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The following is an excerpt from a 10-Q SEC Filing, filed by CYTYC CORP on 5/6/2004.
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CYTYC CORP - 10-Q - 20040506 - MANAGEMENT_ANALYSIS

Item 2.   Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

The following discussion should be read in conjunction with our consolidated financial statements and the related notes appearing in our annual report on Form 10-K for the year ended December 31, 2003. Our discussion contains forward-looking statements based upon current expectations that involve risks and uncertainties, such as our plans, objectives, expectations and intentions. Actual results and events could differ materially from those anticipated in these forward-looking statements as a result of a number of factors, including those set forth elsewhere in this Form 10-Q.

 

Overview

 

Cytyc Corporation is a leading medical device company that designs, develops, manufactures, and markets innovative and clinically effective products primarily focused on women’s health.  Our products cover a range of women’s health applications including cervical cancer screening, breast cancer risk assessment and treatment of excessive menstrual bleeding.

 

The ThinPrep® System is the most widely used method for cervical cancer screening in the United States. The ThinPrep System consists of the ThinPrep 2000 Processor, ThinPrep 3000 Processor, ThinPrep Imaging System, and related reagents, filters, and other supplies.  In addition to the automated preparation of cervical cell specimens on microscope slides for use in cervical cancer screening, our ThinPrep System also allows for the automated preparation of other cell specimens on microscope slides for use in general, non-gynecological testing applications. The ThinPrep System provides the platform from which we have launched our expansion into breast cancer risk assessment with the FirstCyte® Breast Test.

 

Our surgical products division manufactures and markets the NovaSure® Impedance Controlled Endometrial Ablation System, or the NovaSure System, an innovative endometrial ablation device to treat menorrhagia, or excessive menstrual bleeding.  The NovaSure System allows physicians to treat women with excessive menstrual bleeding in a minimally invasive manner to eliminate or reduce their bleeding to normal levels. This division was created following our acquisition of Novacept, a California corporation, in March 2004. We estimate that over 45,000 NovaSure disposable devices have been sold since market introduction in early 2002, primarily to hospitals and outpatient surgery centers in the United States.

 

Critical Accounting Estimates

 

Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. A “critical accounting estimate” is one which is both important to the portrayal of our financial condition and results and requires management’s most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. We continuously evaluate our critical accounting estimates. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

 

Valuation of Long-Lived Assets, Intangibles and Goodwill. Intangible assets acquired in a business combination, including acquired in-process research and development, are recorded under the purchase method of accounting at their estimated fair values at the date of acquisition. The fair values of acquired intangible assets are determined by independent appraisers using information and assumptions provided by management. Fair value is generally calculated as the present value of estimated future cash flows using a risk-adjusted discount rate, which requires significant management judgment with respect to revenue and expense growth rates, and the selection and use of an appropriate discount rate. We assess the impairment of identifiable intangibles, long-lived assets and goodwill whenever events or changes in circumstances indicate that the carrying value may not be recoverable and at least annually in the case of goodwill. If it is determined that the carrying value of intangible, long-lived assets and goodwill might not be recoverable based upon the existence of one or more indicators of impairment, we would measure any impairment based on a projected discounted cash flow method. No such impairment charges have been recorded to date. We are required to perform an impairment review annually, or earlier if indicators of potential impairment exist. Based on our impairment review during 2003, the carrying amount of goodwill did not exceed its fair value and, accordingly, no impairment loss exists. At March 31, 2004, we had $393.7 million of intangible

 

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assets, of which $294.2 million represented goodwill. An impairment to our intangible assets could result in a material, non-cash expense in our condensed consolidated statement of income.

 

Income Taxes and Deferred Taxes . We file income tax returns in ten countries as well as many states and other localities. We must estimate our income tax expense after considering, among other factors, differing tax rates between jurisdictions, allocation factors, tax credits, nondeductible items and changes in enacted tax rates. Deferred taxes arise because of the different treatment between financial statement accounting and tax accounting, known as “temporary differences.” We record the tax effect of these temporary differences as “deferred tax assets” and “deferred tax liabilities” on our consolidated balance sheet. Deferred tax assets generally result in tax deductions or credits subsequent to the period in which the related item was recorded in the consolidated statement of income. Deferred tax liabilities typically reflect a current tax deduction for which the related item has not yet been recorded in the consolidated statement of income. The carrying value of our deferred tax assets assumes that we will be able to generate sufficient future taxable income in certain tax jurisdictions, based on estimates and assumptions, to fully recover the net carrying value of the assets. If these estimates and related assumptions change in the future, we may be required to record a valuation allowance against our deferred tax assets resulting in additional income tax expense in our consolidated statement of income. As a result of the acquisition of Novacept, we recorded approximately $31.4 million of deferred tax assets related to acquired net operating losses (“NOL’s”).  If we are unable to realize the benefits of these NOL’s in future years, we may be required to record additional tax expense in our condensed consolidated statement of income.

