (“DBS”) and the Responsive Neurostimulator System (“RNStm”), but these treatments are not currently approved for commercial distribution.
VNS Therapy for Epilepsy
The VNS Therapy System is indicated as an adjunctive treatment for patients who are refractory to antiepileptic drugs. In the two randomized, parallel, double-blind, active-controlled studies that led to FDA approval of our epilepsy indication, the patients who received adjunctive VNS Therapy had a mean seizure reduction of approximately 24% and 28% during the three-month acute phase of the studies. Additionally, many patients, including some who reported no change or an increase in seizure frequency, also reported a reduction in seizure severity. Long-term follow-up data derived from an uncontrolled protocol on the 440 patients in five studies showed that efficacy was maintained and, for many patients, improved over time during treatment with the VNS Therapy System. Analysis of the pooled data showed that the median percentage seizure reduction was 44% after 24 months of treatment and was sustained at that level at 36 months. In the treatment of refractory epilepsy, the side effects associated with the VNS Therapy System are generally mild, localized and related to the period of time in which stimulation is activated. The side effects include voice alteration, neck discomfort, increased cough, shortness of breath and difficulty swallowing. The VNS Therapy System has not typically been associated with the debilitating central nervous system side effects that frequently accompany antiepileptic drugs. Additionally, side effects of VNS Therapy typically decrease over time. To date, over 48,000 patients worldwide have been treated with the VNS Therapy System for epilepsy.
VNS Therapy Depression Indication Overview
Major depressive disorder is one of the most prevalent and serious illnesses in the U.S. It affects nearly 19 million Americans 18 years of age or older every year. Recently published data indicate that approximately one-third of patients with major depressive disorder will not achieve a remission of their depressive symptoms after four well-delivered, optimized treatment steps using standard antidepressant therapies. According to the World Health Organization, based on years lived with disability, depression is the leading cause of disability for the general population. Depression interferes with a person’s ability to function, feel pleasure or maintain interest in everyday living. It is associated with increased mortality due to suicide and other co-morbid general medical conditions or general medical conditions that co-exist with the depressive disorder. Total annual costs for depression in the U.S. are estimated to exceed $80 billion, including $26 billion in annual direct treatment costs. Standard treatment methods for depression include antidepressant drugs, psychotherapy and electroconvulsive therapy (“ECT”). First-line therapy often consists of an antidepressant drug. For patients who do not respond adequately to initial antidepressant treatment, physicians will often switch to a different drug or use two or more drugs in combination. Physicians usually reserve ECT for patients who have not had an adequate response to multiple trials of antidepressant drugs or when they determine a rapid response to treatment is desirable. There are a number of other neuromodulation treatments under development for the treatment of depression, including repetitive transcranial
magnetic stimulation (“rTMS”) and DBS, but these treatments are not currently approved for commercial distribution.
VNS Therapy for Depression
The VNS Therapy System is indicated as an adjunctive treatment for patients 18 years of age or older who have chronic or recurrent treatment-resistant depression who are experiencing a major depressive episode and have not had an adequate response to four or more adequate antidepressant treatments. In Canada and the European Union, VNS Therapy is indicated for the treatment of chronic or recurrent depression in patients who are in a treatment-resistant or treatment-intolerant major depressive episode. The FDA approved the depression indication for the VNS Therapy System based on (a) a long-term uncontrolled trial (the “Pivotal Trial”) of adjunctive VNS Therapy that showed significant, sustained improvement of depressive symptoms over one and two years, and (b) a comparison of the 12-month outcomes in the Pivotal Trial with the 12-month outcomes among a non-randomized, but well-matched, group of patients who received only standard treatments for their depression. After one year of adjunctive VNS Therapy in the Pivotal Trial, response to treatment ranged from 22% to 37% (depending on which outcome was measured). Moreover, 60% of the patients who responded after three months of adjunctive VNS Therapy were still responders at one year and 70% of the three-month responders were responders at the two-year evaluation. For those patients who were responders at the one-year evaluation, 69% were still responders at the two-year evaluation. VNS Therapy was generally well tolerated in the depression clinical studies. The most commonly reported adverse events were similar to those observed in patients being treated with VNS Therapy for epilepsy. These side effects tended to occur during stimulation, tended to be reported as mild or moderate and tended to be reported less frequently over time.
FDA Post-Approval Study Commitments and Other Clinical Research Studies
As a condition of approval for the VNS Therapy System’s depression indication, the FDA requires us to conduct two post-approval clinical studies. One is a 460-patient randomized, controlled study that compares outcomes for different levels of vagus nerve stimulation. The other is a patient registry that will include 500 patients experiencing “treatment as usual” (as defined in the study) plus adjunctive VNS Therapy and 500 patients experiencing only treatment as usual. Both studies are actively enrolling patients. To maintain timely progress in the 460-patient dosing study, we announced a program in early 2007 whereby we are donating the VNS Therapy Systems and paying for the facility- and surgery-related costs (at a negotiated rate) for patients being enrolled in the dosing study.
We are also sponsoring post-marketing studies in refractory epilepsy and supporting a variety of studies to improve the fundamental understanding of how VNS Therapy works. The E-06 Study is an open randomized post-marketing study being conducted in Europe to assess the efficacy and safety of adjunctive VNS versus adjunctive new anti-epileptic drug AED treatment in children with refractory seizures. The European Indication for Use allows children under the age of 12 to be implanted with VNS Therapy. The PuLsE Study is an open prospective randomized long-term effectiveness post-marketing study being conducted in Europe and Canada comparing best medical practice with or without adjunctive VNS Therapy in patients 16 years or older with pharmaco-resistant partial epilepsy. Both studies are actively enrolling patients. We expect to continue to invest in future research activities as appropriate.
VNS Therapy System
VNS Therapy is the first treatment approved by the FDA for both medically refractory epilepsy and depression. The safety profiles for VNS Therapy and the VNS Therapy System, including the implant procedure, are well established in clinical studies of refractory epilepsy and depression and in commercial use in over 52,000 patients.
The VNS Therapy System is a proprietary, integrated system consisting of an implantable generator that delivers an electrical signal to an implantable lead attached to the left vagus nerve. The vagus nerve is the longest of the cranial nerves, extending from the brain stem through the neck to organs in the chest and abdomen. The left vagus nerve has been shown to have influence over numerous areas of the brain. Preclinical studies and mechanism-of-action research suggest that intermittent stimulation of the left vagus nerve in the neck modulates a number of structures and alters blood flow bilaterally in several areas of the brain. These studies have also shown that stimulation of the left cervical vagus nerve is effective in suppressing the intensity or frequency of seizures and results in persistent or carryover antiepileptic effects, which increase with chronic intermittent stimulation. The mechanism-of-action research associated with our depression studies has shown stimulation of the left vagus nerve results in modulation of areas of the brain thought to be important in the regulation of mood.
The VNS Therapy System consists of a pulse generator, a bipolar lead, a programming wand and software and a tunneling tool. The pulse generator and bipolar lead are surgically implanted in a procedure that takes from 60 to 90 minutes, during which time the patient is under general, regional or, rarely, local anesthesia. The pulse generator is surgically implanted in a subcutaneous pocket in the upper left chest. The bipolar lead is connected to the pulse generator and attached to the vagus nerve in the lower left side of the patient’s neck.
The VNS Therapy System delivers stimulation on a chronic, intermittent basis. The initial stimulation parameters that we typically recommend are a 30-second period of stimulation, which we refer to as ON time, followed by a five-minute period without stimulation, which we refer to as OFF time. To optimize patient treatment, the current pulse width, amplitude and frequency and stimulation ON and OFF intervals of the pulse generator can be adjusted non-invasively by the treating physician with a handheld computer using our programming wand and software. In addition, epilepsy patients can use a small, handheld magnet provided with the VNS Therapy System to activate or deactivate stimulation manually. On-demand therapy can be useful for those epilepsy patients who sense an oncoming seizure and has been reported by a number of patients to abort or reduce the severity or duration of seizures. The magnet can also be used to provide epilepsy patient control of stimulation side effects by allowing the patient to deactivate stimulation temporarily.
Pulse Generator. The pulse generator is an implantable, programmable signal generator designed to be coupled with the bipolar lead to deliver electrical signals to the vagus nerve. The pulse generator is a battery powered device. Shortly before or upon depletion of the battery, the pulse generator may be removed and a new generator implanted in a short, outpatient procedure.
The Model 102, 102R, DemiPulse™ and DemiPulse™ Duo VNS Therapy pulse generators, the only pulse generators we currently offer in the U.S., are similar in design and manufacture to a cardiac pacemaker. The generators are comprised of one printed circuit board and a battery hermetically sealed in a titanium case. Standard components are assembled on printed circuit boards using surface-mount technology. The assembled circuit boards are then tested and mounted with the battery in the titanium case, which is laser welded. A header to which the bipolar lead connects is added and each unit is subject to final release testing prior to being sterilized.
Bipolar Lead. The bipolar lead conveys the electrical signal from the pulse generator to the vagus nerve. The lead incorporates electrodes, which are self-sizing and flexible, minimizing mechanical trauma to the nerve and allowing body fluid interchange within the nerve structure. The lead’s two electrodes and anchor tether wrap around the vagus nerve and the connector end is tunneled subcutaneously to the chest where it attaches to the pulse generator. The leads are available in two sizes of inner spiral diameter to ensure optimal electrode placement on different size nerves.
Programming Wand and Software. Our programming wand and proprietary software are used to interrogate the device and to transmit programming information from a handheld computer to the pulse generator via electromagnetic signals. Programming capabilities include modification of the pulse generator’s programmable parameters (pulse width, amplitude, frequency and ON and OFF intervals) and storage and retrieval of telemetry data.
Tunneling Tool. The tunneling tool is a single use, sterile, disposable surgical tool designed to be used during surgical placement of the bipolar lead. The tool is used for subcutaneous tunneling of the lead assembly between the nerve site in the neck and the pulse generator site in the chest.
Accessory Pack. The accessory pack includes two resistor assemblies used to test the function of the device prior to implantation, the bipolar lead tie-downs and one hex screwdriver.
Our product development efforts are directed toward improving the VNS Therapy System, improving its efficacy and developing new products that provide additional features and functionality while improving cost effectiveness.
In May 2005, we received approval from KEMA Registered Quality, Inc. (“KEMA”) to market our DemiPulse and DemiPulse Duo VNS Therapy System generators in the member countries of the European Union for the approved epilepsy and depression indications for use. The DemiPulse generator is the next generation single-connector VNS Therapy System generator, and the DemiPulse Duo generator is the next generation dual-connector VNS Therapy System generator for use in patients whose physicians have elected replacement of their previous dual-connector generator at the end of its battery life. Both the DemiPulse and DemiPulse Duo generators are capable of delivering greater functionality and are smaller and lighter than the previous models. We submitted the Premarket Approval Application Supplement (“PMA-S”) for both the DemiPulse and the DemiPulse Duo generators to the FDA in January 2007 and initiated limited release in Europe in May 2007. We received FDA approval in July 2007, initiated limited release in the U.S. in late 2007 and commenced commercial release in May 2008.
The VNS Therapy Perenniatm Lead was approved by the FDA in May 2006 and by KEMA in August 2006. Functionally, the new lead is the same as its predecessor, the Model 302 Lead, but it incorporates a new design and is constructed from more durable components. Mechanical tests conducted in a laboratory setting have shown the Perennia Lead to be more robust than its predecessor.
We are conducting ongoing product development programs to enhance the VNS Therapy System pulse generator, the bipolar lead and programming software. We will be required to file for the appropriate U.S. and international regulatory approvals, and some projects may require clinical trials, in connection with the introduction of new and improved products.
Manufacturing and Sources of Components and Raw Materials
We manufacture our products at the manufacturing facility located in our corporate headquarters in Houston, Texas. We purchase many of the components and raw materials used in manufacturing these products from various suppliers. For reasons of quality, product availability and expense control, certain components and raw materials are purchased from sole source suppliers. We work closely with our suppliers, including our sole source suppliers, to ensure continuity of supply and quality. Due to the FDA’s rigorous quality requirements regarding the manufacture of medical devices, including the VNS Therapy System, we may not be able to change suppliers or identify alternate suppliers quickly or easily. Although component or raw material supply has not historically been an issue, any reduction or interruption in supply could adversely impact our business.