 

Legal Proceedings . We are involved in various legal actions, the outcomes of which are not within our complete control and may not be known for prolonged periods of time. In some actions, the claimants seek damages, as well as other relief, which, if granted, would require significant expenditures. We record a liability in our consolidated financial statements for these actions when a loss is known or considered probable and the amount can be reasonably estimated. We review these estimates each accounting period as additional information is known and adjust the loss provision when appropriate. If the loss is not probable or cannot be reasonably estimated, a liability is not recorded in the consolidated financial statements. Our significant legal proceedings, some of which are a result of our acquisition of Novacept in March 2004, are discussed in Note 15 to these consolidated financial statements and in our annual report on Form 10-K for the year ended December 31, 2003.

 

The above list is not intended to be a comprehensive list of all of our accounting policies. In many cases, the accounting treatment of a particular transaction is specifically dictated by generally accepted accounting principles, with no need for management’s judgment in their application. There are also areas in which management’s judgment in selecting any available alternative would not produce a materially different result. See our audited consolidated financial statements and notes thereto included in our annual report on Form 10-K for the fiscal year ended December 31, 2003, which contain accounting policies and other disclosures required by generally accepted accounting principles in the United States.

 

Results of Operations

 

Three Months Ended March 31, 2004 and 2003

 

Net sales increased to $80.7 million in the first quarter of 2004 from $72.6 million for the same period of 2003, an increase of 11%. In our diagnostic products segment, domestic net sales increased to $69.6 million in the first quarter of 2004 from $65.3 million for the same period of 2003, an increase of 9%, primarily due to increased sales of our ThinPrep Pap Test. Domestic sales of our ThinPrep Pap Test increased 3% in the three months ended March 31, 2004 compared to the same period of 2003, reflecting a 9% increase in unit sales. This increase was partially offset by a decrease in average selling prices primarily reflecting higher pricing in the first quarter of 2003 to our largest customer, Quest Diagnostics, Inc. (“Quest”), prior to the signing of their current multi-year purchase agreement with us. ThinPrep Pap Test sales to Quest and our second largest customer, Laboratory Corporation of America (“LabCorp”), increased by 5% in the first three months of 2004 as compared to the same period of 2003, reflecting a 15% increase in unit sales. ThinPrep Pap Test sales to Quest and LabCorp represented 30% of our consolidated net sales in the first quarter of 2004. Domestic sales of disposables for use with our ThinPrep Imaging System, which was released in June 2003, reached $3.9 million in the first quarter of 2004.

 

International net sales in our diagnostic products segment increased to $9.7 million in the first quarter of 2004 from $7.3 million for the same period in 2003, an increase of 33%, reflecting both increased unit sales and average pricing of the ThinPrep Pap Test internationally, as well as the favorable impact of the weaker U.S. dollar on sales in foreign currencies. International sales grew to 12% of worldwide net sales in the first quarter of 2004, as compared with 10% in the same period of 2003.

 

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Due to the March 24, 2004 closing date of the acquisition of Novacept, only five business days of revenues from our surgical products segment, totaling approximately $1.4 million, were included in our results for the first quarter of 2004.

 

Gross profit increased to $65.5 million in the first quarter of 2004 from $60.3 million for the same period of 2003, an increase of 9%. The gross margin decreased to 81% in the first quarter of 2004 as compared to 83% for the same period of 2003. The decrease resulted primarily from expenses related to the introduction of the ThinPrep Imaging System, as well as an increase in international sales as a percentage of total sales, which generally have lower margins as compared to domestic sales.

 

Total operating expenses increased to $51.0 million in the first quarter of 2004 from $27.9 million for the same period of 2003, an increase of 83%. Operating expenses for the first quarter of 2004 included a one-time charge of $19.1 million to write off acquired in-process research and development costs related to the acquisition of Novacept.

 

Research and development costs in the first quarter of 2004 increased to $4.3 million from $3.0 million for the same period of 2003, an increase of 46%. This increase reflects efforts to continue to improve the ThinPrep Imaging System, clinical trial expenses primarily related to the FirstCyte Breast Test, as well as the costs related to the collaborative research agreements with Harvard Medical School and Northeastern University we entered into during 2003. The purpose of the agreements is to develop further improvements to our testing platforms for cervical, breast and other forms of cancer.

 

Sales and marketing costs increased to $20.2 million in the first quarter 2004 from $18.9 million for the same period of 2003, an increase of 7%, primarily due to marketing costs associated with our international expansion efforts following the recommendation of liquid-based cytology as the primary means to process samples for cervical cancer screening programs in England and Wales by the United Kingdom’s National Institute for Clinical Excellence (“NICE”) in October 2003, as well as increased selling and customer training costs associated with supporting the continued market release of the ThinPrep Imaging System.

 

General and administrative costs increased to $7.4 million in the first quarter of 2004 from $6.1 million for the same period of 2003, an increase of 23%, largely due to legal costs associated with litigation, as well as higher business insurance costs. As a percentage of revenues, general and administrative expenses increased slightly to 9% of revenues for the three months ended March 31, 2004 compared to 8% for the same period of 2003.

 

Interest income remained consistent at $0.7 million in the first quarter of 2004 and 2003, as interest rates remained relatively flat and there was minimal change in our cash balance during the majority of the quarter. Other expense of $0.5 million primarily reflected costs associated with securing alternative financing, in case it was needed, for our acquisition of Novacept.

 

Our effective tax rate for the three months ended March 31, 2004 was 39%, exclusive of the effects of the nondeductible $19.1 million in-process research and development charge incurred in connection with the Novacept acquisition, compared to 40% for the same period of 2003. The decrease is primarily due to savings from tax planning initiatives which began in 2003.

 

Liquidity and Capital Resources

 

At March 31, 2004, we had cash, cash equivalents and investment securities totaling $220.6 million. Cash provided by operations was $21.3 million for the three months ended March 31, 2004, compared to $22.5 million during the same period of 2003. The decrease in cash flows from operations for the three months ended March 31,  2004 as compared to the same period in 2003 primarily reflects an increase in receivables in the first quarter of 2004. Our net accounts receivable increased 35% to $56.6 million at March 31, 2004 as compared to $42.1 million at December 31, 2003, due to $6.6 million of receivables acquired as part of our acquisition of Novacept in March 2004 as well as a greater percentage of sales occurring in the last two months of the quarter ended March 31, 2004 compared to the quarter ended December 31, 2003. Our Days Sales Outstanding increased from 46 days at December 31, 2003 to 53 days at March 31, 2004 due to the increased amount of sales in the latter part of the quarter ended March 31, 2004 compared to the quarter ended December 31, 2003. We have had no significant issues of collectibility. The term “Days Sales Outstanding”, which we calculate by dividing gross trade accounts receivable at the end of the period by our average daily consolidated net sales for the quarter, refers to roughly the number of days’ worth of sales that are outstanding and unpaid at any given time. Our inventories increased 30% to $23.2 million at March 31, 2004, as compared to $17.8 million at December 31, 2003, primarily reflecting $4.0 million of NovaSure inventory acquired as part of the acquisition of Novacept, as well as the purchase of materials to support current demand for the ThinPrep Imaging System.

 

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Our investing activities used cash of $184.6 million in the first quarter of 2004, primarily related to the purchase of Novacept in March 2004. Of the aggregate purchase price of $325.6 million including acquisition-related costs, we paid $238.2 million during the first quarter of 2004, with the remainder reflected as a payable in our condensed consolidated balance sheet as of March 31, 2004.  Primarily all of this balance was paid in April 2004. We used a combination of debt financing and cash on hand to purchase Novacept. During the first quarter of 2004, we invested $6.5 million in ThinPrep Imaging Systems, which we place at customer sites under use-plan agreements and reflect in other assets in our condensed consolidated balance sheet. We made $1.5 million of capital expenditures during the first quarter of 2004, related primarily to the build-out of our manufacturing facility in Londonderry, New Hampshire.

 

Our financing activities in the first quarter of 2004 generated cash of $251.9 million, primarily as a result of the private placement of $250 million of convertible notes (see detailed discussion below). Proceeds from this offering are net of debt issuance costs, most of which were paid during the first quarter of 2004. We also generated cash of $10.8 million as a result of proceeds from the exercise of stock options. We suspended our stock repurchase program in January 2004. During the first quarter of 2004 and 2003, we spent $1.7 million and $15.6 million, respectively, under this program.

 

Long-Term Debt and Contractual Obligations

 

On March 22, 2004, we completed the sale (the “Offering”) of $250 million aggregate principal amount of its 2.25% convertible notes due 2024. The convertible notes were sold to qualified institutional buyers pursuant to exemptions from the registration requirements of the Securities Act of 1933, as amended. We used the proceeds from the Offering along with existing cash to finance the acquisition of Novacept. Total proceeds from the private placement were $242.6 million, net of debt issue costs of $7.4 million.

 

The notes bear interest at a rate of 2.25% per year on the principal amount, payable semi-annually in arrears in cash on March 15 and September 15 of each year, beginning September 15, 2004.  In addition, if the average trading price of a note for the five trading days immediately preceding the first day of the applicable six-month period equals 120% or more of the principal amount of such note, we will also pay contingent interest during any six month period from March 15 to September 14, and from September 15 to March 14, with the initial six month period commencing March 15, 2009. During any interest period when contingent interest shall be payable, the contingent interest payable per note will equal 0.25% of the average trading price of the notes during the five trading days immediately preceding the first day of the applicable six-month interest period.

 

The holders of the notes may convert the notes into shares of our common stock at a conversion rate of 33.7041 shares per $1,000 principal amount of notes, which represents a conversion price of $29.67 per share, subject to adjustment, prior to the close of business on March 15, 2024, subject to prior redemption or repurchase of the notes, under any of the following circumstances: (1) during any calendar quarter commencing after June 30, 2004 if the closing sale price of our common stock exceeds 120% of the conversion price for at least 20 trading days in the 30 consecutive trading days ending on the last trading day of the preceding calendar quarter (if the specified threshold is met, the notes will thereafter be convertible at any time at the option of the holder prior to the close of business on March 15, 2024); (2) during the five business day period after any five consecutive trading day period in which the trading price per $1,000 principal amount of notes for each day of such period was less than 98% of the product of the closing sale price of our common stock and the number of shares issuable upon conversion of $1,000 principal amount of the notes; (3) if the notes have been called for redemption; or (4) upon the occurrence of specified corporate events.