Our manufacturing operations are required to comply with the FDA’s Quality System Regulation (“QSR”). The QSR is promulgated under section 520 of the Food, Drug and Cosmetic Act, which requires manufacturers to have a quality system for the design and production of medical devices. The regulation also requires that:
Thus, the QSR helps assure that medical devices are safe and effective for their intended use. In addition, certain international markets have regulatory, quality assurance and manufacturing requirements that may be more or less rigorous than those in the U.S. Specifically, we have authorized KEMA to ensure that we are in compliance with the requirements of International Standards Organization 13485:2003, “Medical devices — Quality management systems — Requirements for regulatory purposes” and the European Council Directive 90/385/CEE relating to Active Implantable Medical Devices (“AIMD”). KEMA is an entity that confirms that a company’s products and quality systems are compliant, and serves as our notified body within the scope and framework of the European Council Directive 90/385/CEE relating to AIMD, audits us on an annual basis for such compliance.
Marketing and Sales
We market and sell our products for refractory epilepsy and depression through separate direct sales and marketing forces.
In the U.S., our sales and marketing plan focuses on creating awareness and demand for the VNS Therapy System among epileptologists and neurologists who treat refractory epilepsy, implanting surgeons, nurses, third-party payers, hospitals and patients and their families.
To reach each of these groups, we conduct direct selling activities using a specialized sales force consisting of:
In addition to our direct selling activities, we facilitate and support peer-to-peer interactions such as symposia, conference presentations, journal articles and patient support groups to provide experienced clinicians and patients the opportunity to share their perspectives on the VNS Therapy System with others.
During fiscal year 2008, we restructured our sales organization to establish separate sales groups for the epilepsy and depression indications. We experienced a significant sales decline in depression in fiscal year 2008, in part, as a result of the May 2007 negative coverage determination by CMS. As previously announced, we have a plan to obtain favorable coverage policies. This plan includes an additional clinical trial or trials and the intention to transfer our depression business to another entity, in which we plan to retain at least a minority interest.
We do not anticipate any meaningful sales growth in depression until we obtain favorable coverage policies for VNS Therapy in depression. Favorable coverage policies are not expected until we have completed additional clinical trial(s), and submitted further evidence of the efficacy of VNS Therapy for depression. This evidence is not expected to be available until at least 2011.
We market and sell our products in approximately 71 countries through a combination of a direct sales force in certain European countries and independent distributors elsewhere. Our objectives include increasing sales and expanding the number of countries where VNS Therapy can be made available to patients.
The VNS Therapy System is currently sold by a direct sales force in Austria, Belgium, Denmark, France, Germany, Luxemburg, The Netherlands, Norway, Spain, Sweden, Switzerland and the United Kingdom. The sales price in each direct country is based on local market conditions, including public and private reimbursement, and is generally lower than the sales price in the U.S.
We have distribution agreements with independent distributors covering a number of other territories including Canada, Mexico, Australia, and parts of Central and South America, Asia, Middle East and Europe. The distribution agreements generally grant the distributor exclusive rights for the particular territory for a specified period of time, generally one to three years. Under the terms of the agreement and local law, we may be required to compensate the distributor in the event that the agreement is terminated by us or is not renewed upon expiration. The distributor generally assumes responsibility for obtaining regulatory and reimbursement approvals for the relevant territory and agrees to certain minimum marketing and sales expenditures and purchase commitments. Under the terms of the distributor agreements, no product return rights are granted to the distributor, and no additional product performance issues exist for us after shipment to the distributor. Our pricing to distributors is generally fixed under the terms of the distribution agreements, but may change at our election, with as little as 30 days prior notice under most agreements. Sales incentives, if provided, are recorded as a reduction of net sales in the same period net sales are recognized.
Third-Party Reimbursement in the U.S. Market
We sell the VNS Therapy System to hospitals and ambulatory surgery centers (“ASCs”) on payment terms that are generally 30 days from shipment date. Our ability to successfully expand the commercialization of the VNS Therapy System depends on obtaining and maintaining favorable coding, reimbursement and coverage for the VNS Therapy System, the associated implant procedure and follow-up care. Favorable reimbursement coverage allows our customers to invoice and get paid by third party payers for the costs of purchasing the VNS Therapy System and the associated surgery and patient care. Reimbursement or payment rates were largely unchanged over the past year, with a slight increase in the Medicare allowable amount. With respect to epilepsy, the coverage environment was largely unchanged, with virtually all technology assessments being favorable and most third-party payers having favorable coverage policies.
Coverage for VNS Therapy in depression has been difficult to obtain. As a result, we have announced our plan to transfer our depression business to a separate entity and to seek a financial partner to fund one or more new clinical trials.
We employ case managers, available through our reimbursement hotline, to help with coverage, coding and reimbursement issues on a case-by-case basis and/or policy level.
The implant procedure, including the cost of the device (approximately $21,000 for a DemiPulse model VNS Therapy System), hospital charges and physician fees, generally costs between $23,000 and $38,000.
Under the current CMS policy, VNS Therapy is covered for patients with medically refractory partial onset seizures for whom surgery is not recommended or for whom surgery has failed. However, in May 2007, CMS issued its Decision Memorandum for Vagus Nerve Stimulation for Treatment of Resistant Depression (CAS-00313R), concluding that Medicare coverage is not available for VNS Therapy as a treatment for depression. For additional information, see “General” above.
Medicaid programs generally cover hospital inpatient and outpatient services that are medically necessary and appropriate. With respect to epilepsy, most state Medicaid agencies have developed their own coverage policy for VNS Therapy or have adopted the national CMS coverage policy, although payment amounts vary from state to state. With respect to depression, a small number of Medicaid programs provide coverage for VNS Therapy on a case-by-case basis, but most are still evaluating a coverage policy or have issued a non-coverage policy. CMS’s non-coverage determination on Medicare coverage for the treatment of depression has made gaining coverage with Medicaid programs more difficult.
Medicaid reimbursement mechanisms vary state by state. Medicaid policy and payment methodologies change on a regular basis, so we are engaged in vigilant and ongoing work to ensure continued access and acceptable reimbursement for patients covered by Medicaid programs.
Private payers (commercial, managed care and other third-party payers) generally cover hospital inpatient and outpatient services that are considered to be medically necessary. Currently, private payers account for 50% to 60% of patients implanted with the VNS Therapy System. As with other payers, many private payers have developed clinical guidelines for coverage or adopted the national CMS coverage policy for use of VNS Therapy in epilepsy. As of the end of fiscal year 2008, coverage for VNS Therapy for depression is still very limited. Only a few plans have issued favorable coverage policies for VNS Therapy in depression, and approximately 300 plans have approved one or more case-by-case requests. Most plans have either no policy or a non-coverage policy with respect to coverage for depression. Following the May 2007 CMS national non-coverage determination for depression, we have had difficulty expanding or even maintaining coverage among private payers.
As stated above, we believe it will be necessary to undertake at least one additional clinical trial to provide further evidence to support coverage for VNS Therapy for depression. This trial will take several years to complete, and we cannot give any assurances that, if we undertake an additional trial, private payers will provide, expand or maintain coverage for VNS Therapy in depression once such additional clinical trial work is completed.
Payment rates vary among third-party plans based on contracts and payment methods of specific providers. Audits of providers have revealed that the average reimbursement rates for VNS Therapy-related procedures are generally acceptable to the providers.
In deciding to cover a new product or therapy, private payers base their initial coverage decisions on several factors, including, but not limited to:
Payment for VNS Therapy Outside the US
Payment by customers for VNS Therapy Systems outside the U.S. varies on a country-by-country basis and depends on the method of product distribution chosen by the company for that country. In almost all countries, governments are involved in setting the final price to be paid, which is generally lower than the price paid to the company in the U.S. market. In fiscal year 2008, our international net sales accounted for 22% of total net sales, and the three largest individual country markets were France, Great Britain and Germany. In those countries, we sell directly to hospitals, and the amount received may vary in each market within that country. Total sales are also affected by national and local health budgets.
Increasing prices for the VNS Therapy System, or setting a higher price for new models, such as the DemiPulse and DemiPulse Duo generators, can be a difficult and time-consuming process, in some instances involving submissions to government agencies.
Although the VNS Therapy System has been approved for commercial distribution in European Union countries and Canada for the treatment of chronic or recurrent depression, we do not anticipate significant sales volumes until reimbursement approvals are achieved in these countries for this indication. We are continuing to pursue appropriate reimbursement approvals for these countries.
We believe that in the fields of refractory epilepsy and depression, existing and future drug therapies are and will continue to be the primary competition for the VNS Therapy System. We may also face competition from other medical device companies for the treatment of partial seizures and depression. Medtronic, Inc., for example, continues to conduct clinical studies involving an implantable signal generator used with an invasive deep brain probe for the treatment of neurological disorders including epilepsy and depression, and has received FDA approval for the device for the treatment of essential tremor and Parkinson’s Disease. St. Jude Medical, Inc. has also announced that it will conduct a trial of a similar device for the treatment of depression. We could also face competition from other large medical device and pharmaceutical companies that have the technology, experience and capital resources to develop alternative devices for the treatment of epilepsy and depression. Many of our competitors have substantially greater financial, manufacturing, marketing and technical resources than we have. In addition, the healthcare industry is characterized by extensive research efforts and rapid technological progress. Our competitors may develop technologies, obtain patents and regulatory approval for products that are more effective in treating epilepsy or depression than our current or future products. In addition, advancements in surgical techniques could make surgery a more attractive therapy for epilepsy or depression. The development by others of new treatment methods with novel antiepileptic and depression drugs, medical devices or surgical techniques for epilepsy or depression could render the VNS Therapy System noncompetitive or obsolete.
We believe that the primary competitive factors within the epilepsy and depression treatment markets are the efficacy and safety of the treatment relative to alternative therapies, physician and patient acceptance of the product and procedure, availability of third-party reimbursement, quality of life improvements and product reliability. We also believe that the VNS Therapy System compares favorably with competitive products as to these factors.
While no other device therapies have been specifically approved for depression, a well-established array of antidepressant drugs, typically combined with other antidepressants of complementary action or with atypical antipsychotic drugs and/or mood stabilizers, are frequently used for refractory patients. For severe patients or those at acute risk for suicide, ECT is often used. These treatment modalities may pose a competitive threat in the near term, to the extent that they may delay a decision to offer VNS Therapy to depression patients. As other forms of neurostimulation are investigated and developed for epilepsy or depression, these may emerge as competition for VNS patient candidates. Less invasive procedures like rTMS and magnetic seizure therapy (“MST”) may compete for a similar place in the depression treatment market. Finally, ECT is undergoing refinements in technique to increase specificity and reduce the cognitive deficit side effects; if successful, the tolerability and patient acceptance of ECT could improve in the future. These neurostimulation techniques could prove to be more effective, more predictable, or more rapidly acting than VNS Therapy.
We face similar competition with respect to the development and sale of VNS Therapy as a treatment for the other disorders we are evaluating, including, but not limited to fibromyalgia, multiple sclerosis, Alzheimer’s disease, anxiety, obsessive-compulsive disorders and bulimia.
Patents, Licenses and Proprietary Rights
Including the patents referred to in the agreements described above, as of April 25, 2008, we owned or licensed 40 U.S. patents and 78 pending U.S. patent applications, covering various aspects of the VNS Therapy System, potential improvements to the VNS Therapy System and methods of treatment for a variety of disorders through electrical stimulation of the vagus nerve or other cranial nerves. In addition to epilepsy and neuropsychiatric disorders (including depression), other method patents cover the fields of eating disorders (including obesity and bulimia), endocrine disorders, migraine headaches, dementia, motility disorders, sleep disorders, coma, chronic pain, cardiac disorders and hypertension. We have filed counterparts of certain of our key U.S. patent applications in certain international jurisdictions and currently own or license 25 patents issued by the European Patent Office or other international authorities and 97 patent applications pending in the European Patent Office or before other national or international authorities.
We have an exclusive license agreement with Jacob Zabara, Ph.D., a co-founder and consultant to us, pursuant to which we currently maintain exclusive licenses on five U.S. method patents (and such international counterparts that have been or may be issued) covering the VNS Therapy System for vagus nerve and other cranial nerve stimulation for the control of movement disorders (including epilepsy), neuropsychiatric disorders (including depression) and other disorders. We believe that these patents give us an advantage by limiting competition in VNS to treat refractory epilepsy and depression globally. The license agreement will give us coverage until expiration of the licensed patents in July 2011 for movement disorders and May 2011 for neuropsychiatric disorders. Pursuant to the license agreement, we are obligated to pay Dr. Zabara a royalty equal to 3.0% of net sales through July 2011, after which royalties will be reduced to 1.0% for the duration of any remaining patents covering licensed products.