 

Holders may require us to repurchase the notes on March 15 of 2009, 2014 and 2019 at a repurchase price equal to 100% of their principal amount, plus accrued and unpaid interest, including contingent interest and liquidated damages, if any, to, but excluding, the repurchase date. We may redeem any of the notes beginning March 20, 2009, by giving holders at least 30 days’ notice. We may redeem the notes either in whole or in part at a redemption price equal to 100% of their principal amount, plus accrued and unpaid interest, including contingent interest and liquidated damages, if any, to, but excluding, the redemption date.

 

The notes will be our senior unsecured obligations and will rank equally with all of our existing and future senior unsecured debt and prior to all future subordinated debt. The notes will be effectively subordinated to any future secured indebtedness to the extent of the collateral securing such indebtedness, and to all indebtedness and other liabilities (including trade payables) of our subsidiaries.

 

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As of March 31, 2004, we had the following additions to the contractual cash obligations described in our annual report on Form 10-K for the fiscal year ended December 31, 2003 to reflect our long-term debt described above and lease commitments of Novacept (in thousands):

 

 

 

 

 

 

Contractual
Obligations

 

Payments Due by Period

 

Total

 

2004

 

2005

 

2006

 

2007

 

2008

 

Thereafter

 

Long-term debt:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Principal (1)

 

$

250,000

 

$

 

$

 

$

 

$

 

$

 

$

250,000

 

Interest

 

56,250

 

5,625

 

11,250

 

11,250

 

11,250

 

11,250

 

5,625

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Operating leases

 

1,423

 

317

 

439

 

218

 

229

 

220

 

 

 


(1)                                   Long-term debt relates to our $250 million aggregate principal amount of 2.25% convertible senior notes described above. The amounts in the table above include interest and principal payable assuming redemption at the earliest redemption date of March 15, 2009. These amounts assume that conversion of the notes into shares of our common stock does not occur.

 

We expect that our cash and cash equivalents, investment securities and cash flows from operating activities will be sufficient to meet our projected operating cash needs, including capital expenditures, lease and purchase commitments and tax payments.

 

Recent Accounting Pronouncements

 

In January 2003, the Financial Accounting Standards Board issued Interpretation No. 46, Consolidation of Variable Interest Entities—an interpretation of ARB No. 51 (“FIN 46”), which addresses consolidation of variable interest entities. FIN 46 expanded the criteria for consideration in determining whether a variable interest entity should be consolidated by a business entity, and requires existing unconsolidated variable interest entities (which include, but are not limited to, Special Purpose Entities, or SPEs) to be consolidated by their primary beneficiaries if the entities do not effectively disperse risks among parties involved.  This interpretation applies immediately to variable interest entities created after January 31, 2003. The adoption of this portion of FIN 46 has not had any effect on our financial position or results of operations. This interpretation applies in the first fiscal year or interim period beginning after December 15, 2003, to variable interest entities in which an enterprise holds a variable interest that is acquired before February 1, 2003.  We do not have any investments or arrangements which would be considered variable interest, and the adoption of FIN 46 did not have any impact on our financial position or results of operations.

 

Certain Factors Which May Affect Future Results

 

The forward-looking statements in this Form 10-Q are made under the safe harbor provisions of Section 21E of the Securities Exchange Act of 1934, as amended. Our operating results and financial condition have varied and may in the future vary significantly depending on a number of factors. Statements in this Form 10-Q which are not strictly historical statements, including, without limitation, statements regarding management’s expectations for future growth and plans and objectives for future management and operations, domestic and international marketing and sales plans, product plans and performance, research and development plans, regulatory uncertainties, potential savings to the healthcare system, management’s assessment of market factors, costs and uncertainties related to current or future litigation, successful integration of acquired businesses and technologies, as well as statements regarding our strategy and plans, constitute forward-looking statements that involve risks and uncertainties. In some cases these forward-looking statements can be identified by the use of words such as “may,” “will,” “could,” “should,” “would,” “expect,” “project,” “predict,” “potential” or the negative of these words or comparable words.

 

In addition to the risk factors detailed below related to our acquisition of Novacept, the factors listed under “Certain Factors Which May Affect Future Results” in our annual report on Form 10-K for the fiscal year ended December 31, 2003, among others, could cause actual results to differ materially from those contained in forward-looking statements made in this report and presented elsewhere by management from time to time. Such factors, among others, may have a material adverse effect upon our business, financial condition, and results of operations. We undertake no obligation to update publicly or revise any forward-looking statements, whether as a result of new information, future events or otherwise. Accordingly, you are cautioned not to place undue reliance on forward-looking statements, which speak only as of the date on which they are made.

 

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Risks related to our acquisition of Novacept

 

If gynecologists and patients do not adopt the NovaSure System as a preferred treatment for excessive uterine bleeding, the intended benefits of our acquisition of Novacept may not be realized and the market price of our common stock could decline.