Effective December 13, 2007, we licensed from Southern Illinois University the exclusive rights to three additional U.S. patents pertaining to VNS for the treatment of traumatic brain injury, modulating brain neural plasticity, and improving memory and learning.
We cannot assure you that patents will issue from any of the pending applications or if patents issue, that they will be of sufficient scope or strength to provide meaningful protection for our technology. Notwithstanding the scope of the patent protection available to us, a competitor could develop treatment methods or devices that are not covered by our patents.
We believe that the patents we own and license provide us with protection in the U.S. in the field of cranial nerve stimulation, including VNS for the control of epilepsy, neuropsychiatric disorders (including clinical depression), eating disorders (including obesity and bulimia), anxiety disorders, dementia (including Alzheimer’s Disease), traumatic brain injury and additional indications for which method patents have been issued. The protection provided by our international patents is not as strong as that provided by our U.S. patents due to differences in patent laws. In particular, European and other countries prohibit patents covering methods for treatment of the human body by surgery or therapy.
There has been substantial litigation regarding patent and other intellectual property rights in the medical device industry. In the future, we may need to engage in litigation to enforce patents issued or licensed to us, to protect our trade secrets or know-how, to defend us against claims of infringement of the rights of others or to determine the scope and validity of the proprietary rights of others. Litigation could be costly and could divert our attention from other functions and responsibilities. Adverse determinations in litigation could subject us to significant liabilities to third parties, could require us to seek licenses from third parties and could prevent us from manufacturing, selling or using the VNS Therapy System, any of which could severely harm our business. We are not currently a party to any patent litigation or other litigation regarding proprietary rights and are not aware of any challenge to our patents or proprietary rights.
Licenses Granted by Us to Other Persons
Effective December 17, 2007, we entered into an Exclusive Patent License Agreement (the “EES License Agreement”) with Ethicon Endo-Surgery, Inc. (“EES”), granting EES an exclusive, worldwide license, with the right to grant non-exclusive sublicenses, for a specified field of use (treatment by means of nerve stimulation for weight reduction or for hypertension or diabetes in patients having a body mass index of 25 or more) under nine U.S. patents and nine U.S. patent applications, and future related patents and international counterparts. Under the terms of the EES License Agreement, EES paid us a non-refundable fee of $9.5 million. EES also agreed to pay us a royalty on future net sales of products covered by any of the subject patents, and EES will reimburse us for future patent-related expenses associated with the filing, prosecution, and maintenance of the licensed patents and patent applications. EES has also been granted a right of first refusal to negotiate any license under any patent rights acquired by us within the specified field of use and offered for licensing.
Product Liability and Insurance
The manufacture and sale of our products subjects us to the risk of product liability claims. We are currently named as a defendant in three product liability lawsuits alleging liability on the basis of negligence and negligent misrepresentation. As the manufacturer of a medical device, we likely will be named in the future as a defendant in other product liability lawsuits. We do not believe that the VNS Therapy Systems involved in existing lawsuits are defective or that VNS Therapy Systems involved in future lawsuits are likely to be defective or otherwise have caused or are likely to cause injury to patients who are or may be involved in these lawsuits; however, the outcome of litigation is inherently unpredictable and could result in an adverse judgment and an award of substantial and material damages against us. We establish a liability reserve on our balance sheet in an amount less than our self-insured retention for all matters that we believe are probable of payment as a result of a judgment or settlement. Although we maintain product liability insurance in amounts that we believe to be reasonable, coverage limits may prove not to be adequate in some circumstances. Product liability insurance is expensive and in the future may be available only at significantly higher premiums or not be available on acceptable terms, if at all. A successful claim brought against us in excess of our insurance coverage could severely harm our business and consolidated results of operations and financial position.
In November 2006, we sent physicians a safety alert letter warning of a software anomaly that can cause the VNS Therapy System’s pulse generator to deliver an output current of eight milliamps during an interrupted programming session. This amount of output current is within the range of currents originally approved by the FDA as safe and effective, but it is higher than is recommended for use. The FDA classified this anomaly as a Class II recall and approved our decision to address this situation by means of the safety alert letter. Although an event can be painful until stimulation is terminated by application of a magnet to the device, we are not aware of any permanent injury to a patient as a consequence of an event; however, additional events could occur and could result in injuries and claims with material adverse consequences to our business.
In August 2007, we published a field notification regarding the potential for dissolution of the lead in the area of a lead fracture if stimulation continues after the fracture. Lead dissolution has been associated with localized pain, inflammation and vocal cord dysfunction in some patients. The field notification advised physicians to program the generator to zero output current if a lead fracture is suspected. The FDA approved our decision to address it by means of a technical bulletin/safety alert letter. A related claim with material adverse consequences to our business could be asserted.
In October 2007, we sent physicians a safety alert letter warning of a software anomaly that can cause the screen on a Model 250 Handheld Programmer to freeze during an interrogation. The anomaly is limited to versions of the Model 250 Programmer using a Dell X5 handheld computer. A screen freeze does not produce a direct adverse health consequence, but could result in an indirect adverse health consequence as a result of delay in programming the generator. The FDA classified this anomaly as a Class III recall and approved our decision to address this situation by means of the safety alert letter. We are not aware of any permanent injuries as a result of this anomaly, but a claim with material adverse consequences to our business could be asserted in the future.
We may in the future identify other product defects, and any such defects may result in legal claims with material adverse consequences to our business.
In February 2008, we sent physicians a safety alert letter warning of a software anomaly that can cause the VNS Therapy DemiPulse and DemiPulse Duo generators to reset (set the output current to zero) during a magnet swipe or in the presence of a strong electric field. The FDA approved our decision to address this situation by means of a safety alert letter. We are not aware of any permanent injuries as a result of this anomaly, but a claim with material adverse consequences to our business could be asserted in the future.
We endeavor to maintain executive and organization liability insurance in a form and with aggregate coverage limits that we believe are adequate for our business purposes, but our coverage limits may prove not to be adequate in some circumstances. In addition, executive and organization liability insurance is expensive and in the future may be available only at significantly higher premiums or not be available on acceptable terms, if at all.
As of May 30, 2008, we had approximately 438 full-time employees. We believe that the success of our business depends, in part, on our ability to attract and retain qualified personnel. We believe our relationship with our employees is generally good, although we have had to undertake significant reductions in personnel over the last two fiscal years. We are also engaged in an ongoing effort to identify, hire, manage and maintain the talent necessary to meet the company’s objectives. However, we cannot assure you that we will be successful in hiring or retaining qualified personnel. The loss of key personnel, or the inability to hire or retain qualified personnel, could significantly harm our business.
Financial Information About Segments and Geographical Areas
We operate our business as a single segment with similar economic characteristics, technology, manufacturing processes, customers, distribution and marketing strategies, regulatory environments and shared infrastructures. We are a neurostimulation business focused on creating new markets, improving our products, developing other indications for VNS Therapy covered by our method patents and expanding our business into other neuromodulation opportunities.
Our financial information, including our net sales and long-lived assets by geographical area, is included in the Consolidated Financial Statements and the related Notes beginning on page F-1.
Website and Availability of Public Filings with the SEC
Our internet address is www.cyberonics.com. We make available free of charge on or through our website our proxy statements, Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”) and reports relating to beneficial ownership of our securities filed or furnished pursuant to Section 16 of the Exchange Act, as soon as reasonably practicable after electronically filing such material with the SEC. Our website also contains the charters for each standing committee of our Board of Directors, our Business Practice Standards, our Code of Ethics, our Corporate Governance Guidelines and our Financial Code of Ethics.
Materials we file with the SEC may be read and copied at the SEC’s Public Reference Room at 100 F Street, NE, Washington, D.C. 20549. Information on the operation of the Public Reference Room may be obtained by calling the SEC at 1-800-SEC-0330. The SEC also maintains a website at www.sec.gov that contains reports, proxy and information statements, and other information regarding our company filed electronically with the SEC.
We may from time to time provide important disclosures to investors by posting them in the investor relations section of our website, as allowed by SEC rules. Information on our website is not incorporated into this Form 10-K.
Item 1A. Risk Factors
Our common stock price constantly changes.
Our common stock is traded on the NASDAQ Global Market under the ticker symbol “CYBX.” The price of stock on that trading market fluctuates, and we expect that the market price of our common stock will continue to fluctuate. For example, during the fiscal year ended April 25, 2008, our stock traded from a high of $22.38 to a low of $9.59 per share. Our stock price may be affected by a number of factors, some of which are beyond our control, including, without limitation:
In addition, the stock market in recent years has experienced broad price and volume fluctuations that have often been unrelated to the operating performance of companies. These broad market fluctuations have also adversely affected, and may continue to adversely affect, the market price of our common stock.
We were not profitable in fiscal year 2008, and we have been profitable for only eight fiscal quarterssince our inception in 1987.>
Through April 25, 2008, we incurred an accumulated deficit of approximately $269.2 million. We continue to incur substantial expenses, including:
Although our financial results improved on a quarterly basis through fiscal year 2008, we can provide no assurance that our net sales will grow or that our expenses will decline sufficiently to enable us to become consistently profitable or to remain profitable in the future.
Our quarterly operating results may fluctuate in the future, which may cause our stock price to decline.>
Our quarterly net sales, expenses and operating results may vary significantly from quarter to quarter for several reasons, including, without limitation:
As a result of any of these factors, our consolidated results of operations may fluctuate significantly and may be below security analyst expectations, which may in turn cause our stock price to decline.
We may fail to comply with one or more of the many regulations that govern our business activities.>
We are subject to extensive and rigorous ongoing regulation of the research, development, testing, manufacture, labeling, promotion, advertising, distribution and marketing of VNS Therapy System. Our failure to comply with regulations or to identify and resolve manufacturing or safety problems prior to commercial marketing could lead to the need for product marketing restrictions, product withdrawal or recall or other voluntary or regulatory action, any of which could delay further marketing until VNS Therapy System is brought into compliance. Our failure to comply with these requirements could have a significant negative impact on our future operating results and may also subject us to stringent penalties and lawsuits.
Our indebtedness and debt service obligations may adversely affect our cash flow, cash position and stock price.>
As of April 25, 2008, we had $125.0 million in convertible debt with aggregate annual debt service obligations, excluding full repayment of principal, of approximately $3.8 million. If we issue other securities in the future, our debt service obligations and interest expense will increase further. We intend to fulfill our debt service obligations from earnings and our existing cash and investments. In the future, if we are unable to generate cash or raise additional cash through financing sufficient to meet these obligations, we may have to delay or curtail our research, development and commercialization programs. Our indebtedness could have significant additional negative consequences, including, without limitation:
Upon the occurrence of a fundamental change, holders of our Senior Subordinated Convertible Notes may force us to purchase their Convertible Notes at the full amount owed, including accrued but unpaid interest.>
If we undergo a fundamental change as defined in the documentation governing our $125.0 million of 3% Senior Subordinated Convertible Notes that may become due in 2011 (“Convertible Notes”), including, but not limited to, the acquisition by any person of the beneficial ownership of 50% of our common stock, our consolidation or merger with or into any other person, our liquidation, or our common stock being removed from listing on the NASDAQ Global Market, the holders of the Convertible Notes may, at their option, require us to purchase their Convertible Notes for the full amount owed including accrued but unpaid interest. This amount may be greater than the value of the Convertible Notes at the time of repurchase. As a result, the possibility of a repurchase requirement may inhibit the consummation of certain transactions such as consolidations or mergers that may be beneficial to our stockholders.
Upon the occurrence of certain events, the initial conversion rate of our Convertible Notes will be adjusted, which could result in an increased number of shares being issued upon conversion.>
The initial conversion rate of our Convertible Notes will be adjusted upon the occurrence of certain events, including, among others, the issuance to our stockholders of certain rights to purchase our common stock at less than the current market price of our common stock or the issuance of cash dividends to substantially all of our stockholders. If the conversion rate is adjusted, holders of our Convertible Notes will receive a greater number of shares of our common stock per Convertible Note, resulting in increased percentage ownership of our common stock by the noteholders and increased dilution of the interests held by current holders of our common stock.