 

The only product acquired as a result of our acquisition of Novacept is the NovaSure System, which is an endometrial ablation device to treat menorrhagia, or excessive uterine bleeding. Novacept began full commercial release of the NovaSure System in the United States in January 2002. The NovaSure System is supported by only three years of patient follow-up data from Novacept’s U.S. pivotal clinical trial, and we could discover that the results of this clinical trial are not indicative of results experienced in the market over time. Furthermore, some of the existing data has been produced in studies that involve relatively small patient groups, and such data may not be reproduced in wider patient populations.

 

Because of its recent commercial introduction, the NovaSure System has limited product and brand recognition and has been used by a limited number of gynecologists. We may have difficulty gaining widespread acceptance of the NovaSure System among gynecologists and patients for a number of reasons including:

 

                          the presence of competing products sold by companies with longer operating histories, more recognizable names and more established distribution networks;

 

                          the introduction or existence of competing products or technologies that may be more effective, safer or easier to use than the NovaSure System;

 

                          the results of long-term clinical studies relating to the effectiveness of the NovaSure System;

 

                          the availability of alternative treatments or procedures that provide comparable levels of improvement in uterine bleeding at a lower cost than the NovaSure System;

 

                          gynecologists and patient perceptions of the NovaSure System as compared to other treatments for excessive uterine bleeding; and

 

                          the continued availability of satisfactory reimbursement from healthcare payors for endometrial ablation procedures.

 

We believe that continued recommendation and support for the use of the NovaSure System by influential gynecologists and treatment centers are essential for widespread market acceptance. If the NovaSure System does not continue to receive support from these gynecologists and treatment centers, or if longer-term data do not demonstrate continued support for the clinical efficacy of the NovaSure System, gynecologists may not use, and hospitals and outpatient surgery centers may not purchase, the NovaSure System. If this occurs, the intended benefits of the acquisition, such as increased revenues, may not be realized and the market price of our common stock could decline.

 

Current levels of growth in the market for new endometrial ablation procedures for the treatment of excessive uterine bleeding may not be indicative of future growth.

 

Demand for newly introduced technologies or treatments can initially be exaggerated as supply increases to meet pre-existing demand. However, once the pre-existing demand is met, growth in the market may abruptly stop or significantly slow. We believe that some of the current growth in the market for new endometrial ablation procedures may be the result of a considerable pre-existing unmet demand for products of this nature. We cannot determine what portion of Novacept’s historical sales is attributable to this pre-existing demand, nor can we predict when, or at what rate, this demand may stop or decline in growth. If the demand for treatments like the NovaSure System were to stop abruptly or begin to decline, our operating results and profitability could be adversely affected after the acquisition.

 

We cannot accurately predict the size of the market for endometrial ablation products or our ability to convince women to undergo the NovaSure procedure.

 

We cannot accurately predict the size of the market for endometrial ablation products such as the NovaSure System. The long-term growth for this product will be dependent upon our ability to convince a significant number of gynecologists and women that the NovaSure System is superior to currently available treatments for excessive uterine bleeding as well as treatments that may be developed and commercialized in the future. The most widely used and accepted treatments for excessive uterine bleeding are drug treatment, hysterectomy, dilation and curettage, or D&C, and hysteroscopic rollerball ablation, or rollerball ablation. Over the past several years, the FDA approved several alternative, new endometrial ablation treatments for excessive uterine bleeding, including the NovaSure

 

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System, and the use of these treatments has been increasing. However, most women experiencing excessive uterine bleeding continue to rely primarily on drug therapy for the treatment of this condition or choose not to pursue any form of treatment. Furthermore, since the introduction of these new endometrial ablation treatments, the number of hysterectomies, D&Cs and rollerball ablations has not changed significantly, indicating that traditional treatments for excessive uterine bleeding have not been displaced by these new endometrial ablation treatments.

 

We cannot assure you that the market for endometrial ablation products will develop in the future or that the new endometrial ablation procedures, including the NovaSure procedure, will continue to experience similar or greater rates of use. We cannot assure you that we will be successful in continuing to attract gynecologists and women to use the NovaSure System, or whether or not evolving trends in the treatment of excessive uterine bleeding will favor new endometrial ablation procedures as compared to traditional approaches.

 

We compete against other medical device and drug companies with greater resources and more established products, which may prevent us from achieving significant market penetration with the NovaSure System.

 

We face direct competition from Johnson & Johnson, Boston Scientific Corporation, American Medical Systems, Inc. and Microsulis Medical Limited, each of which markets an FDA-approved endometrial ablation device for the treatment of excessive menstrual bleeding. In addition to these devices, there are alternative treatments to the NovaSure System, such as hormonal drug therapy, hysterectomy, D&C and rollerball ablation.