We may not be able to access sufficient additional capital sources or to access capital on terms which are acceptable to us.>
Our capital requirements will depend on many factors, including market acceptance of our product and clinical and strategic development opportunities. A large portion of our expenses is currently fixed, including expenses related to our facilities, equipment and personnel, and we may need to spend significant amounts to conduct our post-marketing clinical studies or for product improvement and development. If we are unable to generate sufficient profits to fund our capital requirements internally, then we will be forced to turn to outside sources of capital. We may be unable to access sufficient sources of capital or to access capital on terms that are acceptable to us. Additionally, recent unfavorable disclosures by international financial institutions concerning the sub-prime mortgage market may lead to a contraction in credit availability, thereby further impacting our ability to fund our capital requirements. If additional capital sources are unavailable, we may be forced to abandon our efforts with respect to clinical studies or product improvement and development.
We may not be able to transfer our depression business to a separate entity or to secure the resources necessary to implement our clinical plan for the development of the depression indication.
We have announced our intention to search for a financial partner with whom we can operate the depression indication as a separate business. We have also engaged an investment bank to assist us in identifying a financial partner to provide the funding necessary to execute the clinical plan in support of the use of VNS Therapy for the treatment of depression. We expect to transfer rights to VNS Therapy for depression into a separate entity and retain a minority interest in such entity. We are currently entering into preliminary discussions with persons who may be interested in developing VNS Therapy for depression. However, we may be unable to secure a financial partner for the implementation of the clinical plan or transfer the depression business to a separate entity on favorable commercial terms. If we are unable to successfully complete our plan, we may be unable to conduct any additional clinical trials and the future profitability of our depression business, if any, may be severely harmed.
We may not be successful in implementing our open market share repurchase program.
We have announced our intention to conduct an open market share repurchase program for the repurchase of up to one million shares of our outstanding common stock. The number of shares actually repurchased and the timing of any repurchases will depend on factors such as the stock price, economic and market conditions, and corporate and regulatory requirements. The program may be also suspended or discontinued at any time. We may be unable to complete the program as planned. There can be no assurance that any repurchases will have a positive impact on our stock price. Failure to complete the program may negatively impact investor confidence in us and negatively impact our stock price.
We may not be successful in our efforts to directly or indirectly develop VNS Therapy for the treatment of other indications and, as such, we may not experience revenue growth from these other indications.>
We have conducted or supported animal studies or small human pilot studies for the treatment of a number of therapeutic indications beyond refractory epilepsy and depression. Regulatory approval for any new indications would require us to conduct one or more larger scale pivotal trials. We have not conducted such pivotal trials for any indication beyond refractory epilepsy and depression, nor do we have any immediate plans to do so. In the event that we do invest in future studies for new indications, we cannot assure you that our study results will be positive. If we elect not to conduct research with regard to new indications, our study results are not positive, we do not receive additional regulatory approvals, or alternative indications do not prove to be commercially viable, our revenue growth, if any, would be limited to revenue from our existing approved indications in refractory epilepsy and depression.
We may not be able to maintain or expand market acceptance of the use of the VNS Therapy System to treat epilepsy or depression, which could cause our sales to be lower than expectations.>
Regulatory approval for the VNS Therapy System is limited to two indications: refractory epilepsy and depression. Market acceptance of the VNS Therapy System for these indications depends on our ability to convince the medical community and third-party payers of the clinical efficacy and safety of vagus nerve stimulation and the VNS Therapy System. On May 4, 2007, CMS issued a national non-coverage determination with respect to VNS Therapy for depression. Prior to the non-coverage determination, some patients were able to obtain coverage on a case-by-case basis through their local Medicare contractor or fiscal intermediary. Since the national non-coverage determination is binding on all local Medicare contractors, patients will no longer be able to obtain Medicare coverage on a case-by-case basis. In addition, CMS’s non-coverage determination has had a detrimental effect on coverage decisions by other payers, including Medicaid and private payers.
While the VNS Therapy System has been implanted in more than 52,000 patients, many physicians are still unfamiliar with this form of therapy. We believe that existing pharmacological therapies, surgery (for refractory epilepsy) and ECT (for depression) are the only other approved and currently available therapies competitive with the VNS Therapy System. These therapies may be more attractive to patients or their physicians than the VNS Therapy System in terms of efficacy, cost or reimbursement availability. Furthermore, we have not funded significant post-market clinical research that could change physicians’ opinions or use of our product for refractory epilepsy. We cannot assure you that we will receive broad reimbursement coverage for depression or that our sales will increase for epilepsy or depression. Additionally, we cannot assure you that the VNS Therapy System will achieve expanded market acceptance for the treatment of epilepsy, depression or for any other indication. Failure of the VNS Therapy System to gain additional market acceptance could severely harm our business, our consolidated financial position and results of operations.
We may not be successful in finding a partner to develop VNS Therapy for treatment of depression, or the terms of such partnership may not provide substantial returns to us.
We are currently entering into preliminary discussions with persons who may be interested in developing VNS Therapy for depression. We expect to transfer rights to VNS Therapy for depression into a separate entity and retain a minority interest in such entity. We may not be able to find a partner willing to develop VNS Therapy, and the terms of any agreement with that partner and/or the interest we retain in the separate entity may not provide us with a significant return.
We may not be successful in our marketing and sales effort in VNS Therapy for depression, which could severely harm our business.
We launched VNS Therapy for depression in August 2005 following an expansion of our sales and case management organization to support anticipated sales demand in the depression market. Although patient demand in depression has been strong, our depression sales have decreased markedly since fiscal year 2006. At the present time, we do not expect sales of the VNS Therapy System for depression to result in any consistent revenue growth until the product receives broader regional or national coverage by insurers and other third-party payers. In addition, the absence of broad regional or national insurance coverage has had a negative effect on psychiatrists’ prescribing habits, resulting in decreasing sales of VNS Therapy Systems for depression.
Patient confidentiality and federal and state privacy and security laws and regulations may adversely impact our selling model.>
The Health Insurance Portability and Accountability Act of 1996 (“HIPAA”) establishes federal rules protecting the privacy and security of personal health information. The privacy and security rules address the use and disclosure of individual health care information and the rights of patients to understand and control how such information is used and disclosed. HIPAA provides both criminal and civil fines and penalties for covered entities that fail to comply with HIPAA. We intend to comply with applicable privacy and security standards. However, if we fail to comply with the applicable regulations, we could suffer civil penalties up to $25,000 per calendar year for each violation and criminal penalties with fines up to $250,000 and potential imprisonment. In addition to HIPAA, virtually every state has enacted one or more laws to safeguard privacy, and these laws vary significantly from state to state and change frequently. Even if our business model is compliant with the HIPAA Privacy and Security Rule and the Texas privacy laws, it may not be compliant with the privacy laws of all states. Because the operation of our business involves the collection and use of substantial amounts of “protected health information,” we endeavor to conduct our business as a “covered entity” under the HIPAA Privacy and Security Rule and consistent with the Texas privacy laws, obtaining HIPAA-compliant patient authorizations where required to support the collection and use of patient information. We also sometimes act as a “business associate” for a covered entity. Despite extensive efforts to conduct our business as a covered entity under the HIPAA Privacy and Security Rules, the Office for Civil Rights of the Department of Health and Human Services or another government enforcement agency may determine that our business model or operations are not in compliance with the HIPAA Privacy and Security Rules, which could subject us to penalties, could severely limit our ability to market and sell VNS Therapy under our existing business model and could harm our business growth and consolidated financial position.
We may be unable to obtain and maintain adequate third-party reimbursement on our product, which could have a significant negative impact on our future operating results.>
Our ability to commercialize the VNS Therapy System successfully depends, in large part, on whether third-party payers, including private healthcare insurers, managed care plans, Medicare and Medicaid programs and others, agree to cover the VNS Therapy System and associated procedures and services and to reimburse at adequate levels for the costs of the VNS Therapy System and the related services in the U.S. or internationally. While we currently have reimbursement approval for epilepsy, we have not yet received substantial reimbursement coverage approval for the treatment of depression. In May 2007, CMS issued a national non-coverage determination with respect to VNS Therapy for depression. This non-coverage determination means that Medicare will not cover VNS Therapy for depression. Prior to the non-coverage determination, some patients were able to obtain coverage on a case-by-case basis through their local Medicare contractor or Fiscal Intermediary. Since the national non-coverage determination is binding on all local Medicare contractors, patients are no longer able to obtain Medicare coverage on a case-by-case basis. In addition, the CMS non-coverage determination also has had a detrimental effect on potential and existing coverage by Medicaid and private payers. In addition, periodic changes to reimbursement methodology for medical devices under the Medicare and Medicaid programs occur and may reduce the rate of increase in federal expenditures for health care costs. Such changes, as well as any future regulatory changes and the failure of the VNS Therapy System to continue to qualify for reimbursement under these programs, may have an adverse impact on our business.
Healthcare, as one of the largest industries in the U.S., continues to attract substantial legislative interest and public attention. Congress and state legislatures are constantly reassessing the propriety of coverage for various health services and the payment level for such services. Certain reform proposals and other policy shifts, if enacted, could limit coverage for VNS Therapy or the reimbursement available for VNS Therapy from governmental agencies or third-party payers. Changes in Medicare, Medicaid and other programs, cost-containment initiatives by public and private payers, a failure to obtain substantial regional and national coverage policies for VNS Therapy in depression, and proposals to limit payments and health care spending could have a significant negative impact on our future operating results.
Our current and future expense estimates are based, in large part, on estimates of our future sales, which are difficult to predict.>
We may be unable to adjust spending quickly enough to offset any unexpected sales shortfall. If increased expenses are not accompanied by increased sales, our consolidated results of operations and financial position for any particular fiscal quarter could be harmed.
If our suppliers and manufacturers are unable to meet our demand for materials, components and contract services, we may be forced to qualify new vendors or change our product design, which would impair our ability to deliver products to our customers on a timely basis.>
We rely upon sole source suppliers for certain of the key components, materials and contract services used in manufacturing the VNS Therapy System. We periodically experience discontinuation or unavailability of components, materials and contract services, which may require us to qualify alternative sources or, if no such alternative sources are identified, change our product design. We believe that pursuing and qualifying alternative sources and/or redesigning specific components of the VNS Therapy System, if or when necessary, could consume significant resources. In addition, such changes generally require regulatory submissions and approvals. Any extended delays in securing or an inability to secure alternative sources for these or other components, materials and contract services could result in product supply and manufacturing interruptions, which could significantly harm our business.
We may not be able to meet regulatory quality standards applicable to our manufacturing process.
We are required to register with the FDA as a device manufacturer and as a result, we are subject to periodic inspection by the FDA for compliance with the FDA’s QSR requirements, which require manufacturers of medical devices to adhere to certain regulations, including testing, quality control and documentation procedures. In addition, the federal Medical Device Reporting regulations require us to provide information to the FDA whenever there is evidence that reasonably suggests that a device may have caused or contributed to a death or serious injury, or may contain an anomaly which, if a malfunction were to occur, could cause or contribute to a death or serious injury. Compliance with applicable regulatory requirements is subject to continual review and is rigorously monitored through periodic inspections by the FDA. In the European Community, we are required to maintain certain ISO certifications in order to sell products, and we undergo periodic inspections by notified bodies to obtain and maintain these certifications. If we fail to adhere to QSR or ISO requirements, this could delay production of our products and lead to fines, difficulties in obtaining regulatory clearances, recalls or other consequences, which could in turn have a material adverse effect on our financial condition and results of operations.
Our products may have defects that result in product recalls, which may result in substantial costs and reduced sales.>
The VNS Therapy System includes an electronic pulse generator and lead designed to be implanted in the human body and a programming wand connected to a handheld computer for programming the pulse generator. Component failures, manufacturing or shipping problems or hardware or software design defects could result in the product not delivering the therapy for which it is indicated or the product delivering a therapy that is not intended. The occurrence of such problems or other adverse clinical reactions could result in a recall of our VNS Therapy System, possibly requiring explantation and potential reimplantation of the VNS Therapy System, which may increase risk to the patient. Any product recall could result in a substantial loss of physician and patient confidence in our products, with a consequential substantial decrease in sales, and could result in substantial product liability litigation, with liabilities well in excess of our product liability insurance coverage limits, any or all of which could severely harm our business and our consolidated financial position and results of operations.
We may not be able to protect our technology from unauthorized use, which could diminish the value of our products and impair our ability to compete.>
Our success depends upon our ability to obtain and maintain patent and other intellectual property protection for the VNS Therapy System and its improvements. To that end, we have acquired licenses under certain patents and have patented and intend to continue to seek patents on our own inventions used in our VNS Therapy System and treatment methods. The process of seeking patent protection can be expensive and time consuming, and we cannot assure you that patents will be issued from our currently pending or future applications or that, if patents are issued, they will be of sufficient scope or strength to provide meaningful protection of our technology or any commercial advantage to us. Further, the protection offered by the licensed international patents is not as strong as that offered by the licensed U.S. patents due to differences in patent laws. In particular, the European Patent Convention prohibits patents covering methods for treatment of the human body by surgery or therapy. Without effective patent protection, whether in the U.S. or abroad, we may be subject to competition that negatively affects our business and our consolidated financial position and results of operations.