 

Some of the competitors in this market, including Johnson & Johnson, Boston Scientific Corporation, American Medical Systems, Inc. and the pharmaceutical companies that sell hormonal drugs, are large companies that enjoy significant competitive advantages over us, including:

 

                          significantly greater name recognition;

 

                          established relationships with healthcare professionals, customers and third-party payors;

 

                          established distribution networks;

 

                          additional lines of products, and the ability to offer rebates or bundle products to offer discounts or incentives to gain competitive advantage; and

 

                         greater resources for product development, sales and marketing.

 

The market for products treating excessive uterine bleeding is intensely competitive, subject to rapid change and significantly affected by new product introductions and other market activities of industry participants. Improvements in existing competitive products or the introduction of new competitive products may reduce our ability to compete for sales, particularly if those competitive products demonstrate better safety or effectiveness, clinical results, ease of use or lower cost than the NovaSure System. If we are unable to compete effectively against existing and future competitors and existing and future alternative treatments, our sales could decline and our business could be adversely affected.

 

If we are unable to prevent third parties from using the intellectual property related to the NovaSure System, our ability to market the NovaSure System will be harmed and our operating results could be adversely affected.

 

With our acquisition of Novacept, we have acquired all of Novacept’s intellectual property rights, including those with respect to the NovaSure System. However, the medical device industry in general, and the therapeutic use of devices employing radiofrequency energy, such as the NovaSure System, in particular, have been subject to extensive litigation and administrative proceedings regarding patents and other intellectual property rights. For example, we are currently engaged in a patent re-examination proceeding initiated by Johnson & Johnson in the U.S. Patent and Trademark Office, or USPTO, with respect to a patent relating to the NovaSure System and procedure. We cannot assure you that we will be successful in maintaining the claims of this patent during re-examination, and we expect that at least the broadest claims will be narrowed as a result of this proceeding. If the patent claims are narrowed substantially by the pending USPTO proceeding, the patent coverage afforded to the NovaSure System could be impaired.

 

If we fail to protect, defend and maintain the intellectual property rights with respect to the NovaSure System (in connection with the pending USPTO re-examination proceeding or otherwise) or if we are subject to a successful third party claim of infringement, the competitive position of the NovaSure System could be impaired. In addition, infringement, interference and other intellectual property claims and proceedings, with or without merit, are expensive and time-consuming to litigate and could adversely affect our business, financial condition and operating results.

 

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If there is a failure to meet the demand for the NovaSure disposable device as a result of the completion of the transition to in-house manufacturing in Costa Rica, we may experience a decrease in sales.

 

Historically, the disposable component of the NovaSure System has been manufactured by an independent contractor located in Costa Rica. The manufacturing operation is in the process of being transferred from the independent contractor to our own manufacturing operation in Costa Rica. This new facility could be hampered by unforeseen circumstances, including:

 

                          inability to obtain critical equipment on a timely basis;

 

                          shortages of qualified personnel to operate equipment and manage manufacturing operations;

 

                          shortages of key raw materials or component inputs to the manufacturing process; and

 

                          difficulties associated with moving from smaller-scale production to higher volumes.

 

If any of the above occurs, we could also experience increased per-unit costs because we would need to re-engage the Costa Rican contract manufacturer. Increasing production capacity at the new facility may be difficult for us because of the complex nature of the manufacturing processes for the disposable component of the NovaSure System. As we scale-up operations at the new facility, we could also experience difficulties in producing sufficient number of products or in achieving sufficient quality and manufacturing yield levels. If we are unable to scale up manufacturing at the new Costa Rica facility on schedule or otherwise fail to meet our manufacturing needs, we may not be able to meet the demand or the quality expectations of NovaSure customers, and we could experience a decrease in sales of the NovaSure System.

 

Because a component of the NovaSure System is and will be manufactured in Costa Rica, we will be subject to the political and economic risks of doing business there.

 

We cannot guarantee that the political, labor and economic climate in Costa Rica will remain sufficiently stable for our manufacturing purposes. Our operations relating to the NovaSure System could be adversely affected by political unrest and fluctuations in the value of the local Costa Rican currency. We could also be harmed by strikes and other labor disruptions. Any of these events could result in increased costs or in disruptions of supply of the NovaSure disposable devices, which could harm our business, financial condition and operating results.

 

We are currently defending a number of product liability lawsuits and we may be subject to the risk of additional product liability claims relating to the NovaSure System.

 

The NovaSure System is used on patients in endometrial ablation procedures, which involve a significant risk of serious complications, including bleeding that may require blood transfusions, uterine and bowel perforation and other damage to adjacent tissue and organs, infection and even death. Consequently, companies that produce medical devices for use in the uterus are subject to risk of product liability litigation.

 

Novacept is a party to a number of legal proceedings involving injuries to patients that occurred during a NovaSure procedure. We will vigorously defend against these product liability claims and any others that may arise related to the NovaSure System. However, there can be no assurance that any defense against these alleged claims will be successful.