We may engage in litigation to protect our proprietary rights, or defend against infringement claims by third parties, causing us to suffer significant liabilities or expenses or preventing us from selling our products.>
There has been substantial litigation regarding patent and other intellectual property rights in the medical device industry. Litigation, which could result in substantial cost to and diversion of effort by us, may be necessary to enforce patents issued or licensed to us, to protect trade secrets or know-how owned by us or to defend ourselves against claimed infringement of the rights of others and to determine the scope and validity of the proprietary rights of others. Adverse determinations in litigation could subject us to significant liabilities to third parties, could require us to seek licenses from third parties and could prevent us from manufacturing, selling or using the VNS Therapy System, any of which could severely harm our business.
Intense competition and rapid technological changes could reduce our ability to successfully market our products and achieve sales.>
We believe that existing and future pharmaceutical therapies will continue to be the primary competition for the VNS Therapy System. However, we may also face competition from other medical device companies that have the technology, experience and capital resources to develop alternative devices for the treatment of epilepsy and depression. Many of our competitors have substantially greater financial, manufacturing, marketing and technical resources than we do and have obtained third-party reimbursement approvals for their therapies. We may not have invested in the past, or may not be investing in the future, sufficient resources in engineering research and development to prepare the VNS Therapy System for competition in the future with other neurostimulation technologies. In addition, the healthcare industry is characterized by extensive research efforts and rapid technological progress. Our competitors may develop technologies and obtain regulatory approval for products that are more effective in treating epilepsy and depression than our current or future products. In addition, advancements in surgical techniques may make surgery a more attractive therapy for epilepsy and depression. The development by others of new treatment methods with novel drugs, medical devices or surgical techniques for epilepsy and depression could render the VNS Therapy System non-competitive or obsolete. We may not be able to compete successfully against current and future competitors, including new products and technology, which could severely harm our business and our consolidated financial position and results of operations.
We are subject to claims of product liability, and we may not have the resources or insurance to cover the cost for losses under these claims.>
The manufacture and sale of the VNS Therapy System entails the risk of product liability claims, which arise from time to time in the ordinary course of business. We may be responsible for large self-insured retentions for each claim, and our product liability coverage limit may not be adequate to pay defense costs and judgments that may result from these claims. Product liability insurance is expensive and in the future may only be available at significantly higher premiums or may not be available on acceptable terms, if at all. A successful claim brought against us in excess of our insurance coverage could significantly harm our business and consolidated financial position.
If we do not continue to comply with the applicable laws and regulations, we could lose our ability to market and sell our product or be subject to substantial fines or other penalties.>
The preclinical and clinical design, testing, manufacturing, labeling, sale, distribution, servicing and promotion of the VNS Therapy System are subject to extensive and rigorous laws and regulations, including regulations from the Department of Health and Human Services (related to Medicare, Medicaid, HIPAA and FDA), comparable state agencies and foreign agencies. In the future, it will be necessary for us to obtain additional government approvals for other indications of the VNS Therapy System, if we choose to develop new indications, and for modified or future-generation products. It is also necessary for us to ensure that our marketing and sales practices comply with all applicable laws and regulations. Commercial distribution in foreign countries is also subject to regulatory approvals from the appropriate authorities in such countries.
The process of obtaining FDA and other required regulatory approvals is lengthy, expensive and uncertain. Moreover, regulatory approvals may include regulatory restrictions on the indicated uses for which a product may be marketed. Failure to comply with applicable regulatory requirements can result in, among other things, fines, suspension or withdrawal of approvals, confiscations or recalls of products, operating restrictions and criminal prosecution. Adverse results in post-approval studies may result in limitations on or withdrawal of previously granted approvals. Furthermore, changes in existing regulations or adoption of new regulations could prevent us from obtaining, or affect the timing of, future regulatory approvals. We may not be able to obtain additional future regulatory approvals on a timely basis or at all. Delays in receipt of or failure to receive such future approvals, suspension or withdrawal of previously received approvals or recalls of the VNS Therapy System could severely harm our ability to market and sell our current and future products and improvements. As a condition of approval for the depression indication, the FDA has required us to conduct a post-approval 460-patient dosing study and a 1,000-patient registry of which 500 will be treated with VNS Therapy. The results of these studies may be included in product labeling. If we fail to conduct or complete these studies in a timely manner, we may be subject to regulatory action, including withdrawal of our depression indication approval. Also, any adverse regulatory action, depending on its breadth, may be detrimental to our business.
We are subject to governmental laws addressing our sales and marketing practices, and failure to adhere to these laws could result in substantial fines and other penalties.>
We are subject to certain laws and regulations, including the federal Anti-Kickback Statute, the federal False Claims Act and the HIPAA Privacy Rule, that govern the sales and marketing practices of healthcare companies. The Anti-Kickback Statute contains both civil and criminal sanctions, which are enforced by the Office of the Inspector General of Health and Human Services Department (“OIG”) and the U.S. Department of Justice (“DOJ”). Over the past several years, the U.S. government has accused an increasing number of pharmaceutical and medical device manufacturers of violating the federal Anti-Kickback Statute based on certain marketing and sales practices and compensation arrangements with referral sources. Pharmaceutical and medical device manufacturers also have been accused of alleged violations of the federal False Claims Act, which imposes civil liability (including substantial monetary penalties and damages) on any person or corporation that (a) knowingly presents a false or fraudulent claim for payment to the U.S. government, (b) knowingly uses a false record or statement to obtain payment or (c) engages in a conspiracy to defraud the federal government to obtain allowance for a false claim. Under the whistleblower provisions of the federal False Claims Act, private parties may bring actions on behalf of the U.S. government. These private parties are entitled to share in any amounts recovered by the government through trial or settlement. Both direct enforcement activity by the government and whistleblower lawsuits have increased significantly in recent years and have increased the risk that we may be forced to defend a prosecution under the federal Anti-Kickback Statute, to defend against a false claims action, be liable for monetary fines or be excluded from the Medicare and Medicaid programs as a result of an investigation resulting from an enforcement action or a whistleblower case.
In January 2006, we adopted revisions to our Business Practice Standards that we believe more thoroughly address our compliance risks with respect to healthcare laws. We endeavor to conduct our business in compliance with our Business Practice Standards and to ensure continued compliance through regular education of our employees, audits of employee activities, and appropriate responses to violations of the Business Practice Standards. Although we believe that these efforts have been successful and that we are in substantial compliance with our policies and the healthcare laws, given the complexity of our business model, including extensive interactions with patients and healthcare professionals, and the large number of field personnel employed by us, violations of our policy and the law could occur. We could be subject to investigation by the OIG or the DOJ or a comparable state agency. If investigated, we could be forced to incur substantial expense responding to the investigation and defending our actions. If unsuccessful in our defense, we could be found to be in violation of the healthcare laws and be subject to substantial fines and penalties, including exclusion of the VNS Therapy System from Medicare and Medicaid reimbursement.
Our international operations are subject to risks not generally associated with commercialization efforts in the U.S.>
We may not be successful in increasing our international sales or in obtaining reimbursement or any regulatory approvals required in foreign countries. The anticipated international nature of our business is also expected to subject us and our representatives, agents and distributors to laws and regulations of the foreign jurisdictions in which we operate or where the VNS Therapy System is sold. The regulation of medical devices in a number of such jurisdictions, particularly in the European Union, continues to develop and new laws or regulations may impair our ability to market and sell our products in those jurisdictions.
Our failure to attract and retain qualified personnel and any changes in our key personnel including officers, could adversely affect our operations.>
In connection with the commercialization of and the lack of consistent reimbursement for the VNS Therapy System in the U.S. for depression, we made significant changes to our organization, including an initial scale up in personnel from February 2005 through July 2005 of approximately 50% and subsequent reductions in personnel of 11% in fiscal year 2006, 15% in fiscal year 2007 and a further 15% in fiscal year 2008. These activities have placed, and may continue to place a significant strain on our resources and operations. Our ability to grow in the future will depend upon our ability to attract, hire and retain highly qualified employees and management personnel. We compete for such personnel with other companies, academic institutions, government entities and other organizations and we may not be successful in hiring or retaining qualified personnel.
Since November 2006, we have experienced significant turnover in our management. These changes in key management positions may strain our existing resources, creating a risk of loss of other key employees. As a result, our business could be adversely affected.
We are involved in an investigation conducted by the staff of the Senate Finance that may result in adverse publicity, expenditure of substantial resources and diversion of management attention, all with an adverse effect on our business.>
We received a letter in November 2006 and a second letter in March 2007 from Senator Charles Grassley on behalf of the United States Senate Committee on Finance (“SFC”) requesting our cooperation in providing certain documents and information relating to (a) our employees, agents and consultants regarding their meetings and communications with the CMS regarding coverage of the VNS Therapy System for depression and (b) our agents’ and consultants’ participation in presentations, preparation of publications and advice to government agencies on VNS Therapy for depression. A discussion of the SFC investigation is contained in “Note 14. Litigation — Senate Finance Committee Investigation.” We are unable to provide assurance at this time as to any further action that may be taken by the SFC or its staff in regard to this matter. Any further action taken by the SFC or its staff could have a material adverse effect on our business, including but not limited to increased expense to comply with requests and diversion of management attention from the conduct of our business.
We are the subject of governmental investigations related to our stock option granting practices and procedures and other matters, the outcome of which could adversely affect our business.>
In June 2006, the SEC staff advised us that it had commenced an informal inquiry of our stock option grants and related practices, procedures and accounting. In June 2006, we also received a subpoena from the U.S. Attorney requesting documents related to the same matters. In October 2006, the SEC staff made an additional request for certain documents and information related to our revised guidance on February 8, 2006 and our financial results announced on May 1, 2006, our sales for the quarter ended April 28, 2006, coverage or potential coverage of our VNS Therapy System by Alabama BlueCross BlueShield and Aetna and the aging of our accounts receivable since January 1, 2003.
In November 2007, we also received an Internal Revenue Service (“IRS”) request for a remote examination and associated information document requests seeking information related to our stock option practices. In February 2008, the IRS made an additional information document request also related to our stock option practices.
We are cooperating with these governmental investigations. A more detailed discussion of these matters is contained in “Note 14. Litigation — Governmental Investigations of Options Granting Practices.” Although it is not possible at this early stage to predict the likely outcome of these inquiries, an adverse result could have a material adverse effect on us, our consolidated financial position, results of operations and cash flows. Even if the result of such inquiries is not adverse, the cost of defending against such inquiries has been and will continue to be expensive and could have a material adverse effect on our consolidated financial position.
We have an obligation to advance legal fees for our current and former officers and directors in certain situations, and that obligation could be costly to us.
We and certain former officers are the subject of an informal inquiry by the SEC. For details on the inquiry, see "Note 14. Litigation -- Governmental Investigations of Options Granting Practices." Pursuant to our bylaws, we have an obligation to advance reasonable legal fees and expenses incurred by our former officers in connection with their defense of the inquiry. The amount of legal fees and expenses we are required to advance could be substantial and could have a material adverse effect on our consolidated financial position.
Item 1B. Unresolved Staff Comments
Currently, there are no outstanding, unresolved written comments by the SEC regarding any of our periodic or current reports filed under the Exchange Act. We have, however, previously disclosed that we are subject to an inquiry by the SEC relating to our accounting for stock option grants. We are cooperating with the SEC in such inquiry.
Item 2. Properties
In December 2007, we re-negotiated the lease on 114,000 square feet of office and manufacturing space at 100 Cyberonics Blvd in Houston, Texas, extending the term for 86 months, commencing on November 1, 2007 and ending on December 31, 2014, and agreeing to surrender the use of 19,376 square feet of the premises. In January 2008, we completed the abandonment of the portion of the leased space that we had agreed to surrender. In March 2008 we agreed to surrender an additional 294 square feet. We have also agreed to lease approximately 8,800 square feet of warehouse and office facilities at 11275 West Sam Houston Parkway South in Houston, Texas.
As part of our international operations, we have also agreed to lease approximately 17,000 square feet in sales offices in Europe through April 2010. All leased properties include the appropriate space to accommodate expected growth in our respective domestic and international businesses.
Item 3. Legal Proceedings
For a description of our material pending legal and regulatory proceedings and settlements, see “Note 14. Litigation.”
Item 4. Submission of Matters to a Vote of Security Holders
Our common stock is quoted on the NASDAQ Global Market under the symbol “CYBX.” The high and low sale prices for our common stock during fiscal years 2007 and 2008 are set forth below. Price data reflect actual transactions, but do not reflect mark-ups, mark-downs or commissions.
As of June 19, 2008, according to data provided by our transfer agent, there were 377 stockholders of record.
During fiscal year 2007 and 2008, we did not pay any cash dividends to our stockholders. We currently intend to retain future earnings to fund the development and growth of our business and, therefore, do not anticipate paying cash dividends within the foreseeable future. Any future payment of dividends will be determined by our Board of Directors and will depend on our consolidated financial position and results of operations and other factors deemed relevant by our Board of Directors.
For a discussion of the securities authorized under our equity compensation plans, see “Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters,” which incorporates by reference the information to be disclosed in our definitive proxy statement for our 2008 Annual Meeting of Stockholders.
In February 2008, we announced the rescission of the open market share repurchase program previously announced in May 2006 and the authorization of a new open market share repurchase program for the repurchase of up to 1.0 million shares of our outstanding common stock. The actual number of shares actually repurchased and the timing of any repurchases will depend on factors such as the stock price, economic and market conditions, and corporate and regulatory requirements. The program may be also suspended or discontinued at any time. This program has resulted in our aggregate repurchasing of approximately 479,000 shares of common stock for approximately $6.3 million through April 25, 2008.
The table below presents purchase of equity securities by the issuer and affiliated purchasers:
Item 6. Selected Financial Data
The following table summarizes certain selected financial data and is qualified by reference to, and should be read in conjunction with the Consolidated Financial Statements and related Notes and with “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in this Form 10-K. The selected financial data and the related Notes for the 52 weeks ended April 25, 2008, April 27, 2007 and April 28, 2006 are derived from consolidated financial statements that are included in this Form 10-K. The selected financial data for the 52 weeks ended April 29, 2005 and the 53 weeks ended April 30, 2004 are derived from audited financial statements that are not included in this Form 10-K.
As discussed in “Note 9. Stock Incentive and Purchase Plans” in the Notes to the Financial Statements, we adopted Statement of Financial Accounting Standards Board (“SFAS”) 123 (revised 2004) ”Share-Based Payment” (“SFAS 123(R)”) effective April 29, 2006. As a result, we recognized compensation expenses during fiscal years 2008 and 2007 in the amount of $11.6 million and $19.4 million, respectively. See “Note 9. Stock Incentive and Purchase Plans” in the Notes to the Consolidated Financial Statements for additional information.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations>
You should read the following discussion and analysis together with Part I of this Form 10-K, including the matters set forth in “Item 1A. Risk Factors” and our Consolidated Financial Statements and the related Notes included elsewhere in this Form 10-K.
This item provides material historical and prospective disclosures enabling investors and other users to assess our consolidated financial position and results of operations. The Consolidated Financial Statements, excluding the related Notes, include the consolidated balance sheets, consolidated statements of operations, consolidated statements of stockholders’ equity (deficit) and comprehensive income (loss) and consolidated statements of cash flows. The Notes are an integral part of the Consolidated Financial Statements and provide additional information required to fully understand the nature of amounts included in the Consolidated Financial Statements.
We are a neuromodulation company founded to design, develop and bring to market medical devices that provide a unique therapy, VNS Therapy, for the treatment of epilepsy, depression and other disorders as approved by the applicable regulatory bodies.
Our ability to expand successfully the commercialization of the VNS Therapy System depends on obtaining and maintaining favorable coverage, coding and reimbursement for the implant procedure and follow-up care. Currently, we have broad coverage, coding and reimbursement for VNS Therapy for the treatment of epilepsy. Absent favorable national and regional coverage policies, we have been obtaining certain case-by-case approvals for depression since FDA approval in July 2005, although case-by-case coverage is very limited at present. We believe that long-term growth in depression is dependent on identifying and entering into an agreement with a third party for the development of VNS Therapy for depression and obtaining favorable national and regional coverage policies in depression.
Our clinical development program has included pilot and pivotal studies in using VNS Therapy (a) as an adjunctive therapy for reducing the frequency of seizures in patients over 12 years of age with partial onset seizures that are refractory to antiepileptic drugs and (b) as an adjunctive treatment of patients 18 years of age and older with chronic or recurrent depression in a major depressive episode. We have also conducted or provided support for small pilot studies for the treatment of Alzheimer’s Disease, anxiety, chronic migraine headache, bulimia and other disorders. These studies have been conducted to determine the safety and effectiveness of VNS Therapy for the treatment of these disorders and, in the case of pilot studies, to determine which new indications might be considered for pivotal studies and, therefore, these studies are an important component of our clinical research activities.
Since inception, we have incurred substantial expenses, primarily for research and development activities that include product and process development and clinical trials and related regulatory activities, sales and marketing activities, manufacturing start-up costs and systems infrastructure. We have also made significant investments in recent periods in connection with sales and marketing activities in the U.S. and clinical research costs associated with VNS Therapy. As of April 25, 2008, we incurred an accumulated deficit of approximately $269.2 million. We anticipate increasing investments in post-approval clinical studies.
The primary exchange rate movements that impact our consolidated net sales growth include the U.S. dollar as compared to the Euro. The weakening of the U.S. dollar generally has a favorable impact on our sales for the year. The impact of foreign currency fluctuations on net sales is not indicative of the impact on our operations due to the offsetting foreign currency impact on operating costs and expenses.
Proceedings Related to Stock Option Grants and Practices
Regulatory Proceedings. In June 2006, the SEC staff advised us that it had commenced an informal inquiry of our stock option grants and related practices, procedures and accounting. In October 2006, the SEC staff made an additional request for certain documents and information related to our revised guidance on February 8, 2006 and our financial results announced on May 1, 2006, our sales for the quarter ended April 28, 2006, coverage or potential coverage of our VNS Therapy System by Alabama BlueCross BlueShield and Aetna and the aging of our accounts receivable since January 1, 2003. In addition, we received a subpoena from the U.S. Attorney requesting documents related to the same matters. We are cooperating with both of these governmental investigations. For additional information, see “Note 14. Litigation – Governmental Investigation of Options Granting Practices” in the Notes to the Consolidated Financial Statements.
In November 2007, we received an IRS request for a remote limited scope examination and associated information document requests seeking information related to our stock option practices. In February 2008, the IRS made an additional information document request also related to our stock option practices. We are endeavoring to cooperate with the IRS in this examination by providing documents and information in response to its examination requests. The examination is ongoing.
Significant Accounting Policies and Critical Accounting Estimates
We have adopted various accounting policies to prepare the Consolidated Financial Statements in accordance with accounting principles generally accepted in the U.S. (“GAAP”). Our most significant accounting policies are disclosed in “Note 1. Summary of Significant Accounting Policies and Related Data” in the Notes to the Consolidated Financial Statements.
The preparation of the Consolidated Financial Statements, in conformity with GAAP, requires us to make estimates and assumptions that affect the amounts reported in the Consolidated Financial Statements and the related Notes. Our estimates and assumptions are updated as appropriate, which in most cases is at least quarterly. We base our estimates on historical experience or various assumptions that are believed to be reasonable under the circumstances, and the results form the basis for making judgments about the reported values of assets, liabilities, revenues and expenses. Actual results may materially differ from these estimates.
We consider the following accounting policies as the most significant because, in management’s view, they are most important to the portrayal of our consolidated financial position and results of operations and most demanding in terms of requiring estimates and other exercises of judgment.
Accounts Receivable. We provide an allowance for doubtful accounts based upon specific customer risks and general historical trends. An increase in losses beyond that expected by management or what we have historically experienced would reduce earnings when they become known.
Inventories. We state our inventories at the lower of cost, the first-in, first-out (“FIFO”) method, or market. Our calculation of cost includes the acquisition cost of raw materials and components, direct labor and overhead. Management considers potential obsolescence at each balance sheet date. An acceleration of obsolescence could occur if consumer demand differs from expectations.
Property and Equipment. Property and equipment are carried at cost, less accumulated depreciation. Maintenance, repairs and minor replacements are charged to expense as incurred; significant renewals, improvements and expansions are capitalized. For financial reporting purposes, we compute depreciation using the straight-line method over useful lives ranging from two to nine years. An unanticipated change in the utilization or expected useful life of property and equipment could result in acceleration in the timing of the expenses.
Leases. SFAS No. 13“Accounting for Leases” establishes standards of financial accounting and reporting for leases by lessees and lessors. We are a party to the contract of leased facilities and other lease obligations recorded in compliance with SFAS No. 13. The lease terms provide for tenant improvement allowances that are recorded as deferred rent and amortized, using the straight-line method, as reduction to rent expense over the term of the lease. At April 25, 2008 and April 27, 2007, we had approximately $0.0 and $152,000 in deferred rent, respectively. Scheduled rent increases and paid holidays are recognized on a straight-line basis over the term of the lease. During fiscal year 2008 we surrendered a portion of our leased facilities at 100 Cyberonics Boulevard in Houston Texas. The net present value of our future lease obligations related to the space surrendered as of April 25, 2008, is approximately $563,000, partially offset by the net present value of estimated proceeds from the sub-lease of the space surrendered of approximately $480,000. A net expense and accrued liability of approximately $83,000 were recorded as of April 25, 2008.
Revenue Recognition. We recognize revenue when title to the goods and risk of loss transfer to customers, providing there are no remaining performance obligations required of us or any matters requiring customer acceptance. We record estimated sales returns and discounts as a reduction of net sales in the same period revenue is recognized. Our net sales are dependent upon sales to new and existing customers pursuant to our current policies. Changes in these policies or sales terms could impact the amount and timing of revenue recognized.
Licensing Revenue. We evaluate our licensing agreements and recognize licensing revenue considering the guidance provided by Staff Accounting Bulletin (“SAB”) Topic 13, “Revenue Recognition,” EITF 00-21 “Revenue Arrangements with Multiple Deliverables,” Regulation S-X Rule 5-03(b)(1) “Sales and Revenue,” EITF 01-14 “Income Statement Characterization of Reimbursement of Out-of-pocket Expenses” and other regulations as applicable. See “Note 13. Licensing Agreement” for additional information.
Licensing Expense. We have executed license agreements under which we have secured the rights provided under certain patents. Royalties payable under the terms of these agreements are expensed as incurred.
Research and Development. All research and development costs are expensed as incurred. We have entered into contractual obligations for the conduct of clinical studies. Costs are incurred over the duration of the studies and paid under the terms of the contracts. Research and development expenses could vary significantly due to possible changes in the timing of clinical activity.
Stock Options. Prior to April 29, 2006, we adopted the disclosure-only provisions of SFAS No. 123, “Accounting for Stock-Based Compensation” and SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure,” which disclosures are presented in “Note 1. Summary of Significant Accounting Policies and Related Data” in the Notes to the Consolidated Financial Statements. Because of this election, we accounted for our employee stock-based compensation plans under Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees” and the related interpretations.
We adopted SFAS 123(R) on April 29, 2006 using the Black-Scholes option pricing model and the Modified Prospective Method, which require the compensation cost to be recognized under SFAS 123(R) for grants issued after the adoption date and the unvested portion of grants issued prior to the adoption date. As a result of the adoption of SFAS 123(R), we recognized share-based compensation expense of approximately $11.6 million and $19.4 million during fiscal years 2008 and 2007, respectively, including the impact associated with the resignation of certain officers and employees during fiscal year 2007. We anticipate recognizing approximately $9.6 million in non-cash compensation expense during fiscal year 2009. Stock-based compensation cost is affected by assumptions regarding a number of complex and subjective variables.
Restricted Stock, Restricted Stock Units and Other Share-Based Awards. We may grant restricted stock, restricted stock units or stock awards to directors, officers and certain key employees. Nonvested restricted stock grantees are entitled to dividends, if any, and voting rights for their respective shares. Sale or transfer of the shares is restricted until they are vested. Share grants have no purchase cost to the grantee. Typically, grants vest ratably and compensation costs are amortized over the requisite service period of one to five years. We also grant restricted stock subject to performance or market conditions that can vest over derived service periods. The fair value of restricted stock is determined for accounting purposes, on the grant date using the grant date fair market value of our stock. We utilize the Monte Carlo simulation method to establish the fair value, the expected vesting date and the derived service period of the market conditions based grants. The Monte Carlo simulation method is subject to variability, as several factors utilized must be estimated, including stock price volatility.