 

If the NovaSure System is found to have caused or contributed to injuries or deaths, we could be held liable for substantial damages. Product liability insurance is in place for the NovaSure product and the Novacept shareholders have agreed, subject to certain conditions and limitations, to indemnify us for certain pending product liability claims to the extent that the damages are not covered by the existing insurance. However, we cannot assure you that available insurance and the indemnification payment, if any, will be sufficient to cover the damages from these claims. In addition, claims of this nature may adversely affect the reputation of the NovaSure System, which could damage its competitive position in the market. Any product liability claim brought against us, with or without merit, could result in the increase of our product liability insurance rates or the inability to secure additional coverage in the future. Also, even a meritless or unsuccessful product liability claim could be time consuming and expensive to defend, which could result in a diversion of management’s attention from our business and adversely affect our financial condition and operating results.

 

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Our failure to obtain or maintain necessary regulatory clearances or approvals could hurt our ability to commercially distribute and market the NovaSure System.

 

The NovaSure System is a medical device and is subject to extensive regulation in the United States and in foreign countries where we intend to market NovaSure. Unless an exemption applies, a medical device must first receive either 510(k) clearance or premarket approval (“PMA”) from the FDA before it is marketed in the United States. The FDA’s 510(k) clearance process usually takes from three to twelve months but may take significantly longer. The premarket approval process generally takes from one to three years from the time the application is submitted to the FDA, but it can be significantly longer and can be significantly more expensive and uncertain than the 510(k) clearance process. Medical devices may be marketed only for the indications for which they are approved or cleared. Although Novacept has obtained premarket approval for the NovaSure System to treat excessive uterine bleeding in pre-menopausal women who have completed childbearing, the FDA can take action affecting these premarket approvals if serious safety or other problems develop in the marketplace. In the future, we may be required to obtain 510(k) clearances or premarket approvals to market additional products, for modifications to the NovaSure System, or for new indications for the NovaSure System. We cannot be certain that we would be able to obtain 510(k) clearances or additional premarket approvals in a timely manner or at all. Delays in obtaining clearances or approvals would adversely affect our ability to introduce new or enhanced products in a timely manner, which in turn could harm our revenue and future profitability.

 

In addition to the clearance requirements, we will be subject to Medical Device Reporting regulations that will require us to report to the FDA if the NovaSure System causes or contributes to a death or serious injury or if it malfunctions. Our failure to comply with applicable regulatory requirements could result in enforcement action by the FDA, which may include any of the following sanctions:

 

                          fines, injunctions and civil penalties;

 

                          recall or seizure of our products;

 

                          operating restrictions, partial suspension or total shutdown of production;

 

                          refusal of our requests for 510(k) clearance or premarket approval of new products or new intended uses;

 

                          withdrawal of 510(k) clearance or premarket approvals that are already granted; and

 

                          criminal prosecution.

 

Any of these actions could have a material adverse effect on our business, financial condition and operating results.

 

Modifications to the NovaSure System may require premarket supplements, or new regulatory clearances or premarket approvals, or may require us to cease marketing or recall the modified devices until clearances or approvals are obtained.

 

Any modifications to a device that has received a premarket approval that could significantly affect its safety or effectiveness, or would constitute a major change in its function, intended use or manufacturing, require a premarket approval supplement or possibly a separate premarket approval. The FDA requires the device manufacturer to make and document its determination whether or not a premarket approval or supplement is required, but the FDA can review the manufacturer’s decision. Before the acquisition, Novacept modified various aspects of the NovaSure System and filed and received approval for one premarket supplement with respect to some of the changes in the design of and manufacturing process for its disposable device. However, the FDA may not agree with Novacept’s decisions not to seek supplements or new approvals for the other device modifications or with our decisions regarding any future device modifications in the future. If the FDA requires us to seek one or more premarket approval supplements or new premarket approvals for any modification to a previously approved device, we may be required to cease marketing or to recall the modified device until we obtain approval, and we may be subject to significant regulatory fines or penalties. We intend to introduce a second-generation NovaSure controller in the future and will be required to file a premarket supplement in connection with that controller. If FDA does not approve our premarket supplement or any future supplement in a timely manner or at all, our business, financial condition and operating results could be adversely affected.

 

The NovaSure System may be subject to recalls even after receiving FDA clearance or approval, and if a recall occurs, the reputation of the NovaSure System and our operating results could be adversely affected.

 

The FDA and similar governmental bodies in other countries have the authority to require the recall of the NovaSure System in the event of material deficiencies or defects in design or manufacture. A government mandated

 

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or voluntary recall by us could occur as a result of component failures, manufacturing errors or design defects, including defects in labeling. Any recall could harm the reputation of the NovaSure System and adversely affect our financial condition and operating results.

 

If we or our contract manufacturers fail to comply with the FDA’s Quality System regulations, manufacturing operations relating to NovaSure System could be interrupted, and our product sales and operating results could be adversely affected.

 

The manufacturing processes relating to the NovaSure System, including the manufacturing operations in Costa Rica, and those of our contract manufacturers are required to comply with the FDA’s Quality System regulations, which cover the procedures and documentation of the design, testing, production, control, quality assurance, labeling, packaging, sterilization, storage and shipping of our devices. The FDA enforces its Quality System regulations through periodic unannounced inspections. The new, in-house Costa Rican manufacturing facility has passed an FDA Quality System inspection prior to commencement of operations, but we cannot assure you that it would pass any future Quality System inspection. If one of these manufacturing facilities fails a Quality System inspection, operations and manufacturing relating to the NovaSure System could be disrupted. Failure to take adequate and timely corrective action in response to an adverse Quality System inspection could force a shutdown of these manufacturing operations or a recall of the product. If we shut down manufacturing operations for the NovaSure System or recall that product, we may lose customers and experience a decline in our revenues.