Foreign Exchange. The primary exchange rate movement that impacts our consolidated net sales growth is the U.S. dollar as compared to the Euro. The weakening of the U.S. dollar generally has a favorable impact on our sales. The impact of foreign currency fluctuations on net sales is not indicative of the impact on our operations due to the offsetting foreign currency impact on operating costs and expenses.
Income Taxes. We account for income taxes under the asset and liability method. Under this method, deferred income taxes reflect the impact of temporary differences between financial accounting and tax bases of assets and liabilities. Such differences relate primarily to the deductibility of certain accruals and reserves and the effect of tax loss and tax credit carryforwards not yet utilized. Deferred tax assets are evaluated for realization based on a more-likely-than-not criteria in determining if a valuation allowance should be provided.
Results of Operations
We sell VNS Therapy Systems to hospitals and ambulatory surgical centers (“ASCs”) for both epilepsy and depression indications, but we often do not know the intended use for a specific VNS Therapy System at the time of its sale. As a result, we use information available from two separate internal databases to estimate our sales by indication for use.
The FDA has designated our VNS Therapy System, which is a Class III implantable medical device, as a “tracked” device under the FDA’s Medical Device Tracking regulation. Consistent with the tracking regulation, we urge each implanting hospital or ASC to complete and return to us an implant card that provides information from which we can identify the corresponding indication for use. We maintain the returned information in an implant card database. Separately, we accumulate information relating to prospective and actual patients, prescribing and implanting physicians, and hospitals and ASCs in a sales-related database.
We do not receive an implant card for each device we sell, and we sometimes sell devices that are not the subject of data included in our sales-related database. In addition, the delay between the date of a sale and the date of receipt of the corresponding implant card may result in an implant card being received in a fiscal quarter subsequent to the fiscal quarter corresponding to the date of the sale. We assume that any delay, however, will affect each fiscal quarter by approximately the same extent. By combining information derived from both the tracking and sales-related databases, we form an estimate of the split between units and net sales for the epilepsy and depression indications. The accuracy of our estimates of sales by indication for use, however, may vary from one fiscal quarter to the next, and investors should exercise caution in relying on these estimates.
U.S. net sales attributable to the depression indication have declined significantly since the CMS’s May 2007 issuance of a national non-coverage determination with respect to VNS Therapy for depression. Using the methodology disclosed above, we estimate that our net domestic sales attributable to depression for fiscal year 2008 were approximately $4.7 million compared to $29.6 million for the same period last year, a decrease of approximately 84%. For fiscal year 2007, U.S. sales attributable to depression were $29.6 million compared to $16.6 million for the fiscal year 2006, an increase of approximately 78%.
In fiscal year 2008 U.S. net product sales decreased by $16.7 million, or 15%, compared to fiscal year 2007 due to the continued reduction in the number of VNS Therapy Systems attributable to the depression indication, following both the preliminary and final non-coverage determinations by CMS in February 2007 and May 2007, respectively. International net sales increased by $6.4 million, or 32%, in fiscal year 2008 compared to fiscal year 2007, due primarily to unit growth and the impact of foreign currency movements.
U.S. net sales increased by $3.2 million, or 3%, in fiscal year 2007 compared to fiscal year 2006 primarily due to higher average selling prices. International net sales increased by $4.3 million, or 28%, in fiscal year 2007 compared to fiscal year 2006, due to a 22% increase in new patient sales and a 9% higher average selling price, which in turn was largely due to favorable currency impact and changes in country mix.
The increase in average system price in the U.S. market over the prior year is primarily attributable to an increase in the average price for generators of 7%, partially offset by an increase in the number of generators assumed to be sold for the purpose of replacing implanted generators having a battery at or near the end of its useful life. A replacement generator may be sold without a lead, and therefore the total system price is lower than if a lead was included in the sale. In the most recent year in the U.S. market, the number of generators sold without leads increased from 1,167 to 2,135.
Effective December 17, 2007, we entered into the EES License Agreement, which grants EES an exclusive license to certain patents and patent applications pertaining to weight reduction, hypertension or diabetes. Under the terms of the EES License Agreement, EES paid an up-front, non-refundable payment of $9.5 million in December 2007. In addition, the EES License Agreement requires EES to pay a royalty on future commercial sales of any product covered by the licensed patents. The EES License Agreement also requires us to retain the responsibility to prosecute the licensed patent applications and maintain the licensed patents subject to reimbursement by EES. We are recognizing the $9.5 million payment on a straight-line basis from the date of execution of the EES License Agreement to April 2014, which represents the estimated time frame to fulfill our obligation to prosecute the licensed patent applications. During fiscal year 2008, we recognized revenue in the amount of approximately $0.5 million applicable to the EES License Agreement, and recorded a related cost of $47,500 in cost of goods sold applicable to the transfer of certain patent rights under the EES License Agreement. There was no licensing revenue recognized during fiscal years 2007 or 2006.
Gross profit on products sold decreased by $13.1 million, or 12% in fiscal year 2008, compared to fiscal year 2007 primarily due to lower volume of overall sales in the U.S. and a higher volume of sales in international markets. While the average selling prices were higher in both the U.S. and international markets, the consolidated average selling price was lower due to the mix between domestic and international sales. Gross profit margin decreased by 350 basis points to 82.6% compared to fiscal year 2007 due to (a) lower production volumes affecting operational efficiencies, which had an adverse impact of 237 basis points, (b) stock-based compensation expense of $1.2 million, which had an adverse impact of 48 basis points and (c) higher average selling prices in generators offset by lower volume of complete systems, which had an unfavorable impact of 65 basis points.
Gross profit on products sold increased by $5.1 million, or 5% in fiscal year 2007, compared to fiscal year 2006 primarily due to higher average selling prices and increased sales volumes. Gross profit margin decreased by 112 basis points to 86.1% compared to fiscal year 2006 due to (a) lower production volumes affecting operational efficiencies, which had an adverse impact of 233 basis points, (b) stock-based compensation expense of $0.8 million, which had an adverse impact of 60 basis points, and offset by (c) higher average selling prices, which had a favorable impact of 181 basis points.
Cost of products sold consists primarily of direct labor, allocated manufacturing overhead, third-party contractor costs, royalties and the acquisition cost of raw materials and components. Gross profit margins can be expected to fluctuate in future periods based upon the mix between U.S. and international sales, direct and distributor sales, the VNS Therapy System selling price, applicable royalty rates and the levels of production volume.
Gross profit in licensing revenue for fiscal year 2008 was approximately $0.5 million, or 91.1% of licensing revenue. The cost of licensing revenue represents royalties paid applicable to the assignment of certain patents. We had no licensing revenue or related costs during fiscal year 2007 or 2006.
Selling, General and Administrative (“SG&A”) Expenses. SG&A expenses are comprised of sales, marketing, development, general and administrative activities. SG&A expenses for the fiscal year 2008 decreased by $48.2 million, or 35.9%, as compared to fiscal year 2007. The decrease is primarily due to cost-saving strategies implemented throughout fiscal year 2008, including an ongoing reduction in selling and marketing expenses of $25.6 million primarily associated with the depression indication. Further, fiscal year 2007 expenses included expenses of $5.4 million primarily associated with the resignations of our Chief Executive Officer (“CEO”) and our Chief Financial Officer (“CFO”), proxy costs of approximately $1.6 million associated with a director election contest, and significant legal and other expenses primarily due to costs associated with the investigation into our stock options granting and accounting practices. Legal expenses decreased by $10.0 million in fiscal 2008, including the receipt of approximately $1.5 million in insurance recoveries. Stock-based compensation charges of $8.7 million were lower by $6.7 million than in fiscal year 2007. SG&A expenses for fiscal year 2007 decreased by $3.2 million, or 2.3%, as compared to fiscal year 2006. The decrease was primarily due to a decrease of $37.9 million in sales, marketing, and related expenses that had been associated with the depression launch during fiscal year 2006, partially offset by higher finance and administration expenses of $5.4 million primarily associated with the resignations of our CEO and our CFO, proxy cost of approximately $1.6 million associated with a director election contest, an increase of $10.9 million in legal and other expenses primarily due to costs associated with the investigation into our stock options granting and accounting practices, and an increase in non-cash stock-based compensation charges of $17.7 million applicable to our adoption of SFAS 123(R).
Research and Development (“R&D”) Expenses. R&D expenses are comprised of expenses related to our product and process development, product design efforts, clinical trials programs and regulatory activities. R&D expenses decreased by $5.7 million, or 20.2%, as compared to fiscal year 2007. This decrease was primarily due to the implementation of cost-saving strategies throughout the year and a reduction of $1.6 million in stock-based compensation charges. R&D expenses decreased by $1.4 million in fiscal year 2007, or 4.9%, as compared to fiscal year 2006. The decrease in fiscal year 2007 was primarily due to a reduction in engineering and regulatory expenses of $4.9 million, partially offset by an increase of $2.4 million in international clinical expenses and $2.5 million in higher non-cash stock-based charges.
Interest income of $3.8 million during fiscal year 2008 decreased by 17.3% as compared to interest income of $4.6 million for fiscal year 2007, due to decreased interest rates, partially offset by higher cash balances. Interest income of $4.6 million during fiscal year 2007 increased by 45% as compared to interest income of $3.2 million for fiscal year 2006, due to increased interest rates.
Interest expense of $5.8 million for fiscal year 2008 decreased by $0.1 million, or 1.6%, compared to $5.9 million during fiscal year 2007. The change is primarily due to interest and other savings from the voluntary termination of our Credit Agreement in January 2008, and reduced liquidated damages on the Convertible Notes, offset by $0.4 million in termination fees and write off of origination fees of approximately $0.2 million also associated with the termination of the Credit Agreement. Interest expense of $5.9 million for fiscal year 2007 increased 96% from $3.0 million in fiscal year 2006 primarily due to higher loan balances and interest and fees applicable to the Convertible Notes, including $0.4 million of liquidated damages.
Other Income (Expense), Net
Other expense, net of $0.4 million for fiscal year 2008 represented an increase of $86,000, or 27.7%, as compared to fiscal year 2007. The increase is primarily due to the impact of foreign currency exchange rates and an approximately $0.1 million loss in disposal of assets associated with the re-negotiation of the leased facilities at our corporate headquarters. Other expense, net of $0.3 million for fiscal year 2007, represented a decrease of $0.4 million, or 548% as compared to other income of $0.1 million for the same period during the previous fiscal year. These expenses, primarily include income related to the transaction gains and losses associated with the impact of changes in foreign currency exchange rates offset by derivative expense associated with the extension of certain stock option grants to former employees whose grants would have expired unexercised due to our inability to issue stock under our stock option plans as a consequence of our delinquent SEC reports during our fiscal year 2007.
At April 25, 2008, we had net operating loss carryforwards for federal income tax purposes of approximately $254.5 million. The following is a reconciliation of statutory federal income tax rates to our effective income tax rate expressed as a percentage of loss before income taxes:
Liquidity and Capital Resources
We generated a net loss of $10.3 million for the year ended April 25, 2008 compared to a net loss of $51.2 million for the year ended April 27, 2007 and a net loss of $59.1 million for the year ended April 28, 2006. During fiscal year 2008, we generated $14.5 million in cash from operating activities, which includes $9.5 million in proceeds from the EES License Agreement. This revenue is being recognized on a straight-line basis during the estimated time of approximately six and one half years to fulfill our obligations under the EES License Agreement, and the balance of $9.0 million remains in deferred revenue as of April 25, 2008. Cash used in operations was $20.7 million for the year ended April 27, 2007, as compared to $70.9 million used in operations for the year ended April 28, 2006.
On January 13, 2006, we established the $40.0 million revolving line of credit (“Credit Agreement”) with Merrill Lynch Capital, a division of Merrill Lynch Business Financial Services Inc. (“Administrative Agent”) and the lenders who were party to the Credit Agreement (“Lenders”). During fiscal year 2008, we voluntarily terminated the Credit Agreement, requiring us to pay off an outstanding balance of $10.0 million and pay a termination fee of $0.4 million. The termination of the Credit Agreement also required us to recognize $0.2 million in expenses relating to unamortized origination costs. We incurred $5.0 million in additional indebtedness in fiscal year 2007 through additional borrowings under the Credit Agreement.