 

Changes in reimbursement for procedures using the NovaSure System could affect the adoption of the NovaSure System and its future sales.

 

Widespread adoption of the NovaSure System by the medical community is unlikely to occur if physicians do not receive sufficient reimbursement from payors for performing the NovaSure procedure. A currently effective Category I Current Procedural Terminology, or CPT, billing code covers endometrial ablation procedures. The NovaSure procedure is reimbursed by many private healthcare insurance and managed care payors. However, many of these private payors use reimbursement amounts determined by Medicare and the Center for Medicare and Medicaid Services, or CMS, as a guideline in setting their reimbursement policies. CMS guidelines set the reimbursement rates for procedures covered by Medicare. However, future regulatory action by CMS or other government agencies or negative clinical results may diminish reimbursement coverage for physicians, hospitals and outpatient surgery centers. Additionally, some private payors do not follow the CMS and Medicaid guidelines and those payors may reimburse for only a portion of our procedure or not at all. Even if the NovaSure product is reimbursed by private payors and governmental payors, adverse changes in payors’ policies toward reimbursement for the procedure could also impair our ability to market and sell the NovaSure System.

 

In addition, even if we fulfill international regulatory requirements to market the NovaSure System, our success will be partly dependent upon the availability of reimbursement within prevailing healthcare payment systems. Reimbursement and healthcare payment systems in international markets vary significantly by country and include both government-sponsored healthcare and private insurance. Also, healthcare cost containment efforts similar to those we face in the United States are prevalent in many of the other countries in which we intend to sell the NovaSure System, and these efforts are expected to continue. Although we may seek international reimbursement approvals in certain markets, we may not be able to obtain approvals in a timely manner, if at all, which could impair our ability to market and sell the NovaSure System internationally.

 

A limited number of third-party suppliers manufacture components and materials comprising the NovaSure System, and if we lose or experience deterioration in our relationship with third-party suppliers or supplies are otherwise not available in sufficient quantities, there could be manufacturing delays and reduced sales of the NovaSure System.

 

A limited number of third-party suppliers manufacture components and materials that comprise the NovaSure System, including some components that are obtained from single sources. For example, while the RF controllers (a primary component of the NovaSure System that generates and delivers an amount of radio frequency energy individually determined for each patient, monitors several critical treatment and safety parameters, and automatically controls other aspects of the procedure) are available from more than one supplier, many parts of the RF controllers are in high demand for uses other than the manufacture of the NovaSure System. This demand could lead to a shortage of supply, which could affect our ability to manufacture our NovaSure System to meet demand. In addition, there are no contractual obligations by suppliers to continue to supply to us, nor are we contractually obligated to purchase from a particular supplier. Additionally, the NovaSure System utilizes several electronic components that may become obsolete or no longer be manufactured. Although we believe that alternative sources for these components are available, a supply interruption could harm our ability to manufacture the NovaSure System until a new source of supply is identified and qualified. Switching components may require product redesign

 

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and submission to the FDA of a premarket supplement or possibly a separate premarket approval, either of which could significantly delay production.

 

Any interruption or delay in the supply of components or materials, or our inability to obtain components or materials from alternate sources at acceptable prices in a timely manner, could impair our ability to meet customer demand for the NovaSure System. If customers cancel orders or switch to other competing products, sales of the NovaSure System could be harmed and our operating results could decline.

 

We may engage in acquisitions that may harm our operating results, dilute our stockholders’ equity, divert management’s attention from other important business concerns, and potentially create other difficulties for us.

 

On March 24, 2004, we completed the acquisition of Novacept. We may in the future pursue acquisitions that we believe could provide us with new technologies, products or service offerings, or enable us to obtain other competitive advantages.

 

Acquisitions by us may involve some or all of the following financial risks:

 

                  use of significant amounts of cash;

 

                  potential dilutive issuances of equity securities;

 

                  incurrence of debt or amortization expenses related to certain intangible assets; and

 

                  future impairment charges related to diminished fair value of businesses acquired as compared to their net book value.

 

Such acquisitions also may involve numerous other risks, including:

 

                  diversion of management’s attention from other business concerns;

 

                  difficulties associated with assimilating and integrating personnel, operations and technologies of acquired companies;

 

                  failure to retain key personnel;

 

                  loss of key customers, customer dissatisfaction or performance problems with the acquired company;

 

                  the costs associated with the integration of acquired operations; and

 

                  assumption of unknown liabilities.

 

We may not be successful in overcoming the risks described above or any other problems associated with our acquisition of Novacept or any future acquisitions. Any of these risks and problems could materially harm our business, prospects, and financial condition. Additionally, we cannot guarantee that any companies we may acquire will achieve anticipated revenues and operating results.

 

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