In February 2008, we announced a plan to purchase 1.0 million shares of our outstanding common stock under the open market share repurchase program. Through April 25, 2008 we have purchased approximately 479,000 shares pursuant to this plan at an average cost of $12.92, resulting in a total investment of approximately $6.3 million. The completion of this program is subject to certain conditions which may or may not be met.
We believe our current financial and capital resources will be adequate to fund anticipated business activities through fiscal year 2009, although there can be no assurance of this, as this estimate is based upon a number of assumptions, that may not hold true. Our liquidity could be adversely affected by the factors affecting future operating results that are discussed in “Item 1A. Risk Factors.”
Net cash provided by (used in) operating, investing and financing activities were as follows:
Net cash provided by operating activities during fiscal year 2008 was approximately $14.5 million compared to $20.7 million used in operating activities during fiscal year 2007. The increase in cash provided by operating activities is primarily due to a lower net loss that includes $11.3 million of non-cash charges as well as $9.5 million in proceeds from the EES License Agreement. Net cash provided by operating activities improved by approximately $35.1 million during fiscal year 2008, primarily due to a decrease of approximately $40.8 million in net loss and $9.3 million in favorable changes in assets and liabilities, partially offset by an $8.2 million decrease in non-cash expenses. Net cash used in operating activities during fiscal year 2007 was approximately $20.7 million, as compared to net cash used in operating activities of approximately $70.9 million in fiscal year 2006. Net cash provided by operating activities improved by approximately $50.2 million during fiscal year 2007, primarily due to a decrease of approximately $7.9 million in net loss and favorable changes in non-cash expenses of approximately $19.9 million and in operating assets and liabilities of approximately $22.4 million.
Net cash used by investing activities during fiscal year 2008 was approximately $0.8 million compared to net cash used in investing activities in fiscal year 2007 of approximately $1.4 million. Net cash used in investing activities during fiscal year 2008 was invested in the purchase of property and equipment. Net cash used by investing activities during fiscal year 2007 was approximately $1.4 million compared to cash provided by investing activities in fiscal year 2006 of approximately $17.5 million. Cash used during fiscal year 2007 was invested in the purchase of property and equipment. Net proceeds during fiscal year 2006 of approximately $22.8 million from the sale of short-term marketable securities were offset by purchases of property and equipment of approximately $4.3 million and the investment of approximately $1.0 million in restricted cash.
Net cash used in financing activities during fiscal year 2008 was approximately $7.4 million, compared to proceeds of $14.4 million during fiscal year 2007. Net cash provided by financing activities during fiscal year 2007 was approximately $14.4 million compared to net proceeds of approximately $107.0 million in fiscal year 2006. The net cash used in financing activities during fiscal year 2008 includes $7.5 million in payment of all amounts due on termination of the Credit Agreement, $0.1 million in payment of financing obligations, $6.3 million in acquisition of treasury stock, partially offset by $6.4 million in proceeds from stock option exercises. The net proceeds during fiscal year 2007 include approximately $5.0 million in borrowings under the Credit Agreement and approximately $9.7 million in proceeds from issuance of common stock, partially offset by approximately $0.3 million in payments on financing obligations.
Debt Instruments and Related Covenants
Line of Credit
Effective January 14, 2008, we voluntarily terminated the Credit Agreement in accordance with its terms. Early termination of the Credit Agreement triggered an obligation on our part to pay a Deferred Commitment Fee (as defined in the Credit Agreement) in the amount of $0.4 million in addition to obligations to repay the $7.5 million outstanding at the beginning of fiscal year 2008, plus additional borrowings during the fiscal year, for a total of $10.0 million outstanding loan balance and accrued interest as of the effective date of termination. We satisfied these obligations on January 14, 2008. We also wrote off unamortized origination fees of approximately $0.2 million.
In September 2005, we issued the Convertible Notes. Interest on the Convertible Notes at the rate of 3% per year on the principal amount is payable semi-annually in arrears in cash on March 27 and September 27 of each year, beginning March 27, 2006. The Convertible Notes are unsecured and subordinated to all of our existing and future senior debt and equal in right of payment with our existing and future senior subordinated debt. Holders may convert their Convertible Notes, which were issued in the form of $1,000 bonds, into 24.0964 shares of our common stock per bond, which equal a conversion price of approximately $41.50 per share, subject to adjustments, at any time prior to maturity.
In April 2008, we settled litigation in connection with the Convertible Notes and, as a result, we may be forced to repurchase the Convertible Notes at par if tendered to us on December 27, 2011 nine months prior to the original maturity. For additional information, see “Note 14. Litigation – Indenture Default Litigation” in the Notes to the Consolidated Financial Statements. As a result of the settlement and the associated documents, we are able to reflect the Convertible Notes as a long-term liability as of April 25, 2008.
We are party to a number of contracts pursuant to which we are paying for clinical studies for current operating obligations payable totaling $2.0 million as of April 25, 2008. Although we have no firm commitments, we expect to make capital expenditures of approximately $3.0 million during fiscal year 2009, primarily to maintain organizational capacity, business infrastructure and facilities.
The chart below reflects our obligations under our material contractual obligations as of April 25, 2008.
Factors Affecting Future Operating Results and Common Stock Price
The factors affecting our future operating results and common stock prices are disclosed in “Item 1A. Risk Factors.”
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
We are exposed to limited market risk on interest rates and foreign currency exchange rates.
Our exposure to market risk for changes in interest rates relates primarily to our short-term investments. We do not hedge our interest rate exposure or invest in derivative securities. Based upon the average outstanding balances in cash, cash equivalents and our line of credit, a 100-basis point change in interest rates would not have a material impact on our consolidated financial results.
Due to the global reach of our business, we are also exposed to market risk from changes in foreign currency exchange rates, particularly with respect to the U.S. dollar over the Euro. Our wholly owned foreign subsidiary is consolidated into our financial results and is subject to risks typical of an international business including, but not limited to, differing economic conditions, changes in political climate, differing tax structures, other regulations and restrictions and foreign exchange rate volatility. Accordingly, our future results could be materially impacted by changes in these or other factors. At this time, we have not deemed it to be cost effective to engage in a program of hedging the effect of foreign currency fluctuations on our operating results using derivative financial instruments. A sensitivity analysis indicates that, if the U.S. dollar uniformly weakened 10% against the Euro, the effect upon the net loss recorded during fiscal year 2008 would be favorable by approximately $0.3 million, or 2.7%. Conversely, if the U.S. dollar uniformly strengthened 10% against the Euro, the impact on our operations would be unfavorable by approximately $0.2 million, or 2.2%.
Our Convertible Notes are sensitive to fluctuations in the price of our common stock into which the debt is convertible. Changes in equity prices may result in changes in the fair value of the convertible subordinated debt due to the difference between the current market price of the debt and the market price at the date of issuance of the debt. At April 25, 2008, a 10% decrease in the price of our common stock could have resulted in a decrease of approximately $2.2 million on the net fair value of our Convertible Notes, while a 10% increase in the price of our common stock could have resulted in an increase of approximately $1.3 million on the fair value of our Convertible Notes.
In conjunction with the Convertible Notes, we purchased call options to buy approximately 3,000,000 shares of our common stock at an exercise price of $41.50 per share (the “Note Hedge”). On May 5, 2008 we received from Merrill Lynch International (“MLI”) a notice pursuant to which MLI asserted that the Note Hedge was terminated effective May 6, 2008 in accordance with its terms. MLI asserted that our execution of the supplemental indenture agreement dated April 18, 2008 (the “Supplemental Indenture”) in connection with the settlement of the litigation related to the Convertible Notes constituted an “Amendment Event” (as such term is defined in the Note Hedge confirmation) that resulted in the occurrence of an “Additional Termination Event” (as such term is defined in the Note Hedge confirmation) and gave rise to a right to termination. We are reviewing MLI’s assertion that the Note Hedge has been terminated and the consequences of that action. For a detailed description of the lawsuit, refer to “Note 14. Litigation – Indenture Default Litigation.”
Item 8. Financial Statements and Supplementary Data
The information required by this Item is incorporated by reference to the Consolidated Financial Statements beginning on page F-1.
Item 9A. Controls and Procedures
Disclosure Controls and Procedures
(a) Evaluation of Disclosure Controls and Procedures
We maintain a system of disclosure controls and procedures that are designed to ensure that information required to be disclosed in our reports filed under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Such information is also accumulated and communicated to management, including our CEO and CFO, as appropriate, to allow timely decisions regarding required disclosure. Our management, under the supervision and with the participation of our CEO and CFO, evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this Form 10-K. Based on that evaluation, our CEO and CFO concluded that our disclosure controls and procedures were effective as of April 25, 2008.
(b) Management’s Report on Internal Control Over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In connection with the preparation of our annual consolidated financial statements, our management, under the supervision and with the participation of our CEO and CFO, assessed the effectiveness of our internal control over financial reporting based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). Based on this assessment, our management has concluded that our internal control over financial reporting was effective as of April 25, 2008.
KPMG LLP, the independent registered public accounting firm who audited the consolidated financial statements included in this Form 10-K, has issued a report on our internal control over financial reporting as of April 25, 2008.
(c) Changes in Internal Control Over Financial Reporting
There was no change in our internal control over the current financial reporting period that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders
We have audited Cyberonics, Inc.’s internal control over financial reporting as of April 25, 2008, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Cyberonics, Inc.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control Over Financial Reporting (Item 9A(b)). Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, Cyberonics, Inc. maintained, in all material respects, effective internal control over financial reporting as of April 25, 2008, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Cyberonics, Inc. and subsidiary as of April 25, 2008 and April 27, 2007, and the related consolidated statements of operations, stockholders’ equity (deficit) and comprehensive income (loss), and cash flows for the 52 weeks ended April 25, 2008, April 27, 2007, and April 28, 2006, and our report dated June 24, 2008 expressed an unqualified opinion on those consolidated financial statements.
/s/ KPMG LLP
June 24, 2008
Item 9B. Other Information
Item 10. Directors, Executive Officers and Corporate Governance
Pursuant to general instruction G to Form 10-K, we incorporate by reference into this item the information to be disclosed in our definitive proxy statement for our 2008 Annual Meeting of Stockholders.
Financial Code of Ethics
Our Board has adopted a Financial Code of Ethics, which represents the code of ethics applicable to our principal executive officer, principal financial officer, principal accounting officer or controller and other senior financial officers (“senior financial officers”). A copy of the Financial Code of Ethics is available on our website, http://www.cyberonics.com, and a copy will be mailed without charge, upon written request, to our investor relations department. We intend to disclose any amendments to or waivers of the Financial Code of Ethics on behalf of our senior financial officers on our website, at http://www.cyberonics.com> promptly following the date of the amendment or waiver.
Item 11. Executive Compensation
Pursuant to general instruction G to Form 10-K, we incorporate by reference into this Item the information to be disclosed in our definitive proxy statement for our 2008 Annual Meeting of Stockholders.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters>
Pursuant to general instruction G to Form 10-K, we incorporate by reference into this Item the information to be disclosed in our definitive proxy statement for our 2008 Annual Meeting of Stockholders.
Item 13. Certain Relationships and Related Transactions, and Director Independence>
Pursuant to general instruction G to Form 10-K, we incorporate by reference into this Item the information to be disclosed in our definitive proxy statement for our 2008 Annual Meeting of Stockholders.
Item 14. Principal Accounting Fees and Services
Item 15. Exhibits, Financial Statement Schedules
(1) Financial Statements.
The Consolidated Financial Statements of Cyberonics, Inc. and its subsidiary, and the Report of Independent Registered Public Accounting Firm are included in this Form 10-K beginning on page F-1:
(2) Financial Statement Schedules
All schedules required by Regulation S-X have been omitted as not applicable or not required, or the information required has been included in the Notes to the financial statements.
(3) Index to Exhibits
The exhibits marked with the asterisk symbol (*) are filed or furnished (in the case of Exhibit 32.1) with this Form 10-K. The exhibits marked with the cross symbol (†) are management contracts or compensatory plans or arrangements filed pursuant to Item 601(b)(10)(iii) of Regulation S-K. The exhibits marked with the pound symbol (#) have been redacted and are the subject of an application for confidential treatment filed with the SEC pursuant to Rule 24b-2 of the general rules and regulations promulgated under the Exchange Act.
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Date: June 24, 2008
POWER OF ATTORNEY
KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Daniel J. Moore and Gregory H. Browne, jointly and severally, his attorneys-in-fact, each with the power of substitution, for him in any and all capacities, to sign any amendments to this Annual Report on Form 10-K, and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said attorneys-in-fact, or his substitute or substitutes, any do or cause to be done by virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated: