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Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

 

 

FORM 10-Q

 

(Mark One)

 

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ending June 30, 2012

OR

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from              to             

Commission file number: 000-51567

 

 

NxStage Medical, Inc.

(Exact Name of Registrant as Specified in Its Charter)

 

 

 

Delaware   04-3454702

(State or Other Jurisdiction of

Incorporation or Organization)

 

(I.R.S. Employer

Identification No.)

439 S. Union St., 5th Floor,

Lawrence, MA

  01843
(Address of Principal Executive Offices)   (Zip Code)

(978) 687-4700

(Registrant’s Telephone Number, Including Area Code)

 

(Former Name, Former Address, and Former Fiscal year, If Changed Since Last Report)

 

 

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  x    No  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  ¨

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 the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer   x    Accelerated filer   ¨
Non-accelerated filer   ¨  (Do not check if a smaller reporting company)    Smaller reporting company   ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

There were 58,944,696 shares of the registrant’s common stock outstanding as of the close of business on August 3, 2012.

 

 

 


Table of Contents

NXSTAGE MEDICAL, INC.

QUARTERLY REPORT ON FORM 10-Q

FOR THE QUARTER ENDED JUNE 30, 2012

TABLE OF CONTENTS

 

     Page  

PART I - FINANCIAL INFORMATION

  

Item 1. Financial Statements (unaudited):

  

Condensed Consolidated Balance Sheets at June 30, 2012 and December 31, 2011

     3   

Condensed Consolidated Statements of Comprehensive Loss for the Three and Six months ended June 30, 2012 and 2011

     4   

Condensed Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2012 and 2011

     5   

Notes to Condensed Consolidated Financial Statements

     6   

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

     12   

Item 3. Quantitative and Qualitative Disclosures About Market Risk

     20   

Item 4. Controls and Procedures

     20   

PART II - OTHER INFORMATION

     21   

Item 1A. Risk Factors

     21   

Item 6. Exhibits

     41   

SIGNATURES

     42   

 

2


Table of Contents

PART I - FINANCIAL INFORMATION

Item 1. Financial Statements (unaudited)

NXSTAGE MEDICAL, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited)

 

     June 30,
2012
    December 31,
2011
 
     (In thousands, except share data)  
ASSETS     

Current assets:

    

Cash and cash equivalents

   $ 102,859      $ 102,909   

Accounts receivable, net

     17,643        15,808   

Inventory

     34,670        32,775   

Prepaid expenses and other current assets

     2,084        2,777   
  

 

 

   

 

 

 

Total current assets

     157,256        154,269   

Property and equipment, net

     29,049        17,599   

Field equipment, net

     9,971        12,182   

Deferred cost of revenues

     39,792        41,132   

Intangible assets, net

     21,217        22,615   

Goodwill

     42,698        42,698   

Other assets

     2,066        1,213   
  

 

 

   

 

 

 

Total assets

   $ 302,049      $ 291,708   
  

 

 

   

 

 

 
LIABILITIES AND STOCKHOLDERS’ EQUITY     

Current liabilities:

    

Accounts payable

   $ 14,559      $ 15,634   

Accrued expenses

     17,932        15,165   
  

 

 

   

 

 

 

Total current liabilities

     32,491        30,799   

Deferred revenues

     55,668        57,014   

Long-term debt

     —          43,235   

Other long-term liabilities

     18,612        9,474   
  

 

 

   

 

 

 

Total liabilities

     106,771        140,522   

Commitments and contingencies (Note 11)

    

Stockholders’ equity:

    

Undesignated preferred stock: par value $0.001, 5,000,000 shares authorized; no shares issued and outstanding as of June 30, 2012 and December 31, 2011

     —          —     

Common stock: par value $0.001, 100,000,000 shares authorized; 59,391,169 and 56,167,090 shares issued as of June 30, 2012 and December 31, 2011, respectively

     59        56   

Additional paid-in capital

     544,997        489,542   

Accumulated deficit

     (340,035     (329,828

Accumulated other comprehensive loss

     (192     (68

Treasury stock, at cost: 541,584 and 480,923 shares as of June 30, 2012 and December 31, 2011, respectively

     (9,551     (8,516
  

 

 

   

 

 

 

Total stockholders’ equity

     195,278        151,186   
  

 

 

   

 

 

 

Total liabilities and stockholders’ equity

   $ 302,049      $ 291,708   
  

 

 

   

 

 

 

See accompanying notes to these condensed consolidated financial statements.

 

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Table of Contents

NXSTAGE MEDICAL, INC.

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS

(Unaudited)

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     2012     2011     2012     2011  
     (In thousands, except per share data)  

Revenues

   $ 59,009      $ 53,768      $ 115,960      $ 104,332   

Cost of revenues

     36,620        34,903        72,259        67,434   
  

 

 

   

 

 

   

 

 

   

 

 

 

Gross profit

     22,389        18,865        43,701        36,898   
  

 

 

   

 

 

   

 

 

   

 

 

 

Operating expenses:

        

Selling and marketing

     9,918        9,369        19,838        18,579   

Research and development

     4,250        3,589        8,147        7,306   

Distribution

     4,582        4,431        9,114        8,589   

General and administrative

     6,930        5,460        13,552        11,042   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total operating expenses

     25,680        22,849        50,651        45,516   
  

 

 

   

 

 

   

 

 

   

 

 

 

Loss from operations

     (3,291     (3,984     (6,950     (8,618
  

 

 

   

 

 

   

 

 

   

 

 

 

Other expense:

        

Interest expense

     (1,456     (1,170     (2,649     (2,327

Other expense, net

     (79     (170     (131     (196
  

 

 

   

 

 

   

 

 

   

 

 

 
     (1,535     (1,340     (2,780     (2,523
  

 

 

   

 

 

   

 

 

   

 

 

 

Net loss before income taxes

     (4,826     (5,324     (9,730     (11,141

Provision for income taxes

     237        226        477        419   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net loss

   $ (5,063   $ (5,550   $ (10,207   $ (11,560
  

 

 

   

 

 

   

 

 

   

 

 

 

Net loss per share, basic and diluted

   $ (0.09   $ (0.10   $ (0.18   $ (0.22
  

 

 

   

 

 

   

 

 

   

 

 

 

Weighted-average shares outstanding, basic and diluted

     57,733        54,014        55,319        53,716   
  

 

 

   

 

 

   

 

 

   

 

 

 

Other comprehensive loss:

        

Foreign currency (loss) gain

   $ (249   $ 80      $ (100   $ 304   

Other (loss) gain

     (48     1        (24     6   
  

 

 

   

 

 

   

 

 

   

 

 

 

Comprehensive loss

   $ (5,360   $ (5,469   $ (10,331   $ (11,250
  

 

 

   

 

 

   

 

 

   

 

 

 

See accompanying notes to these condensed consolidated financial statements.

 

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NXSTAGE MEDICAL, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

 

     Six Months Ended June 30,  
         2012             2011      
     (In thousands)  

Cash flows from operating activities:

    

Net loss

   $ (10,207   $ (11,560

Adjustments to reconcile net loss to net cash provided by (used in) operating activities:

    

Depreciation and amortization

     11,580        11,459   

Stock-based compensation

     6,252        6,701   

Other

     2,345        1,737   

Changes in operating assets and liabilities:

    

Accounts receivable

     (1,851     (1,753

Inventory

     (7,809     (13,363

Prepaid expenses and other assets

     (170     (546

Accounts payable

     (946     5,471   

Accrued expenses and other liabilities

     3,038        (2,446

Deferred revenues

     (1,346     629   
  

 

 

   

 

 

 

Net cash provided by (used in) operating activities

     886        (3,671
  

 

 

   

 

 

 

Cash flows from investing activities:

    

Purchases of property and equipment

     (3,953     (1,999
  

 

 

   

 

 

 

Net cash used in investing activities

     (3,953     (1,999
  

 

 

   

 

 

 

Cash flows from financing activities:

    

Proceeds from stock option and purchase plans

     3,656        3,898   

Purchase of treasury stock

     (522     (2,533

Repayments on loans and lines of credit

     —          (31
  

 

 

   

 

 

 

Net cash provided by financing activities

     3,134        1,334   
  

 

 

   

 

 

 

Foreign exchange effect on cash and cash equivalents

     (117     423   
  

 

 

   

 

 

 

Decrease in cash and cash equivalents

     (50     (3,913

Cash and cash equivalents, beginning of period

     102,909        104,339   
  

 

 

   

 

 

 

Cash and cash equivalents, end of period

   $ 102,859      $ 100,426   
  

 

 

   

 

 

 

Noncash Investing Activities

    

Transfers from inventory to field equipment

   $ 5,032      $ 8,421   
  

 

 

   

 

 

 

Transfers from field equipment to deferred cost of revenues

   $ 5,202      $ 5,874   
  

 

 

   

 

 

 

See accompanying notes to these condensed consolidated financial statements.

 

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NXSTAGE MEDICAL, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1. Nature of Operations

We are a medical device company that develops, manufactures and markets innovative products for the treatment of kidney failure, fluid overload and related blood treatments and procedures. Our primary product, the NxStage System One, or System One, was designed to satisfy an unmet clinical need for a system that can deliver the therapeutic flexibility and clinical benefits associated with traditional dialysis machines in a smaller, portable, easy-to-use form that can be used by healthcare professionals and trained lay users alike in a variety of settings, including patient homes, as well as more traditional care settings such as hospitals and dialysis clinics. Given its design, the System One is particularly well-suited for home hemodialysis and a range of dialysis therapies including more frequent, or “daily,” dialysis, which clinical literature suggests provides patients better clinical outcomes and improved quality of life. The System One is cleared or approved for commercial sale in the United States, or U.S., Europe, Canada and certain other markets for the treatment of acute and chronic kidney failure and fluid overload. The System One is cleared specifically by the U.S. Food and Drug Administration, or FDA, for home hemodialysis as well as therapeutic plasma exchange, or TPE, in a clinical environment. We also sell needles and blood tubing sets primarily to dialysis clinics for the treatment of end-stage renal disease, or ESRD. These products are cleared or approved for commercial sale in the U.S., Europe, Canada and certain other markets. We believe our largest product market opportunity is for our System One used in the home hemodialysis market for the treatment of ESRD.

Basis of Presentation

The accompanying condensed consolidated financial statements as of June 30, 2012 and for the three and six months then ended, and related notes, are unaudited but, in the opinion of our management, include all adjustments, consisting of normal recurring adjustments that are necessary for fair statement of the interim periods presented. Our unaudited condensed consolidated financial statements have been prepared following the requirements of the Securities and Exchange Commission, or SEC, for interim reporting. As permitted under these rules, we have condensed or omitted certain footnotes and other financial information that are normally required by U.S. generally accepted accounting principles, or GAAP. Our accounting policies are described in the notes to the consolidated financial statements in our Annual Report on Form 10-K for the year ended December 31, 2011 and updated, as necessary, in this Quarterly Report on Form 10-Q. Operating results for the three and six months ended June 30, 2012 are not necessarily indicative of results for the entire year or future periods. The December 31, 2011 condensed consolidated balance sheet contained herein was derived from audited financial statements, but does not include all disclosures required by GAAP. For further information, refer to the consolidated financial statements and footnotes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2011.

2. Summary of Significant Accounting Policies

Principles of Consolidation and Basis of Presentation

The accompanying condensed consolidated financial statements include the accounts of NxStage Medical, Inc. and our wholly-owned subsidiaries. All material intercompany transactions and balances have been eliminated in consolidation.

Use of Estimates

The preparation of our condensed consolidated financial statements in conformity with GAAP requires our management to make estimates and assumptions that affect reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Concentration of Credit Risk

Concentration of credit risk with respect to accounts receivable is primarily limited to certain customers to whom we make substantial sales. One customer represented 21% of accounts receivable at June 30, 2012 and two customers represented 14% and 13% of accounts receivable at December 31, 2011.

 

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Warranty Costs

We accrue estimated costs that we may incur under our product warranty programs at the time the product revenue is recognized, based on contractual rights and historical experience. Warranty expense is included in cost of revenues in the condensed consolidated statements of comprehensive loss. The following is a rollforward of our warranty accrual (in thousands):

 

Balance at December 31, 2011

   $ 380   

Provision

     237   

Usage

     (363
  

 

 

 

Balance at June 30, 2012

   $ 254   
  

 

 

 

Derivative Instruments and Hedging

Derivative instruments, namely our foreign exchange forward contracts, are recognized on the balance sheet at fair value at the balance sheet date. Changes in the fair value of derivatives that are designated and highly effective as cash flow hedges are recorded either in cost of revenues or deferred in accumulated other comprehensive income (loss) and subsequently recognized in cost of revenues in the same period the hedged items are recognized. The ineffective portion of derivative instruments designated as cash flow hedges, are recorded in other income (expense), net. For derivatives that are designated as cash flow hedges, if the underlying forecasted transaction does not occur, or it becomes probable that it will not occur, the gains and losses on the related derivative instrument are recognized in earnings and any related gains and losses recorded in other comprehensive income are reclassified into earnings.

Recent Accounting Pronouncements

Effective January 1, 2012, we adopted revised guidance related to the presentation of comprehensive income. This guidance eliminates the option to present the components of other comprehensive income as part of the statement of changes in stockholders' equity and, instead, requires presentation of total comprehensive income, which includes the components of net income, and the components of other comprehensive income, either in a single continuous statement of comprehensive income or in two separate but consecutive statements. This guidance is required to be applied retrospectively. We have chosen to disclose comprehensive loss, which consists of the components of net loss and other comprehensive income (loss), as part of one continuous statement, referred to as the Consolidated Statement of Comprehensive Loss. Other than a change in presentation, the implementation of this guidance did not impact our financial statements.

3. Inventory

Inventory includes material, labor and overhead, and is stated at lower of cost (first-in, first-out) or market. The components of inventory are as follows (in thousands):

 

     June 30,
2012
     December 31,
2011
 

Purchased components

   $ 11,116       $ 12,532   

Work in process

     9,725         9,109   

Finished goods

     13,829         11,134   
  

 

 

    

 

 

 
   $ 34,670       $ 32,775   
  

 

 

    

 

 

 

4. Property and Equipment and Field Equipment

Accumulated depreciation on property and equipment was $16.6 million and $15.1 million at June 30, 2012 and December 31, 2011, respectively. Accumulated depreciation on field equipment was $33.0 million and $32.9 million at June 30, 2012 and December 31, 2011, respectively. The tenant improvement allowance of $4.3 million paid by our landlord during the six months ended June 30, 2012 pursuant to our lease agreement for our new corporate headquarters represents a non-cash investing activity.

At June 30, 2012, we had $12.6 million recorded in property and equipment and other long-term liabilities related to construction of a new manufacturing facility in Germany pursuant to the terms of our Dialyzer Production Agreement entered into in May 2009 with Asahi Kasei Medical Co., Ltd., or Asahi. We are overseeing construction of this new facility and will operate the new facility under a manufacturing agreement upon its completion. Asahi will fund construction costs up to an original amount; however, we will be responsible for any additional costs. If the agreement is terminated during the construction period due to our breach, insolvency or bankruptcy, Asahi has the option to require us to pay for all amounts expended for construction of the new facility. If such event occurs we would take title to the land and any construction-in-process. Subsequent to the completion of construction, if the agreement is terminated due to our breach, insolvency or bankruptcy, or by us pursuant to certain terms of the agreement, Asahi has the option to require us to purchase the new facility from them by paying one hundred percent of the then net book value of the new facility, as calculated in accordance with GAAP. Given these options and our involvement in the construction, we are considered the owner of the new facility for accounting purposes and will therefore record its cost as construction-in-process and a corresponding liability has been

 

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recorded for the construction cost funded by Asahi. The $12.6 million capitalized at June 30, 2012 reflects the construction costs incurred to date in connection with this project and the $5.5 million and $3.7 million of construction-in-process additions recorded during the six months ended June 30, 2012 and 2011, respectively, represents a non-cash financing activity.

5. Intangible Assets

Accumulated amortization on intangible assets was $13.3 million and $11.9 million at June 30, 2012 and December 31, 2011, respectively.

6. Net Loss per Share

Basic net loss per share is computed by dividing loss available to common stockholders (the numerator) by the weighted-average number of common shares outstanding (the denominator) for the period. The computation of diluted loss per share is similar to basic loss per share, except that the denominator is increased to include the number of additional common shares that would have been outstanding if the potentially dilutive common shares had been issued.

The following potential common stock equivalents, as calculated using the treasury stock method, were not included in the computation of diluted net loss per share as their effect would have been anti-dilutive due to the net loss incurred (in thousands):

 

     Three Months Ended June 30,      Six Months Ended June 30,  
         2012              2011              2012              2011      

Options to purchase common stock

     1,746         3,171         1,958         3,405   

Unvested restricted stock

     252         772         265         738   

Warrants to purchase common stock

     957         1,215         992         1,242   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

     2,955         5,158         3,215         5,385   
  

 

 

    

 

 

    

 

 

    

 

 

 

7. Debt

On May 4, 2012, we repaid in full all principal and interest in the aggregate amount of $45.2 million under our Term Loan and Security Agreement dated June 5, 2009 with Asahi through the issuance of 2,456,246 shares of our common stock, which after the retention by the Company of 28,351 shares for the payment of certain minimum withholding taxes, resulted in a net issuance to Asahi of 2,427,895 shares. As a result, the Term Loan and Security Agreement was terminated. The extinguishment of this debt gave rise to early recognition of approximately $1.0 million of unamortized debt discount which has been recorded as additional interest expense during the second quarter of 2012. The payment during the six months ended June 30, 2012 of all principal and interest due to Asahi of $45.2 million through the issuance of shares of our common stock represents a non-cash financing activity.

The shares were issued pursuant to a Subscription, Sale and Purchase Agreement between us and Asahi dated May 4, 2012. In connection with the issuance of the shares, we entered into a Registration Rights Agreement with Asahi. Pursuant to the Registration Rights Agreement, subject to certain conditions, we were required to register these shares for resale under a registration statement filed with the SEC, which we have done, and to use commercially reasonable efforts to keep such registration statement continuously effective until such time as all of the shares have been publicly sold or may be sold pursuant to Rule 144 without restrictions, whichever is earlier. We issued the shares to Asahi in reliance on the exemption from the registration requirements of the Securities Act of 1933, as amended, set forth in Section 4(2) promulgated thereunder relative to sales by an issuer not involving any public offering.

On May 7, 2012, we amended our loan and security agreement with Silicon Valley Bank, or SVB. The amendment extended the maturity date from April 1, 2012 to March 31, 2014 and reduced the interest rate on borrowings to prime with a floor of 3.25%. Financial covenants and other terms remain essentially unchanged. The agreement, as amended, continues to provide for a $15.0 million revolving line of credit, is secured by all or substantially all of our assets, includes certain financial covenants relating to liquidity requirements and adjusted EBITDA, and contains events of default customary for transactions of this type, including nonpayment, misrepresentation, breach of covenants, material adverse effect and bankruptcy.

8. Segment Disclosures

The results of our operations are included in two separately reportable segments, System One and In-Center. Other business activities relates primarily to the manufacturing of dialyzers for sale to Asahi, certain business development activities and certain corporate expenses which are excluded from the segment operating performance measures, namely our research and development expenses and general and administrative expenses.

 

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The accounting policies of the reportable segments are the same as those described in Note 2 to the consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2011. The profitability measure employed by us and our chief operating decision maker, or CODM, for making decisions about allocating resources to segments and assessing segment performance is segment profit (loss), which consists of revenues less cost of revenues, selling and marketing and distribution expenses.

Within the System One segment, we derive revenues from the sale and rental of the System One and PureFlow SL equipment and the sale of disposable products in the home and critical care markets. The home market is devoted to the treatment of ESRD patients in the home, while the critical care market is devoted to the treatment of hospital-based patients with acute kidney failure or fluid overload. Within the System One segment, we sell a similar technology platform of the System One with different features to the home and critical care markets. Some of our largest customers in the home market provide outsourced renal dialysis services to some of our customers in the critical care market. Sales of product to both markets are made primarily through dedicated sales forces and distributed directly to the customer, or the patient, with certain products sold through distributors internationally.

Within the In-Center segment, we sell blood tubing sets and needles for hemodialysis primarily for the treatment of ESRD patients at dialysis centers and needles for apheresis. Nearly all In-Center products are sold through national distributors.

Our reportable segments consist of the following (in thousands):

 

     System One      In-Center      Other     Total  

Three Months Ended June 30, 2012

          

Revenues from external customers

   $ 40,064       $ 18,229       $ 716      $ 59,009   

Segment profit (loss)

     6,132         2,133         (11,556     (3,291

Depreciation and amortization

     4,525         387         948        5,860   

Three Months Ended June 30, 2011

          

Revenues from external customers

   $ 35,604       $ 18,164       $ —        $ 53,768   

Segment profit (loss)

     3,387         1,891         (9,262     (3,984

Depreciation and amortization

     4,498         389         882        5,769   

Six Months Ended June 30, 2012

          

Revenues from external customers

   $ 79,404       $ 35,840       $ 716      $ 115,960   

Segment profit (loss)

     11,386         3,943         (22,279     (6,950

Depreciation and amortization

     8,974         754         1,852        11,580   

Six Months Ended June 30, 2011

          

Revenues from external customers

   $ 69,087       $ 35,245       $ —        $ 104,332   

Segment profit (loss)

     6,024         4,043         (18,685     (8,618

Depreciation and amortization

     8,915         784         1,760        11,459   

Substantially all of our revenues have been derived from the sale of the System One and related products, which cannot be used with any other dialysis system, and from needles and blood tubing sets to customers located in the U.S.

 

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The following table summarizes the number of customers who individually comprise greater than 10% of total revenues:

 

     Three Months Ended June 30,     Six Months Ended June 30,  
     2012     2011     2012     2011  

Customer A

     20     21     21     21

Customer B

     10     13     10     13

Customer C

     11     14     12     13

Customer D

     12     9     12     9

Sales to Customer A and D are nearly all in the System One segment and sales to Customer B and C are to significant distributors in the In-Center segment. A portion of Customer B’s sales of our products are to Customer A. All of Customer C’s sales of our products are to Customer A.

9. Income Taxes

The provision for income taxes of $0.2 million for both the three months ended June 30, 2012 and 2011 and $0.5 million and $0.4 million for the six months ended June 30, 2012 and 2011, respectively, relates to the profitable operations of certain foreign entities.

10. Derivative Instruments and Hedging

We operate a manufacturing and service facility in Mexico and we purchase materials and pay our employees at that facility in Pesos, and as such, we are potentially exposed to adverse as well as beneficial movements in foreign currency exchange rates. To minimize the impact of foreign currency exchange rate fluctuations on these Peso denominated expenses, during the first quarter of 2012 we instituted a foreign currency cash flow hedging program, and began entering into foreign exchange forward contracts. These contracts have a duration of up to twelve months and are designated as cash flow hedges. The counterparties to these foreign exchange forward contracts are creditworthy financial institutions; therefore, we do not consider the risk of counterparty nonperformance to be material. As of June 30, 2012, the notional amount of our outstanding contracts that are designated as cash flow hedges was approximately $9.4 million. The fair value of these contracts at June 30, 2012 which has been recorded on the balance sheet in other current assets and accrued expenses was not material. The gains and losses related to changes in fair value of these contracts were not material during 2012. Gains or losses related to hedge ineffectiveness recognized in earnings were not material during 2012. Given the short-term nature of our contracts any gains or losses recorded within accumulated other comprehensive income (loss) will be recognized in earnings within the next twelve months.

11. Commitments and Contingencies

As discussed in our Annual Report on Form 10-K for the year ended December 31, 2011, a civil complaint was filed against us on February 28, 2012 in the US District Court for the District of Massachusetts by Gambro Renal Products, Inc., or Gambro (Case No. 1:12cv10370-PBS). The complaint alleges that we violated Section 43(a) of the Lanham Act, 15 U.S.C. § 1125(a), and Massachusetts General Laws Chapter 93A by making false and misleading statements about our and Gambro’s allegedly competing products in the critical care market in commercial and promotional activities. The complaint also alleges that we wrongfully interfered with contractual and advantageous relationships of Gambro in its critical care business. Gambro seeks compensatory and treble damages, disgorgement of profits and injunctive relief. We believe the suit is without merit and intend to defend ourself vigorously. At this time we do not believe a loss is probable and we are not able to estimate a range of possible loss.

Other significant commitments and contingencies at June 30, 2012 are consistent with those discussed in Note 10 to the consolidated financial statements in our Annual Report on Form 10-K for the year ended December 31, 2011.

 

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12. Stock-Based Compensation

Stock-based Compensation Expense

The following table presents stock-based compensation expense included in the condensed consolidated statements of comprehensive loss (in thousands):

 

     Three Months Ended June 30,      Six Months Ended June 30,  
         2012              2011              2012              2011      

Cost of revenues

   $ 313       $ 494       $ 645       $ 1,034   

Selling and marketing

     1,139         1,300         2,399         2,630   

Research and development

     347         324         749         666   

General and administrative

     1,254         1,169         2,459         2,371   
  

 

 

    

 

 

    

 

 

    

 

 

 
   $ 3,053       $ 3,287       $ 6,252       $ 6,701   
  

 

 

    

 

 

    

 

 

    

 

 

 

Stock Options and Restricted Stock Units

The Company granted options to purchase 128,669 and 398,369 shares of common stock during the three months ended June 30, 2012 and 2011, respectively, and options to purchase 396,482 and 473,395 shares of common stock during the six months ended June 30, 2012 and 2011, respectively, The weighted-average fair value of options granted during the six months ended June 30, 2012 and 2011 was $9.57 and $11.22 per option, respectively.

The Company awarded 29,580 and 102,239 restricted stock units during the three months ended June 30, 2012 and 2011, respectively, and 123,381 and 102,239 restricted stock units during the six months ended June 30, 2012 and 2011, respectively, which vest based on continued employment over a period of four years. The weighted-average fair value of these restricted stock units awarded during the six months ended June 30, 2012 and 2011 was $18.21 and $18.94 per unit, respectively.

Performance Based Plans

In March 2012, the Company’s Compensation Committee of the Board of Directors, or the Compensation Committee, approved the Company’s 2012 Performance Share Plan in which it committed to grant up to 284,677 restricted stock units to certain employees and executive officers based on the achievement of certain Company financial performance metrics for the year ending December 31, 2012. The restricted stock units, if earned, vest over a requisite service period of three years. The estimated expense under the 2012 Performance Share Plan is being recognized as stock-based compensation expense over the requisite service period. Further, in March 2012, the Compensation Committee approved the Company’s 2012 Corporate Bonus Plan. Payout under the 2012 Corporate Bonus Plan will be based on individual performance and the achievement of certain Company financial performance metrics for the year ending December 31, 2012 and will be paid in shares of the Company’s common stock, or in cash, at the discretion of the Compensation Committee. The estimated payout under the 2012 Corporate Bonus Plan is being recognized as compensation expense during 2012, with a significant majority of this compensation expense classified as stock-based compensation expense, and has been classified as a liability on the Company’s condensed consolidated balance sheet.

13. Stockholders’ Equity

We received 32,310 and 40,401 shares of common stock that were surrendered in payment for the exercise of stock options through the six months ended June 30, 2012 and 2011. We received 28,351 shares of common stock during the six months ended June 30, 2012 for the payment of certain minimum withholding taxes related to the repayment of our Term Loan and Security Agreement with Asahi. We received 115,418 shares of common stock during the three months ended March 31, 2011 that were surrendered by employees in payment for the minimum required withholding taxes associated with awards under our Corporate Bonus and Performance Share Plans.

The settlement of $0.9 million and $2.8 million during the first quarter of 2012 and 2011, respectively, of the Company’s Corporate Bonus Plan obligation in shares of our common stock represents a noncash financing activity.

14. Fair Value Measurements

At June 30, 2012, we had $84.8 million in money market funds, included in cash and cash equivalents, measured at fair value on a recurring basis utilizing quoted prices (unadjusted) in active markets for identical assets, also referred to as level 1 inputs.

The carrying amounts reflected in the condensed consolidated balance sheets for cash and cash equivalents, accounts receivable, prepaid expenses and other current and non-current assets, accounts payable and accrued expenses approximate fair value due to their short-term nature.

 

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

Special Note Regarding Forward Looking Statements

The following discussion should be read with our unaudited condensed consolidated financial statements and notes included in Part I, Item 1 of this Quarterly Report for the three and six months ended June 30, 2012, as well as the audited financial statements and notes and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for the year ended December 31, 2011, included in our Annual Report on Form 10-K filed with the SEC.

This Quarterly Report contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 concerning our business, operations and financial condition, including statements with respect to: the market adoption of our products in the U.S. and internationally; the growth of the home, critical care and in-center dialysis markets in general and the home hemodialysis market in particular; the development and commercialization of our products; changes in the historical purchasing patterns and preferences of our key customers, including DaVita Inc. and Fresenius Medical Care; the adequacy of our funding; our ability to achieve and sustain positive cash flows; expectations with respect to future demand for our products and revenue growth; the timing and success of our initiatives to improve our gross profit as a percentage of revenues; expectations with respect to our operating expenses and achieving our business plan; expectations with respect to achieving profitable operations; expectations with respect to achieving improvements in product reliability; the timing and success of the submission, acceptance and approval of regulatory filings and the impact of any changes in the regulatory environment with respect to our products or business; the scope of patent protection with respect to our products; expectations with respect to the clinical findings of our FREEDOM study and other ongoing clinical studies evaluating home and/or daily, more frequent hemodialysis; expectations as to the continued availability of raw materials, components, and finished goods, including from key single source suppliers; expectations with respect to our ability to supply on a timely and uninterrupted basis all products ordered by our customers; expectations with respect to the Gambro litigation; the impact of any new business development initiatives on our business, including any potentially negative response from customers; and the impact of new and future changes to reimbursement for chronic dialysis treatments. All statements other than statements of historical facts included in this report regarding our strategies, prospects, financial condition, costs, plans and objectives are forward-looking statements. When used in this report, the words “expect”, “anticipate”, “intend”, “plan”, “believe”, “seek”, “estimate”, “potential”, “continue”, “predict”, “may”, and similar expressions are intended to identify forward-looking statements, although not all forward-looking statements contain these identifying words. Because these forward-looking statements involve risks and uncertainties, actual results could differ materially from those expressed or implied by these forward-looking statements.

Among the important factors that could cause actual results to differ materially from those indicated by our forward-looking statements are those discussed under the heading “Risk Factors” in Item 1A of Part II. We undertake no obligation to revise or update publicly any forward-looking statement for any reason. Readers should carefully review the factors described under the heading “Risk Factors” in Item 1A of Part II of this Quarterly Report and in “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, as well as in other documents filed by us with the SEC, as they may be amended from time to time, including our Annual Report on Form 10-K and Quarterly Reports on Form 10-Q.

Introduction

We are a medical device company that develops, manufactures and markets innovative products for the treatment of kidney failure, fluid overload and related blood treatments and procedures. Our primary product, the NxStage System One, or System One, was designed to satisfy an unmet clinical need for a system that can deliver the therapeutic flexibility and clinical benefits associated with traditional dialysis machines in a smaller, portable, easy-to-use form that can be used by healthcare professionals and trained lay users alike in a variety of settings, including patient homes, as well as more traditional care settings such as hospitals and dialysis clinics. Given its design, the System One is particularly well-suited for home hemodialysis and a range of dialysis therapies including more frequent, or “daily,” dialysis, which clinical literature suggests provides patients better clinical outcomes and improved quality of life. The System One is cleared or approved for commercial sale in the U.S., Europe, Canada and certain other markets for the treatment of acute and chronic kidney failure and fluid overload. The System One is cleared specifically by the U.S. Food and Drug Administration, or FDA, for home hemodialysis as well as therapeutic plasma exchange, or TPE, in a clinical environment. We also sell needles and blood tubing sets primarily to dialysis clinics for the treatment of end-stage renal disease, or ESRD. These products are cleared or approved for commercial sale in the U.S., Europe, Canada and certain other markets. We believe our largest product market opportunity is for our System One used in the home hemodialysis market for the treatment of ESRD.

The results of our operations are included in two separately reportable segments, System One and In-Center. Other business activities relates primarily to the manufacturing of dialyzers for sale to Asahi, certain business development activities and certain corporate expenses which are excluded from the segment operating performance measures, namely our research and

 

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development expenses and general and administrative expenses. In the System One segment we derive our revenues from the sale and rental of the System One and PureFlow SL equipment and the sale of disposable products in the home and critical care markets. The home market is devoted to the treatment of ESRD patients in the home, while the critical care market is devoted to the treatment of hospital-based patients with acute kidney failure or fluid overload. In the In-Center segment, we derive our revenues from the sale of blood tubing sets and needles for hemodialysis primarily for the treatment of ESRD patients at dialysis centers and needles for apheresis, which is referred to as the in-center market.

Segment and Market Highlights

Our customers in the System One segment are highly consolidated. DaVita Inc., or DaVita, and Fresenius Medical Care, or Fresenius, own and operate the two largest chains of dialysis clinics in the U.S. and collectively provide treatment to over two-thirds of U.S. dialysis patients. DaVita and Fresenius are our two largest and most significant customers in the System One segment. Direct sales to DaVita represented 30% and 31% of our System One segment revenues for the three months ended June 30, 2012 and 2011, respectively, and 30% and 31% of our System One segment revenues for the six months ended June 30, 2012 and 2011, respectively. Further, DaVita is our largest customer in the home market, constituting over 40% of our home hemodialysis patients. Direct sales to Fresenius represented 17% of our System One segment revenues for both the three and six months ended June 30, 2012. Increased sales to DaVita and Fresenius have driven a large portion of our historical revenue growth and will be important to future growth. If the purchasing patterns of either of these customers adversely change, our business could be negatively affected.

Our In-Center segment revenues are highly concentrated in several significant purchasers. Our two largest distributors are Gambro Renal Products, Inc., or Gambro, and Henry Schein, Inc., or Henry Schein. Revenues from Gambro represented 36% and 40% of our In-Center segment revenues for the three months ended June 30, 2012 and 2011, respectively, and 40% of our In-Center segment revenues for both the six month periods ended June 30, 2012 and 2011. Revenues from Henry Schein represented 33% and 38% of our In-Center segment revenues for the three months ended June 30, 2012 and 2011, respectively, and 32% and 38% of our In-Center segment revenues for the six months ended June 30, 2012 and 2011, respectively.

DaVita is also a significant customer in the in-center market. Sales of our products through distributors to DaVita accounted for approximately half of In-Center segment revenues for both the three and six months ended June 30, 2012 and 2011. DaVita has contractual purchase commitments under two agreements: one with us for needles and one with Gambro for blood tubing sets. DaVita's purchase obligations with respect to needles will expire under an agreement with us in January 2013. Gambro's long term product supply agreement with DaVita, entered into in connection with the sale of Gambro's United States dialysis clinic business to DaVita, obligates DaVita to purchase a significant majority of its blood tubing set requirements from Gambro. Our distribution agreement with Gambro, which expires in June 2014, contractually obligates Gambro to exclusively supply our blood tubing sets to DaVita.

We offer certain customers rebates based on sales to specific end users and discounts for early payment. Our revenues are presented net of these rebates and discounts. As of June 30, 2012, we had $1.8 million and $0.9 million reserved against trade accounts receivable for future rebates and discounts for customers in our In-Center and System One segments, respectively. We recorded $1.9 million and $1.6 million during the three months ended June 30, 2012 and 2011, respectively, and $3.2 million and $3.0 million during the six months ended June 30, 2012 and 2011, respectively, as a reduction of In-Center segment revenues in connection with rebates and discounts. For the System One segment, we recorded $1.3 million and $0.5 million during the three months ended June 30, 2012 and 2011, respectively, and $2.6 million and $1.1 million during the six months ended June 30, 2012 and 2011, respectively, in connection with rebates and discounts.

As an alternative to a cash-based rebate, we issued to DaVita a warrant that may vest and become exercisable to purchase up to 5.5 million shares of our common stock based upon the achievement of certain System One home patient growth targets at June 30, 2011, 2012 and 2013. This warrant-based rebate structure preserves our cash, and provides for the issuance of shares upon the exercise of any warrants earned only if patient access to home hemodialysis with the System One is materially expanded. The warrants have an exercise price of $14.22 per share, expire during 2013, are non-transferable and must be exercised in cash. The accounting for these warrants is similar to the accounting for cash-based rebates. Specifically, the warrants are measured at fair value through their date of vesting and recognized as a reduction of revenues, based on the number of warrants expected to vest over the same expected period as the related expected product revenues, which is 7 to 10 years. Estimates of the number of warrants expected to vest and the fair value of the warrants will be revised each reporting period through the date of vesting. Approximately 5% of the 5.5 million warrant shares were earned based on the achievement of certain performance targets at June 30, 2011 and no warrants were earned during the performance period ended June 30, 2012. As of June 30, 2012, 30% of the warrants have expired, unearned. While DaVita continues to grow, it is unlikely they will achieve the level of performance needed to earn the remaining outstanding warrants. The reduction of revenues recorded in connection with these warrants has not been significant.

 

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Financial Performance

During the three months ended June 30, 2012 we grew our revenues by 10% to $59.0 million and during the six months ended June 30, 2012 we grew our revenues by 11% to $116.0 million with growth occurring in each market: home, critical care and in-center. Home revenues drove the growth, increasing $3.7 million, or 14%, and $7.2 million, or 14%, for the three and six months ended June 30, 2012 versus the prior year comparable periods, driven by an increase in the number of patients prescribed to use and centers offering the System One. We expect to see continued growth in our System One segment revenues, primarily driven by the annuity nature of our business, as well as the life-sustaining, non-elective nature of dialysis therapy.

We continue to see improvements in our financial performance below the revenue line. We have not yet achieved profitable operating margins, but we continue to improve gross profit as a percentage of revenues from 35% during the three and six months ended June 30, 2011 to 38% during the three and six months ended June 30, 2012. The improvement in gross profit as a percentage of revenues was mainly attributable to favorable product mix with higher relative sales of higher margin products and lower product costs, partially offset by costs incurred by our In-Center segment related to the earthquakes in the second quarter of 2012 affecting our manufacturing facility in northern Italy, and the transition of manufacturing of certain blood tubing sets from a contract manufacturer to our own manufacturing facility in Mexico beginning in the second quarter of 2011. While we expect to continue to improve gross profit as a percentage of revenues as a result of various initiatives, including the consolidation of our manufacturing network, these improvements will continue to be offset in the short-term by associated costs and will be impacted favorably and unfavorably by fluctuations in foreign exchange rates versus the U.S. dollar.

We are encouraged by the improvements to our operating margins and are continuing to work toward our long-term goal of achieving profitable operating margins. However, there can be no assurance that we will be able to continue to improve our operating margins or achieve positive operating margins. Our ability to become profitable and the timing and sustainability, depend principally upon continued improvements in gross margins, growing revenues, and the leverage of our operating infrastructure including after taking into account the effects of any investment in selling and marketing or research and development activities or investment in new business development. Additionally, our profitability will be impacted beginning in 2013 due to the 2.3% medical device excise tax which will be assessed on nearly all of our products sold in the U.S.

Comparison of the Three and Six Months Ended June 30, 2012 and 2011

Revenues

Our revenues for the three and six months ended June 30, 2012 and 2011 were as follows (in thousands, except percentages):

 

     Three Months Ended June 30,     Six Months Ended June 30,  
     2012     2011     2012     2011  

System One segment

              

Home

   $ 30,693         52   $ 27,013         50   $ 60,246         52   $ 53,058         51

Critical Care

     9,371         16     8,591         16     19,158         16     16,029         15
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Total System One segment

     40,064         68     35,604         66     79,404         68     69,087         66

In-Center segment

     18,229         31     18,164         34     35,840         31     35,245         34

Other

     716         1     —           —       716         1     —           —  
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Total

   $ 59,009         100   $ 53,768         100   $ 115,960         100   $ 104,332         100
  

 

 

      

 

 

      

 

 

      

 

 

    

In the home market, revenues increased $3.7 million, or 14%, and $7.2 million, or 14% for the three and six months ended June 30, 2012, respectively, versus the prior year comparable periods, driven by the increase in the number of patients prescribed to use and centers offering the System One. We have increased both the number of patients at existing centers and centers offering the System One, primarily through our existing relationships with service providers, including DaVita and Fresenius. Critical care market revenues increased $0.8 million, or 9%, and $3.1 million, or 20%, for the three and six months ended June 30, 2012, respectively versus the prior year comparable periods, due to increased sales of disposables from our growing number of System One equipment placed within hospitals. We expect future demand for our products and revenue growth in both the home and critical care markets to be strong as we further penetrate these markets, expand internationally, and leverage the annuity nature of our business. Our two largest customers in the home market, DaVita and Fresenius, will be important to that growth, specifically in the U.S. market. If the purchasing patterns of either of these customers adversely change, our business could be negatively affected. As our international business grows, our System One revenue will be susceptible to fluctuations in international equipment sales and changes in inventory levels at our international distributors.

 

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In-Center segment revenues increased slightly for the three and six months ended June 30, 2012 versus the prior year comparable periods. The increase in revenues was driven by higher sales of needles due to increased end user demand and fluctuations in inventory levels at our distributors. While revenues continue to be susceptible to fluctuations in inventory levels at our distributors, end user demand of both our blood tubing sets and our needle products continues to grow. We expect future revenues will continue to be susceptible to fluctuation as a result of increased competition and variations in inventory management policies with both our distributors and end users.

Other revenues for the three months ended June 30, 2012 relates to dialyzers sold to Asahi pursuant to our Dialyzer Production Agreement.

Gross Profit (Loss)

Our gross profit (loss) and gross profit (loss) as a percentage of revenues for the three and six months ended June 30, 2012 and 2011 were as follows (in thousands, except percentages):

 

     Three Months Ended June 30,     Six Months Ended June 30,  
     2012     2011     2012     2011  

System One segment

   $ 18,353        46   $ 15,018         42   $ 35,962        45   $ 28,939         42

In-Center segment

     4,058        22     3,847         21     7,761        22     7,959         23

Other

     (22     (3 )%      —           —       (22     (3 )%      —           —  
  

 

 

     

 

 

      

 

 

     

 

 

    

Gross profit

   $ 22,389        38   $ 18,865         35   $ 43,701        38   $ 36,898         35
  

 

 

     

 

 

      

 

 

     

 

 

    

Gross profit increased $3.5 million, or 19%, and $6.8 million, or 18%, and increased as an overall percentage of revenue for both the three and six months ended June 30, 2012, respectively, versus the prior year comparable periods, driven in large part by the System One Segment. Gross profit for the System One segment increased $3.3 million, or 22%, and $7.0 million, or 24%, for the three and six months ended June 30, 2012, respectively, versus the prior year comparable periods, due to increased revenues and improvement in gross profit as a percentage of revenues. The improvement in gross profit as a percentage of revenues for the three and six months ended June 30, 2012 was attributable to several factors, including lower product costs driven by certain cost savings initiatives, improvement in product design and reliability, continued leveraging of our manufacturing infrastructure, increased relative sales of higher margin products, and lower depreciation expense on our field equipment assets resulting from the change in the useful life of certain of these assets from five to seven years. Additionally, for the three months ended June 30, 2012 we realized favorable impact of foreign exchange rate fluctuations versus the U.S. dollar.

Gross profit for the In-Center segment increased slightly both in absolute dollars and as a percentage of revenues for the three months ended June 30, 2012 versus the prior year comparable period, due to lower costs of revenues driven in large part by lower product manufacturing costs coupled with the favorable impact of foreign exchange rate fluctuations partially offset by costs incurred by our In-Center segment related to the earthquakes in the second quarter of 2012 affecting our manufacturing facility in northern Italy and costs related to the transition of certain blood tubing sets from a contract manufacturer to our own manufacturing facility in Mexico. Gross profit for the In-Center segment decreased slightly in both absolute dollars and as a percentage of revenues for the six months ended June 30, 2012 versus the prior year comparable period, due to costs incurred related to the transition of certain blood tubing sets from a contract manufacturer to our own manufacturing facility in Mexico, which began in the second quarter of 2011, and costs incurred by our In-Center segment related to the earthquakes in the second quarter of 2012 affecting our manufacturing facility in northern Italy partially offset by increased relative sales of higher margin products.

The Other category relates to the manufacturing of dialyzers for sale to Asahi, which should provide us with long term cost efficiencies through increased dialyzer production volumes.

We expect gross profit as a percentage of revenues will continue to improve in the long-term for three general reasons, all of which we expect will reduce costs in the future. First, we expect to introduce additional process improvements and product design changes that have inherently lower costs than the costs associated with our current products. Second, we anticipate that increased volume, rationalization and consolidation of our manufacturing operations, rationalization of our supply chain, and realization of economies of scale will lead to lower costs and better purchasing terms and prices. Finally, we expect to continue to improve product reliability, which would reduce unit service costs. However, there is no certainty that our expectations or the projected timing associated with our expectations will be achieved with respect to these cost reduction plans. Further, these improvements in gross profit as a percentage of revenues may be offset in the short-term for five general reasons, all of which could negatively impact gross profit. First, we manufacture a large majority of our products internationally and purchase products from foreign companies in other than U.S. dollars and, therefore, our product costs are subject to fluctuations due to changes in foreign currency exchange rates. Any unfavorable fluctuations in foreign exchange rates versus the U.S. dollar would negatively impact our gross profit as a percentage of revenues. Second, we expect that we will continue to incur higher transportation costs driven in large part by increased prices from carriers and changes in fuel prices. Third, we may see an

 

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increase in the cost of certain raw materials, due to increases in the cost of commodities, particularly resin. Fourth, we expect future demand for our products to continue to grow; however, higher relative sales of lower margin products and certain pricing strategies would have a negative impact on gross profit as a percentage of revenues. Finally, rationalization and consolidation of our manufacturing operations, in an effort to drive long-term gross margin improvement, will require us to incur additional costs in the short-term.

Selling and Marketing

Our selling and marketing expenses and selling and marketing as a percent of revenues for the three and six months ended June 30, 2012 and 2011 were as follows (in thousands, except percentages):

 

     Three Months Ended June 30,     Six Months Ended June 30,  
     2012     2011     2012     2011  

System One segment

   $ 8,272         21   $ 7,894         22   $ 16,625         21   $ 15,666         23

In-Center segment

     1,292         7     1,262         7     2,655         7     2,576         7

Other

     354         n/     213         n/     558         n/     337         n/
  

 

 

      

 

 

      

 

 

      

 

 

    

Total Selling and marketing

   $ 9,918         17   $ 9,369         17   $ 19,838         17   $ 18,579         18
  

 

 

      

 

 

      

 

 

      

 

 

    

Selling and marketing expenses increased $0.5 million, or 6%, and $1.3 million, or 7%, for the three and six months ended June 30, 2012, respectively, versus the prior year comparable periods. The increase in selling and marketing expense was primarily the result of increased personnel and personnel-related costs due to expanded marketing programs within both segments.

Selling and marketing expenses for the System One segment decreased as a percentage of revenues for the three and six months ended June 30, 2012 versus the prior year comparable periods due to our initiative to continue to leverage our infrastructure. Selling and marketing expenses for the In-Center segment remained consistent as a percentage of revenues for the three and six months ended June 30, 2012 versus the prior year comparable periods due to our efforts to continue to broaden our marketing programs while still leveraging our existing infrastructure. Selling and marketing expenses for our Other category relates primarily to personnel and personnel related costs related to business development activities. We anticipate that selling and marketing expenses will continue to increase as we broaden our marketing and business development initiatives, increase public awareness of the System One in the home market and support growth in international markets.

Research and Development

Our research and development expenses and research and development as a percent of revenues for the three and six months ended June 30, 2012 and 2011 were as follows (in thousands, except percentages):

 

     Three Months Ended June 30,     Six Months Ended June 30,  
         2012             2011             2012             2011      

Research and development

   $ 4,250         7   $ 3,589         7   $ 8,147         7   $ 7,306         7

Research and development expenses increased $0.7 million, or 18%, and $0.8 million, or 12%, for the three and six months ended June 30, 2012, respectively, versus the prior year comparable period but remained consistent as a percentage of revenues. The increase was primarily due to increased personnel and personnel-related costs and increased project related spending. For the near term, we expect research and development expenses will increase as we seek to further develop and enhance our System One and related products.

 

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Distribution

Our distribution expenses and distribution as a percent of revenues for the three and six months ended June 30, 2012 and 2011 were as follows (in thousands, except percentages):

 

     Three Months Ended June 30,     Six Months Ended June 30,  
     2012     2011     2012     2011  

System One segment

   $ 3,949         10   $ 3,737         10   $ 7,951         10   $ 7,249         10

In-Center segment

     633         3     694         4     1,163         3     1,340         4
  

 

 

      

 

 

      

 

 

      

 

 

    

Total Distribution

   $ 4,582         8   $ 4,431         8   $ 9,114         8   $ 8,589         8
  

 

 

      

 

 

      

 

 

      

 

 

    

Distribution expenses increased $0.2 million, or 3%, and $0.5 million, or 6%, for the three and six months ended June 30, 2012 versus the prior year comparable periods, due to increased business volumes but remained consistent as a percentage of revenues. Distribution expenses for the System One segment remained consistent as a percentage of revenues. Distribution network efficiencies were offset by higher carrier rates. Distribution expenses for the In-Center segment decreased in absolute dollars and as a percentage of revenues primarily due to decreased costs associated with shipping certain of our products from our international manufacturing locations to our customers. We expect that distribution expenses will increase at a lower rate than revenues due to expected efficiencies gained from increased business volume and improved reliability of System One equipment. However, these favorable impacts may be offset by overall increases in fuel costs.

General and Administrative

Our general and administrative expenses and general and administrative expenses as a percent of revenues for the three and six months ended June 30, 2012 and 2011 were as follows (in thousands, except percentages):

 

     Three Months Ended June 30,     Six Months Ended June 30,  
     2012     2011     2012     2011  

General and administrative

   $ 6,930         12   $ 5,460         10   $ 13,552         12   $ 11,042         11

General and administrative expenses increased in absolute dollars $1.5 million, or 27%, and $2.5 million, or 23%, and as a percent of revenues for both the three and six months ended June 30, 2012 versus the prior year comparable periods. The increase in general and administrative expenses was primarily the result of increased professional services, personnel and other related infrastructure costs. While we expect that general and administrative expenses will decrease as a percentage of revenues over time as we continue to leverage our existing infrastructure, in the near term the level of these expenses may fluctuate as a percentage of revenues.

Other Expense

Interest expense increased $0.3 million, or 24%, and $0.3 million, or 14%, for the three and six months ended June 30, 2012 versus the prior year comparable periods. In May 2012, we repaid our term loan with Asahi through the issuance of shares of our common stock which resulted in the early recognition of approximately $1.0 million of unamortized debt discount during the second quarter of 2012 offset by a savings of one month of interest expense recognized during the quarter.

The change in other expense, net during both periods is derived primarily by foreign currency gains and losses.

Provision for Income Taxes

The provision for income taxes of $0.2 million for both the three months ended June 30, 2012 and 2011 and $0.5 million and $0.4 million for the six months ended June 30, 2012 and 2011, respectively, relates to the profitable operations of certain foreign entities.

Liquidity and Capital Resources

We have operated at a loss since our inception in 1998. As of June 30, 2012, our accumulated deficit was $340.0 million and we had cash and cash equivalents of $102.9 million, with nearly all of that cash located in the U.S., and working capital of $124.8 million.

Over the past several years, we have improved our cash flows from operating activities and continue to work towards our long term goal of sustained positive cash flows from operating activities. However, there can be no assurance that we will be able to continue to improve cash flows from operating activities or whether we will be able to generate positive cash flows from operating activities in the future. We believe, based on current projections and the current nature of our business, that we have the required resources to fund our ongoing operating requirements. Our ability to and the rate at which we continue to improve cash flows from operating activities will depend on many factors, including growing revenues, continued improvements in gross profit, leverage of our operating infrastructure and continued sale versus rental of a significant percentage of our System One equipment.

 

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Historically, our business was fairly capital intensive due to the manner in which we placed our System One equipment in the home market. However, over the past several years there has been an increase in the number of customers who choose to purchase rather than rent their System One equipment, which has been important to our historical cash flow improvements. Shifting our customers to an equipment purchase versus rental model allows us to recover the cost of our products upon initial sale rather than over an extended period of time, thereby reducing our working capital requirements. A majority of our home market customers have committed to purchase, rather than rent, the significant majority of their future System One equipment requirements. While a significant majority of patients use purchased rather than rented System One equipment, there can be no assurance that we will be able to continue to expand or sustain this level of equipment placements that are purchased rather than rented.

Another important factor that has affected our historical improvements in our cash flows is our effective management of our field equipment assets, including those rented by customers and our “service pool” equipment, which is equipment owned and maintained by us that is swapped for equipment owned or rented by our customers that needs repair or maintenance. Any excess equipment, unused equipment or material write-offs of equipment would negatively impact our working capital requirements.

We have a loan and security agreement with SVB for a $15.0 million revolving line of credit with an original maturity date of April 1, 2012. On May 7, 2012, we entered into an amendment to this agreement which extended the maturity date to March 31, 2014 and reduced the interest rate on borrowings to prime with a floor of 3.25%. Financial covenants and other terms remain essentially unchanged. The agreement, as amended, has certain financial covenants, contains certain customary events of default and is secured by all or substantially all of our assets. At June 30, 2012, we were in compliance with the covenants, there were no outstanding borrowings against the credit commitment, and we had $15.0 million of the credit commitment available for borrowing.

On May 4, 2012, we repaid in full all principal and interest in the aggregate amount of $45.2 million under our Term Loan and Security Agreement dated June 5, 2009 with Asahi through the issuance of 2,456,246 shares of our common stock, which after the retention by the Company of 28,351 shares for the payment of certain minimum withholding taxes, resulted in a net issuance to Asahi of 2,427,895 shares. As a result, the Term Loan and Security Agreement was terminated. The shares were issued pursuant to a Subscription, Sale and Purchase Agreement between us and Asahi dated May 4, 2012. In connection with the issuance of the shares, we entered into a Registration Rights Agreement with Asahi. Pursuant to the Registration Rights Agreement, subject to certain conditions, we were required to register these shares for resale under a registration statement filed with the SEC, which we have done, and to use commercially reasonable efforts to keep such registration statement continuously effective until such time as all of the shares have been publicly sold or may be sold pursuant to Rule 144 without restrictions, whichever is earlier. We issued the shares to Asahi in reliance on the exemption from the registration requirements of the Securities Act of 1933, as amended, set forth in Section 4(2) promulgated thereunder relative to sales by an issuer not involving any public offering.

We are constructing a new manufacturing facility in Germany pursuant to the terms of our Dialyzer Production Agreement entered into in May 2009 with Asahi. We are overseeing construction of this new facility and will operate the new facility under a manufacturing agreement upon its completion. Asahi will fund construction costs up to an original amount; however, we will be responsible for any additional costs. If the agreement is terminated during the construction period due to our breach, insolvency or bankruptcy, Asahi has the option to require us to pay for all amounts expended for construction of the new facility. If such event occurs we would take title to the land and any construction in process. Subsequent to the completion of construction, if the agreement is terminated due to our breach, insolvency or bankruptcy or by us pursuant to certain terms of the agreement, Asahi has the option to require us to purchase the new facility from them by paying one hundred percent of the then net book value of the new facility, as calculated in accordance with GAAP. Given these options and our involvement in the construction, we are considered the owner of the new facility for accounting purposes and will therefore record its cost as construction-in-process and a corresponding liability has been recorded for the construction cost funded by Asahi. The $12.6 million recorded in property and equipment and other long-term liabilities at June 30, 2012 reflects the construction costs incurred to date in connection with this project.

We maintain postemployment benefit plans for employees in certain foreign subsidiaries. The plans provide lump sum benefits, payable based on statutory regulations for voluntary or involuntary termination. Where required, we obtain an annual actuarial valuation of the benefit plans. We have recorded a liability of $1.7 million at June 30, 2012 for costs associated with these plans. The expense recorded in connection with these plans was not significant during 2012 or 2011.

 

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The following table sets forth the components of our cash flows for the periods indicated (in thousands):

 

     Six Months Ended June 30,  
         2012             2011      

Net cash provided by (used in) operating activities

   $ 886      $ (3,671

Net cash used in investing activities

     (3,953     (1,999

Net cash provided by financing activities

     3,134        1,334   

Foreign exchange effect on cash and cash equivalents

     (117     423   
  

 

 

   

 

 

 

Net cash flow

   $ (50   $ (3,913
  

 

 

   

 

 

 

Net cash provided by (used in) operating activities. Net cash provided by (used in) operating activities increased by $4.6 million during the six months ended June 30, 2012, versus the prior year comparable period. Net loss after adjustments for non-cash charges, such as depreciation, amortization and stock-based compensation expense, had a favorable impact on cash flows increasing to a positive $10.0 million during the six months ended June 30, 2012 versus a positive $8.3 million for the prior year comparable period. Additionally, working capital requirements decreased with lower inventory requirements and higher total liabilities relative to the prior year comparable period, including accrued expenses and other liabilities. We expect working capital to fluctuate from quarter to quarter due to various factors including inventory requirements and timing of payments from our customers and to our vendors. Deferred revenues decreased $1.3 million during the six months ended June 30, 2012 and increased $0.6 million during the six months ended June 30, 2011, reflecting an increase of $1.5 million of amortization of deferred revenues into revenues from $7.6 million during the six months ended June 30, 2011 to $9.1 million during the six months ended June 30, 2012 and lower sales of new home equipment during 2012 compared to 2011 as a result of the timing of patient additions, efficiencies in our customers’ utilization of purchased equipment and the conversion of rental equipment to sold equipment.

Non-cash transfers from inventory to field equipment for the placement of units with our customers decreased $3.4 million during the six months ended June 30, 2012 versus the prior year comparable period. Non-cash transfers from field equipment to deferred costs of revenues decreased $0.7 million during the six months ended June 30, 2012 versus the prior year comparable period. These activities fluctuate due to the timing of home patient additions, efficiencies in our customers’ utilization of purchased equipment and equipment levels required for our service pool.

Net cash used in investing activities. For each of the periods above, net cash used in investing activities reflected purchases of property and equipment, primarily for manufacturing operations and capital improvements for our facilities and research and development and information technology. The increase of $2.0 million in purchases of property and equipment was driven by capital improvements to and expansion of certain of our manufacturing facilities to accommodate the increased demand for our Streamline blood tubing sets and the transition of manufacturing of certain of our blood tubing sets from our contract manufacturer to our own manufacturing facility in Mexico and capital spending on our new corporate headquarters. A significant majority of the capital related to our new corporate headquarters was funded by our landlord through a $4.3 million tenant improvement allowance.

Net cash provided by financing activities. During the six months ended June 30, 2012 and 2011 we received $3.7 million and $3.9 million, respectively, of proceeds from stock option and stock purchase plans. Cash inflows during the six months ended June 30, 2012 were reduced by $0.5 million of cash used to repurchase shares of our common stock that were surrendered by Asahi in payment for the required minimum withholding taxes on the term loan and security agreement. Cash inflows during the six months ended June 30, 2011 were reduced by $2.5 million of cash used to repurchase shares of our common stock that were surrendered by employees in payment for the minimum required withholding taxes associated with awards under our annual Bonus and Performance Share Plans.

As discussed above, during the second quarter of 2012 we repaid all principal and interest under our Term Loan and Security Agreement with Asahi. Other than this repayment of our long-term debt obligations, significant contractual obligations at June 30, 2012 are consistent with those disclosed in Item 7, “Managements Discussion and Analysis of Financial Condition and Results of Operations,” in our Annual Report on Form 10-K for the year ended December 31, 2011.

Summary of Critical Accounting Policies and 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 GAAP. The preparation of these consolidated financial statements requires us to make significant estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. These items are regularly monitored and analyzed by management for changes in facts and circumstances, and material changes in these estimates could occur in the future. Changes in estimates are recorded in the period in which they become known. We base our estimates on historical experience and various other assumptions that we believe to be reasonable under the circumstances. Actual results may differ substantially from our estimates.

 

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The significant accounting policies used in preparation of these condensed consolidated financial statements for the three and six months ended June 30, 2012 are described in Note 2 to the consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2011 and updated as necessary in Note 2 to the condensed consolidated financial statements included in this quarterly report on Form 10-Q. The critical accounting policies and the significant judgments and estimates used in the preparation of our condensed consolidated financial statements for the three and six months ended June 30, 2012 are consistent with those described Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” in our Annual Report on Form 10-K for the year ended December 31, 2011.

Recent Accounting Pronouncements

A discussion of recent accounting pronouncements is included in Note 2 to the consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2011 and updated as necessary in Note 2 to the condensed consolidated financial statements included in this quarterly report on Form 10-Q.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

We are subject to market risks in the normal course of our business, including changes in interest rates and exchange rates. A discussion of market risk affecting us is included in Item 7A, “Quantitative and Qualitative Disclosures About Market Risk,” of our Annual Report on Form 10-K for the year ended December 31, 2011 and have been updated as necessary below.

Foreign Currency Exchange Risk

All of our revenues and a majority of our expenses are denominated in U.S. dollars. However, we operate a manufacturing and research facility in Germany, a manufacturing and service facility in Mexico and a manufacturing facility in Italy and we purchase materials for those facilities and pay our employees at those facilities in Euros and Pesos. In addition, we purchase products for resale in the U.S. from foreign companies and have agreed to pay them in currencies other than the U.S. dollar, including the Euro and the Thai Baht. As such, we are potentially exposed to adverse as well as beneficial movements in foreign currency exchange rates. During the first quarter of 2012, we began entering into foreign exchange forward contracts to minimize the impact of foreign currency exchange rate fluctuations on Peso denominated expenses. These contracts are entered into with large financial institutions and have a duration of up to twelve months. These contracts are designated as cash flow hedges and are carried on our balance sheet at fair value, with the effective portion of the contracts’ gains or losses included in cost of revenues in the same period as the related hedged item is recognized. As of June 30, 2012, the notional amount of our outstanding contracts that are designated as cash flow hedges was approximately $9.4 million. Based on our analysis, a hypothetical adverse foreign exchange rate movement of 10 percent against our contracts would have resulted in a net loss in fair value of these contracts of approximately $1.0 million.

In addition, we are exposed to foreign currency exchange risk related to certain foreign currency denominated receivable and payable balances. We utilize natural hedges to mitigate this exposure.

Item 4. Controls and Procedures

Our management, with the participation of our chief executive officer and chief financial officer, evaluated the effectiveness of our disclosure controls and procedures as of June 30, 2012. The term “disclosure controls and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, or the Exchange Act, means controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company’s management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure. Our management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on the evaluation of our disclosure controls and procedures as of June 30, 2012, our chief executive officer and chief financial officer concluded that, as of such date, our disclosure controls and procedures were effective to achieve their stated purpose.

No change in our internal control over financial reporting (as defined in Rule 13a-15(f) and 15d-15(f) under the Exchange Act) occurred during the three months ended June 30, 2012 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

 

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PART II - OTHER INFORMATION

Item 1A. Risk Factors

In addition to the factors discussed in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and elsewhere in this report, the following are some of the important risk factors that could cause our actual results to differ materially from those projected in any forward-looking statements.

Risks Related to our Business

We expect to derive a significant percentage of our future revenues from the sale or rental of our System One and the related products used with the System One and a limited number of other products.

Since our inception, we have devoted a substantial amount of our efforts to the development of the System One and the related products used with the System One. We commenced marketing the System One and the related disposable products to the critical care market in February 2003. We commenced marketing the System One for chronic hemodialysis treatment in September 2004. Prior to the Medisystems Acquisition, on October 1, 2007, nearly 100% of our revenues were derived from the rental or sale of our System One and the sale of related disposables. Although the Medisystems Acquisition broadened our product offerings, we expect that in 2012 and in the foreseeable future, we are likely to derive a significant percentage of our revenues from the System One, and that we will derive the remainder of our revenues from the sale of a few key disposable products, including blood tubing sets and needles. To the extent that any of our primary products are not commercially successful or are withdrawn from the market for any reason, our revenues will be adversely impacted, and we do not have other significant products in development that could readily replace these revenues.

We cannot accurately predict the size of the home hemodialysis market, and it may be smaller, and may develop more slowly than we expect.

We believe our largest future product market opportunity is the home hemodialysis market. However, this market is presently very small and adoption of the home hemodialysis treatment options has been limited. The most widely adopted form of dialysis therapy used in a setting other than a dialysis clinic is peritoneal dialysis. Based on the most recently available data from the U.S. Renal Data System, or USRDS, less than 10% of U.S. ESRD dialysis patients receive some form of dialysis treatment at home with either peritoneal dialysis or home hemodialysis. Because the adoption of home hemodialysis has been limited to date, the number of patients and their partners who desire to, and are capable of, administering hemodialysis treatment with a system such as the System One is unknown and there is limited data upon which to make estimates. In addition, many dialysis clinics do not presently have the infrastructure in place to support home hemodialysis and most do not have the infrastructure in place to support a significant home hemodialysis patient population. Our long-term growth will depend on the number of patients who adopt home hemodialysis and how quickly they adopt it, which in turn is driven by the number of physicians willing to prescribe home hemodialysis and the number of dialysis clinics able or willing to establish and support home hemodialysis therapies.

Because nearly all our home hemodialysis patients are also receiving more frequent dialysis, meaning dialysis delivered five or more times a week, the market adoption of our System One for home hemodialysis is also dependent upon the penetration and market acceptance of more frequent hemodialysis. Given the increased provider costs associated with providing more frequent dialysis versus conventional three-times per week dialysis, market acceptance will be impacted, especially for U.S. Medicare patients, by whether dialysis clinics are able to obtain reimbursement for additional dialysis treatments provided in excess of three times a week. A recent study presented by the University of Michigan Kidney Epidemiology and Cost Center (UM-KECC) at the 2011 American Society of Nephrology meeting showed that in 2009 the average number of Medicare payments per month for home hemodialysis was approximately 1.5 times that of in-center hemodialysis (17.3 vs. 11.6, respectively). The total number of treatments paid varied across Medicare Administrative Contractors and Fiscal Intermediaries. There was a positive correlation between number of paid treatments per month and home hemodialysis utilization in a given jurisdiction. However, some customers may not receive or pursue additional reimbursement in all cases and providing medical justification for treatments beyond three times per week increases administrative burden. Although access to home daily hemodialysis continues to grow, we believe that current Medicare reimbursement leads to adoption rates lower than rates commensurate with the percentage of patients experts believe can perform and medically benefit from this therapy. We believe that more predictable Medicare reimbursement with less administrative burden would allow adoption of more frequent home hemodialysis at rates more consistent with what are deemed to be appropriate by the expert medical community.

New regulations particularly impacting home hemodialysis technologies can also negatively impact the rate and extent of any further market expansion of our System One for home hemodialysis. We saw the impact of such regulations in 2008, when the Centers for Medicare and Medicaid Services, or CMS, released new Conditions for Coverage applicable to our customers. These Conditions for Coverage impose water testing requirements on our patients using our PureFlow SL product. These water testing requirements increase the burden of our therapy for our patients and may impair market adoption, especially for our PureFlow SL product. To the extent additional regulations are introduced unique to the home environment, market adoption could be even further impaired.

 

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We are in a developing market and we will need to continue to devote significant resources to developing the home market. We cannot be certain that this market will develop, how quickly it will develop or how large it will be.

Current Medicare reimbursement rates, at three times per week, limit the price at which we can market our home products, and adverse changes to reimbursement would likely negatively affect the adoption or continued sale of our home products.

As a result of legislation passed by the U.S. Congress more than 30 years ago, Medicare provides broad and well-established reimbursement in the U.S. for ESRD. On August 12, 2010, CMS published the final rule for implementation of the new prospective payment system for dialysis treatment effective January 1, 2011. Under this new ESRD prospective payment system, CMS makes a single bundled payment to the dialysis facility for each dialysis treatment that covers all renal dialysis services and home dialysis and includes certain drugs (including erythropoiesis stimulating agents, or ESAs, iron, and Vitamin D). It has replaced the former system which paid facilities a composite rate for a defined set of items and services, while paying separately for drugs, laboratory tests, or other services that were not included in the composite rate. With a vast majority of U.S. ESRD patients covered by Medicare, the reimbursement rate is an important factor in a potential customer's decision to use the System One or our other products and limits the fee for which we can sell or rent our products. Additionally, current CMS rules limit the number of hemodialysis treatments paid for by Medicare to three times a week, unless there is medical justification provided by the dialysis facility based on information from the patient's physician for additional treatments. Most patients using the System One in the home treat themselves, with the help of a partner, up to six times per week. To the extent that Medicare contractors elect not to pay for additional treatments, adoption of the System One would likely be impaired. The determination of medical justification must be made at the local Medicare contractor level pursuant to local coverage determinations or on a case-by-case basis, based on documentation provided by our customers. If daily therapy is prescribed, a clinic's decision as to how much it is willing to spend on dialysis equipment and services will be at least partly dependent on whether Medicare will reimburse more than three treatments per week for the clinic's patients. Medicare is switching from intermediaries to Medicare administrative contractors and is further consolidating the jurisdictions covered by those contractors. This change in the reviewing entity for Medicare claims could lead to a change in whether a customer receives Medicare reimbursement for additional treatments. If an adverse change to historical payment practices occurs, market adoption of our System One in the home market may be impaired. Based on an analysis of historical Medicare payment files by the UM-KECC, those delivering more frequent dialysis at home receive reimbursement, on average, for 1.5 times the number of treatments per month versus conventional dialysis, although this amount varies by jurisdiction. This variance arises from Medicare Administrative Contractor/Fiscal Intermediary policies, as well as from varying center billing practices. Currently, only 3 of the Medicare Administrative Contractors have formal Local Coverage Determinations (LCDs); the majority do not have a formal policy and thus review claims on a case-by-case basis. As there is no consistent national standard for obtaining medical justification a clinic's decision as to how much it is willing to spend on home daily dialysis equipment and services will be at least partly dependent on the level of confidence the center has in the predictability of receiving reimbursement from Medicare for additional treatments per week based on submitted claims for medical justification. Although access to home daily hemodialysis continues to grow, we believe that current Medicare reimbursement leads to adoption rates lower than rates commensurate with the percentage of patients experts believe can perform and medically benefit from this therapy. We believe more predictable Medicare reimbursement with less administrative burden would allow adoption of more frequent home hemodialysis at rates more consistent with what are deemed to be appropriate by the expert medical community.

CMS is expected to expand the prospective payment system's single bundled payment to include oral medications in 2014. Although a stated goal of the prospective payment system is to encourage home dialysis, it has not had a significant impact on the adoption of home and/or daily hemodialysis or the price for which we can sell our products and barring any modifications, we would not expect it to have a significant impact in the future.

We have limited operating experience, a history of net losses and an accumulated deficit of $340.0 million at June 30, 2012. We cannot guarantee if, when and the extent to which we will become profitable, or that we will be able to maintain profitability if it is achieved.

Since inception, we have incurred negative operating margins and losses every quarter. At June 30, 2012, we had an accumulated deficit of approximately $340.0 million. We expect our operating expenses to continue to increase as we grow our business. While we have achieved positive gross profit for our products, in aggregate, since the fourth quarter of 2007, we cannot provide assurance that our gross profit as a percentage of revenues will improve or, if they do improve, the rate at which they will improve. We cannot provide assurance that we will achieve profitability, when we will become profitable, the sustainability of profitability, should it occur, or the extent to which we will be profitable.

 

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Our customers in the System One and In-Center segments are highly consolidated, with concentrated buying power.

Fresenius and DaVita own and operate the two largest chains of dialysis clinics in the U.S. Collectively, these entities provide treatment to over two-thirds of U.S. dialysis patients; and this percentage may continue to grow with further market consolidation. DaVita, for example, announced that it completed the acquisition of DSI Renal, Inc. More recently, Fresenius finalized their purchase of Liberty Dialysis Holdings, Inc., the holding company for Liberty Dialysis and Renal Advantage. With less than one-third of U.S. dialysis patients cared for by independent dialysis clinics, our market adoption, at least within the U.S., would be more constrained without the presence of both DaVita and Fresenius as customers.

Additionally, Fresenius is not only a dialysis service provider, it is also the leading manufacturer of dialysis equipment worldwide. In February 2011, Fresenius obtained clearance for its 2008K At Home hemodialysis system for use in home chronic therapy. DaVita does not manufacture dialysis equipment, but has certain dialysis supply purchase obligations to Gambro, a dialysis equipment manufacturer, under a long-term preferred supplier agreement. Fresenius may choose to offer its dialysis patients only the dialysis equipment Fresenius manufactures, including its 2008K system. DaVita may choose to offer their dialysis patients the equipment it contractually agreed to offer in its agreement with Gambro. Fresenius and DaVita may also choose to otherwise limit access to the equipment manufactured by competitors. DaVita is our most significant customer, and we expect it to continue to be, at least for the foreseeable future. Fresenius is also our second largest customer in the System One segment. Our agreements with DaVita, Fresenius and other large home market customers are intended to support the continued expansion of patient access to home hemodialysis with the System One, but like all our agreements with home market customers, our agreements with DaVita, Fresenius and other large customers are not requirements contracts and they contain no minimum purchase volumes. Our Amended and Restated National Service Provider Agreement with DaVita expires in mid 2013, which term will be automatically extended month to month thereafter. Our agreement with Fresenius expires at the end of 2012, but may be automatically extended for an additional year if neither party provides advance notice of its desire to have the agreement terminate. We have no assurance that our sales to DaVita, Fresenius or other large customers will continue to grow, and we cannot predict what impact Fresenius' 2008K system will have on our sales to Fresenius in the home market or our overall performance in the home market going forward. Given the significance of DaVita and Fresenius as customers in the home market, any adverse change in either customer's ordering or clinical practices, as might be the case in periodic contract negotiations, would have a significant adverse impact on our home market revenues, especially in the near term.

DaVita is a key customer for our System One and In-Center product lines. The partial or complete loss of DaVita as a customer would materially impair our financial results, at least in the near term.

DaVita is our most significant customer. Sales through distributors to DaVita of products accounted for approximately half of In-Center segment revenues for both the three and six months ended June 30, 2012 and 2011. Direct sales to DaVita represented 30% and 31% of our System One segment revenues for the three months ended June 30, 2012 and 2011, respectively, and 30% and 31% of our System One segment revenues for the six months ended June 30, 2012 and 2011, respectively. Further, DaVita is our largest customer in the home market, constituting over 40% of our home hemodialysis patients. Although we expect that DaVita will continue to be a significant customer in the home market, we cannot be certain that DaVita will continue to purchase and/or rent the System One or add additional System One patients in the future. Our Amended and Restated National Service Provider Agreement with DaVita expires in mid 2013, which term will be automatically extended on a month to month basis thereafter. Our contract for needles with DaVita, expiring in January 2013, includes certain minimum order requirements; however, these can be reduced significantly under certain circumstances. Our contract for blood tubing sets with DaVita expired in September 2009. However, in June 2009, we entered into a five year distribution agreement in the U.S. with Gambro, pursuant to which Gambro will exclusively supply our blood tubing sets to DaVita. The partial or complete loss of DaVita as a customer for any of these product lines would adversely affect our business, at least in the near term.

We face additional risks from the acquisition or development of new lines of business, including in connection with the potential development of centers of excellence focused on the provision of home hemodialysis services.

In connection with our evaluation of strategic alternatives for the Company, it is possible that we may in the future acquire or develop a new line of business or products. The Company made such a strategic acquisition in connection with its acquisition of Medisystems Corporation in 2007. More recently, the Company announced that it was considering forming a limited number of centers of excellence; dialysis clinics focused on the provision of home hemodialysis services. There are substantial risks and uncertainties associated with any change in business lines or strategy, particularly in instances where our customers may perceive the new activity or business line to be in direct competition with their business. In addition to the external risks any such new businesses or strategies may represent, the Company may face internal risks relating to developing knowledge of and experience in the new business, recruiting professionals, as well as business execution risks. New strategies and businesses may also require significant investment and involvement of our senior management, which will take away from the time they ordinarily spend on the remainder of our business. Failure to manage these risks in the development and implementation of new businesses or strategies successfully could materially and adversely affect our business, results of operations and financial condition.

 

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We have a Loan and Security Agreement with Silicon Valley Bank, or SVB the terms of which may restrict our current and future operations, which could affect our ability to respond to changes in our business and to manage our operations.

We have an agreement with SVB for a $15.0 million revolving line of credit with a maturity date of March 31, 2014. The agreement is secured by all or substantially all of our assets. Borrowings under the agreement bear interest at prime with a floor of 3.25%. Pursuant to the agreement, we are subject to certain financial covenants relating to liquidity requirements and adjusted EBITDA. The agreement contains events of default customary for transactions of this type, including nonpayment, misrepresentation, breach of covenants, material adverse effect and bankruptcy.

As of the date hereof, we do not have an outstanding balance under the revolving line of credit. However, were we to draw on the line of credit, in the event we fail to satisfy our covenants, or otherwise go into default, SVB has a number of remedies, including sale of our assets and acceleration of all outstanding indebtedness. Certain of these remedies would likely have a material adverse effect on our business.

We compete against other dialysis equipment manufacturers with much greater financial resources and established products and customer relationships, which may make it difficult for us to penetrate the market and achieve significant sales of our products. Our competitors may also introduce new products or features that could impair the competitiveness of our own product portfolio.

Our System One in the critical care market competes against Gambro, Fresenius, B. Braun and others. Our System One in the home market is currently the only portable system specifically indicated for use in the home market in the U.S. However, in February 2011, Fresenius, our second largest customer in the System One segment, with nearly all of those sales in the home market, obtained clearance for its 2008K At Home hemodialysis system for use in home chronic therapy. Our product lines in the in-center market compete directly against products produced by Fresenius, Gambro, Nipro, B. Braun, Baxter, JMS CO., LTD and others. Our competitors each market one or more FDA-cleared medical devices for the treatment of acute or chronic kidney failure. Each of these competitors offers products that have been in use for a longer time than our System One and are more widely recognized by physicians, patients and providers. These competitors have significantly more financial and human resources, more established sales, service and customer support infrastructures and spend more on product development and marketing than we do. Many of our competitors also have established relationships with the providers of dialysis therapy and, Fresenius owns and operates a chain of dialysis clinics. The product lines of most of these companies are broader than ours, enabling them to offer a broader bundle of products and have established sales forces and distribution channels that may afford them a significant competitive advantage.

The market for our products is competitive, subject to change and affected by new product introductions and other market activities of industry participants, including increased consolidation of ownership of clinics by large dialysis chains. If we are successful, our competitors are likely to develop products that offer features and functionality similar to our products, including our System One. Improvements in existing competitive products or the introduction of new competitive products may make it more difficult for us to compete for sales, particularly if those competitive products demonstrate better reliability, convenience or effectiveness or are offered at lower prices.

Also, Fresenius has commented that it expects to bring its Portable Artificial Kidney (“PAK”) to market in the U.S. for use in the home in 2013. In addition to Fresenius, Baxter has a research and development collaboration with DEKA Research and Development Corporation and HHD, LLC, or DEKA, for the development of a new home hemodialysis system. Baxter has commented that they have started one of the clinical studies intended to support FDA clearance of this system. Baxter has indicated that it hopes to obtain regulatory approval for DEKA's system in Europe in 2013 and to file for regulatory approval in the U.S. in 2014. Other small companies are also working to develop products for this market. We are unable to predict when, if ever, any of these products may attain regulatory clearance and appear in the market, or how successful they may be should they be introduced, but if additional viable products are introduced to the market, it could adversely affect our sales and growth. We also are unable to predict what impact the Fresenius home hemodialysis systems will have on our sales to Fresenius or our overall home market performance. Our ability to successfully market our products could also be adversely affected by pharmacological and technological advances in preventing the progression of ESRD and/or in the treatment of acute kidney failure or fluid overload. If we are unable to compete effectively against existing and future competitors and existing and future alternative treatments and pharmacological and technological advances, it will be difficult for us to penetrate the market and achieve significant sales of our products.

Our continued growth is dependent on our development and successful commercialization of new and improved products.

Our future success will depend in part on our timely development and introduction of new and improved products that address changing market requirements. To the extent that we fail to introduce new and innovative products, including without limitation the next generation System One, or incremental product improvements, we may lose revenues or market share to our competitors, which may be difficult to regain. Our inability, for technological, regulatory or other reasons, to successfully

 

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develop and introduce new or improved products could reduce our growth rate or otherwise damage our business. We cannot assure you that our developments will keep pace with the marketplace or that our new or improved products will adequately meet the requirements of the marketplace.

The success and growth of our business will depend upon our ability to achieve expanded market acceptance of our System One.

In the home market, we have to convince five distinct constituencies involved in the choice of dialysis therapy, namely operators of dialysis clinics, nephrologists, dialysis nurses, patients and payors (private payors and Medicare), that the System One provides an effective alternative to other existing dialysis equipment. In the in-center market, we have to convince all of these constituencies, but to a lesser degree, patients, that our blood tubing sets and needles provide an effective alternative to other dialysis disposables. In the critical care market, we have to convince hospital purchasing groups, hospitals, nephrologists, dialysis nurses and critical care nurses that our system provides an effective alternative to other existing dialysis equipment. Each of these constituencies use different considerations in reaching their decision. Lack of acceptance by any of these constituencies will make it difficult for us to grow our business. We may have difficulty gaining widespread or rapid acceptance of any of our products, including the System One, for a number of reasons including:

 

   

the failure by us to demonstrate to operators of dialysis clinics, hospitals, nephrologists, dialysis nurses, patients and others that our products are equivalent or superior to existing therapy options;

 

   

competition from products sold by companies with longer operating histories and greater financial resources, more recognizable brand names and better established distribution networks and relationships with hospitals or dialysis clinics;

 

   

the failure by us to continue to improve product reliability and the ease of use of our products;

 

   

limitations on the existing infrastructure in place to support home hemodialysis, including without limitation, home hemodialysis training nurses, and the willingness, cost associated with, and ability of dialysis clinics to build that infrastructure;

 

   

the ownership and operation of some dialysis providers by companies that also manufacture and sell competitive dialysis products;

 

   

the introduction of competing products or treatments that may be more effective, easier to use or less expensive than ours;

 

   

regulations that impose additional burden on patients and their caregivers, such as the Medicare conditions for coverage which impose additional water testing requirements in connection with the use of our PureFlow SL;

 

   

the number of patients willing and able to perform therapy independently, outside of a traditional dialysis clinic, may be smaller than we estimate; and

 

   

the availability of satisfactory reimbursement from healthcare payors.

If we are unable to convince additional hospitals and healthcare providers of the benefits of our products for the treatment of acute kidney failure and fluid overload, we will not be successful in increasing our market share in the critical care market.

We sell the System One in the critical care market for use in the treatment of acute kidney failure and fluid overload. Physicians currently treat most acute kidney failure patients using conventional hemodialysis systems or dialysis systems designed specifically for use in the intensive care unit, or ICU. We will need to convince hospitals and healthcare providers that using the System One is as effective as using conventional hemodialysis systems or ICU-specific dialysis systems for treating acute kidney failure or fluid overload and that it provides advantages over conventional systems or other ICU-specific systems because of its significantly smaller size, ease of operation and clinical flexibility. In addition, the impact of tightened credit markets on hospitals could impair the manner in which we sell products in the critical care market. Hospitals facing pressure to reduce capital spending may choose to delay capital equipment purchases or seek alternative financing options.

Our business and results of operations may be negatively impacted by general economic and financial market conditions and such conditions may increase other risks that affect our business.

Global macro-economic conditions and the world's financial markets continue to experience some degree of turmoil, resulting in reductions in available credit, foreign currency fluctuations and volatility in the valuations of securities generally. In general, we believe demand for our products in the home and in-center market will not be substantially affected by the changing market conditions as regular dialysis is a life-sustaining, non-elective therapy. However, there is no assurance that future economic changes or global uncertainties would not negatively impact our business, especially the manner and pace in which we sell equipment in the System One segment or delay equipment placements. Hospitals or clinics facing pressure to reduce capital spending may choose to rent equipment rather than purchase it outright, or to enter into other less-capital

 

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intensive purchase structures with us, which may, in turn, have a negative impact on our cash flows. Our ability to sell products internationally is particularly vulnerable to adverse impacts from global macro economic conditions. Government funded hospitals in various international markets may seek to defer capital purchases or tenders. Distributors with reduced access to capital may be less willing to purchase our equipment outright, impairing our ability to sell our products. Further, unfavorable changes in foreign exchange rates versus the U.S. dollar would increase our product costs which would negatively impact our gross profit and gross profit as a percentage of revenues.

The non-cash discounts we have offered to DaVita may lead to reductions in our future net revenues that will fluctuate because the amount of the discount is based upon the number of warrants earned and our stock price.

Under our July 22, 2010 agreement with DaVita, we offered DaVita the opportunity to earn pricing discounts based upon the achievement of System One home patient growth targets at June 30, 2011, 2012 and 2013.

In order to conserve our cash, the pricing discount was structured to be paid as a warrant, in lieu of cash. The Amended Agreement provides for a range of warrant levels that may be earned based on DaVita and NxStage System One home patient targets. Under this tiered structure, DaVita was required to grow its net patients on the NxStage System One at a compounded annual growth rate of approximately 20 percent from the level at the time of entering into the agreement in order to obtain any discount, while achieving the highest discount would require a significant increase above that. If all tiers of discounts are achieved, the Amended Agreement provides that DaVita may earn warrants to purchase up to 5.5 million shares of our common stock. Approximately 5% of the 5.5 million warrants were earned based on the achievement of certain performance targets at June 30, 2011 and no warrants were earned during the performance period ended June 30, 2012. As of June 30, 2012, 30% of the warrants have expired, unearned. While DaVita continues to grow, it is unlikely that they will achieve the level of performance needed to earn the remaining outstanding warrants. The warrants have an exercise price of $14.22 per share, which is equal to the trailing fifteen day volume weighted average price of a share of NxStage Common Stock on the NASDAQ Global Market as of the close of business on July 21, 2010, the day prior to entering into our agreement, and are non-transferable and must be exercised in cash. The discount associated with these warrants will be measured at fair value through the date of vesting using a Black-Scholes option pricing model, and is being recognized as a reduction of revenues over the same period as the related product revenues (between seven to ten years) based on the number of warrants expected to vest. The reduction of revenues recorded in connection with these warrants has not been significant. However, there can be no assurance that the value of the discount, and, therefore, the amount of reduction of revenues recorded, will not be higher in the future based upon the level of warrants DaVita actually earns under the agreement, as well as the price of our stock on the date the warrants vest. Should our stock price increase above its current price, the amount of the discount would be increased.

Healthcare reform legislation could adversely affect our revenue and financial condition.

In recent years, there have been numerous initiatives on the federal and state levels, and in foreign countries, for comprehensive reforms affecting the payment for, the availability of and reimbursement for healthcare services in the United States and other countries. These initiatives have ranged from proposals to fundamentally change federal and state healthcare reimbursement programs, including providing comprehensive healthcare coverage to the public under governmental funded programs, to minor modifications to existing programs.

In March 2010, the U.S. Congress adopted and President Obama signed into law comprehensive health care reform legislation through the passage of the Patient Protection and Affordable Care Act (Pub. L. No. 111-148) and the Health Care and Education Reconciliation Act of 2010 (Pub. L. No. 111-152). Among other initiatives, these laws impose a 2.3% excise tax on domestic sales of certain medical devices after December 31, 2012. This legislation also applies a productivity adjustment to the Medicare payment rates for dialysis facilities that could cause variable annual decreases in annual adjustments to payment rates as of 2012. Our profitability will be impacted beginning 2013 due to the 2.3% medical device excise which will be assessed on nearly all of our products sold in the U.S. The productivity adjustments may impact our revenues when the amount of the adjustments is announced, however, we cannot predict with any certainty the effect such legislation will have on us. If significant reforms are made to the healthcare system in the U.S., or in other jurisdictions, those reforms may have a material adverse effect on our financial condition and results of operations.

The governments of foreign countries are actively pursuing similar actions intended to reduce costs related to provision of healthcare. The results of these actions may also have a material adverse effect on our financial condition and results of operations.

As our business continues to grow, we may have difficulty managing our growth and expanding our operations successfully.

As our business continues to grow, we will need to expand our manufacturing, sales and marketing and on-going development capabilities or contract with other organizations to provide these capabilities for us. As our operations expand, we expect that we will need to manage additional relationships with various partners, suppliers, manufacturers and other organizations. Our ability to manage our operations and growth requires us to continue to improve our information technology infrastructure, operational, financial and management controls and reporting systems and procedures. Such growth could place

 

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a strain on our administrative and operational infrastructure. We may not be able to make improvements to our management information and control systems in an efficient or timely manner and may discover deficiencies in existing systems and controls. Also, if demand for our products continues to grow, and as we continue to consolidate manufacturing operations into our Tijuana, Mexico facility, we may not be able to increase our manufacturing capacity at that facility fast enough to meet customer demand.

If we are unable to maintain strong product reliability for our products, our ability to maintain or grow our business and achieve profitability could be impaired. Transition of supply or manufacturing locations of products can also lead to product quality and reliability issues which could impair our ability to maintain or grow our business and achieve profitability.

Product reliability issues associated with any of our product lines could lead to decreases in customer satisfaction and our ability to grow or maintain our revenues and could negatively impact our reputation. Further, any unfavorable changes in product reliability would result in increased service and distribution costs which negatively impacts our gross profit and operating profit and increases our working capital requirements. We continue to work to maintain strong product reliability for all products. If we are unable to maintain strong product reliability for our existing products, our ability to achieve our growth objectives as well as profitability could be significantly impaired.

We also need to establish strong product reliability for all new products we offer. With new products, we are more exposed to risks relating to product quality and reliability until the manufacturing processes for these new products mature. We also choose from time to time to transition the manufacturing and supply of products and components to different suppliers or locations. As we make these changes, we are more exposed to risks relating to product quality and reliability until the manufacturing processes mature. In May 2011, we agreed not to renew our supply and distribution agreement with Kawasumi, and we are currently working to consolidate our bloodline supply in our manufacturing facility in Mexico in order to achieve long term margin improvements, and other efficiencies. We also decided not to renew our agreement with Entrada and we are currently working to transition the activities at our Fresnillo facility to our facility in Tijuana. These transitions could expose us to product quality and reliability issues. Like all transitions of this nature, they could also lead us to incur additional costs in the short term, which would negatively impact our gross profits in the short term.

We have a significant amount of System One field equipment, and our inability to effectively manage this asset could negatively impact our working capital requirements and future profitability.

Because our home market relies upon an equipment service swap model and, for some of our customers, an equipment rental model, our ability to manage System One equipment is important to minimizing our working capital requirements. Both factors require that we maintain a significant level of field equipment of our System One and PureFlow SL hardware. In addition, our gross margins may be negatively impacted if we have excess equipment deployed, and unused, in the field. If we are unable to successfully track, service and redeploy equipment, we could (1) incur increased costs, (2) realize increased cash requirements and/or (3) have material write-offs of equipment. This would negatively impact our working capital requirements and future profitability.

If kidney transplantation becomes a viable treatment option for more patients with ESRD, or if medical or other solutions for renal replacement become viable, the market for our products may be limited.

While kidney transplantation is the treatment of choice for most ESRD patients, it is not currently a viable treatment for most patients due to the limited number of donor kidneys, the high incidence of kidney transplant rejection and the higher surgical risk associated with older ESRD patients. According to USRDS data, in 2008, approximately 17,700 patients received kidney transplants in the U.S. The development of new medications designed to reduce the incidence of kidney transplant rejection, progress in using kidneys harvested from genetically engineered animals as a source of transplants or any other advances in kidney transplantation could limit the market for our products. The development of viable medical, pharmaceutical, or other solutions for renal replacement or prolonging kidney life may also limit the market for our products.

We are currently party to litigation and could be subject to additional litigation claims from time to time.

On February 28, 2012 a civil complaint was filed against us in the US District Court for the District of Massachusetts by Gambro Renal Products, Inc., or Gambro (Case No. 1:12cv 10370-PBS). The complaint alleges that we violated Section 43(a) of the Lanham Act, 15 U.S.C. § 1125(a) and Massachusetts General Laws Chapter 93A by making false and misleading statements about our and Gambro's allegedly competing products in the critical care market in commercial and promotional activities. The complaint also alleges that we wrongfully interfered with contractual and advantageous relationships of Gambro's critical care business. Gambro seeks compensatory and treble damages, disgorgement of profits and injunctive relief. We believe the suit is without merit and intend to defend the claim vigorously.

From time to time, we are also threatened with individual actions involving our business, including without limitation, products liability claims. If any of our employees or products is found to have caused or contributed to injuries or deaths, we could be held liable for substantial damages. There are no active claims against us, except for the Gambro litigation. However, there can be no assurance that no additional claims may be filed against us in the future.

 

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Any claims made against us could adversely affect our reputation, which could damage our position in the market. While we maintain insurance, including products and general liability insurance, claims may be brought against us that could result in court judgments or settlements in amounts that are in excess of the limits of our insurance coverage. In addition, our insurance policies have various exclusions, and we may be subject to a claim for which we have no coverage. We will have to pay any amounts awarded by a court or negotiated in a settlement that exceed our coverage limitations or that are not covered by any insurance. Claims can also be time consuming, distracting, and expensive to defend and could result in a diversion of management and financial resources away from our primary business, in which case our business may suffer.

We maintain insurance at levels deemed adequate by management; however, future claims could exceed our applicable insurance coverage.

We maintain insurance for property and general liability, directors' and officers' liability, product liability, workers compensation, and other coverage in amounts and on terms deemed adequate by management based on our expectations for future claims. Future claims could, however, exceed our applicable insurance coverage, or our coverage could not cover the applicable claims.

We face risks associated with having international manufacturing operations, and if we are unable to manage these risks effectively, our business could suffer.

We operate manufacturing facilities in Germany, Italy and Mexico. We also purchase components, products and supplies from foreign vendors. We are subject to a number of risks and challenges that specifically relate to these international operations, and we may not be successful if we are unable to meet and overcome these challenges. Significant among these risks are risks relating to foreign currency, in particular the Euro, Peso and Thai Baht. We did not hedge our foreign currency transactions during 2011, 2010 or 2009 but are engaging in hedging transactions in 2012. To the extent we fail to control our exchange rate risk, our gross profit as a percentage of revenues and profitability could suffer and our ability to maintain mutually beneficial and profitable relationships with foreign vendors could be impaired. In addition to these risks, through our international operations, we are exposed to costs and challenges associated with sourcing and shipping goods internationally and importing and exporting goods, difficulty managing operations in multiple locations, local regulations that may restrict or impair our ability to conduct our operations and increased compliance costs, health issues, such as pandemic disease risk, and natural disasters, such as flooding, hurricanes and earthquakes, which could disrupt our manufacturing and logistical and import activities. For example, the earthquakes experienced in northern Italy during the second quarter of 2012 resulted in the temporary suspension of manufacturing within our facility in Italy. Since that time, we have made both repairs and improvements at this facility and were fully operational by the end of the second quarter 2012. Although we believe that supply to our customers has not been interrupted, there is no guarantee that we will not experience any future interruption in our ability to supply product at any of our facilities or third party facilities, or that any such interruptions will not increase our product costs or impair our product quality or reliability, at least in the near term. Furthermore, in certain locations, such as Mexico, we are also exposed to risks associated with local instability, including threats of increased violence, which could lead to disruptions in supply at our manufacturing facilities or key vendors.

We obtain some of our raw materials, components and finished goods from a single source or a limited group of suppliers. We also obtain sterilization services from a single supplier. We also manufacture certain of our products at only one manufacturing facility. The partial or complete loss of one of these suppliers could cause significant production delays, an inability to meet customer demand, and a substantial loss in revenues.

We depend upon a number of single-source suppliers for certain of raw materials and components as well as finished goods and sterilization services. Two of our most critical single-source supply relationships are with Membrana and Kawasumi. Our dependence upon these and other single-source suppliers of raw materials, components, finished goods and sterilization services, as well as our dependence on our manufacturing facilities, exposes us to several risks, including disruptions in supply, price increases, late deliveries, and an inability to meet customer demand. This could lead to customer dissatisfaction, damage to our reputation, or customers switching to competitive products. Any interruption in supply could be particularly damaging to our customers using the System One to treat chronic ESRD and who need access to the System One and related disposables to continue their therapy.

Finding alternative sources for these raw materials, components, finished goods and sterilization services would be difficult and in many cases entail a significant amount of time, disruption and cost. Although we believe our supply chain has sufficient inventory of raw materials, components and finished goods to withstand a temporary disruption in supply from any single source supplier or manufacturing location, any permanent or long term disruption in supply from any single source supplier or manufacturing location could lead to supply delays or interruptions which would damage our business, at least in the near term.

 

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Membrana is our sole supplier of the fiber used in our filters for System One products. We are contractually prevented from obtaining an alternative source of fiber for our System One products. Our relationship with Asahi could afford us back-up supply in the event of an inability to supply by Membrana, however, switching to Asahi fiber at this time would likely entail significant delays and difficulties. We do not have the regulatory approvals necessary to use Asahi fiber in our System One cartridge in the U.S. Additionally, the performance of Asahi fiber in our System One has not yet been validated.

Kawasumi is our only supplier of needles that we sell to our customers. Kawasumi’s contractual obligation to supply needles to us expires in February 2014, with opportunities to extend the term beyond that date. Kawasumi's contractual obligation to supply needles to us can be, at times, less than our forecasted demand. In the event Kawasumi supplies no more than the amount of their required maximum monthly supply, we may not have enough needle supply to meet the demands of our customers. The flooding experienced by Kawasumi at its bloodline manufacturing facility in Thailand did not impact its needle manufacturing operations. However, there can be no assurance that its operations will not be impacted by any other event which could lead to an interruption in supply. Our supply chain maintains a limited extra supply of needles to mitigate against the risk of intermittent shortfalls in needle supply, at least in the short term. However, any significant interruption in Kawasumi's ability to supply products to us would impair our business, at least in the near term.

Until recently, we had purchased some of our finished goods blood tubing sets from Kawasumi, headquartered in Tokyo, Japan, with manufacturing facilities in Thailand, with the remainder manufactured at our facility in Tijuana, Mexico. While Kawasumi's contractual obligation to manufacture bloodlines expired in February 2012, flooding at the site of Kawasumi’s bloodline manufacturing facility in Thailand prevented Kawasumi from supplying any further bloodlines to us prior to the expiration of that agreement. Although we have transitioned bloodline supply from Kawasumi to our Tijuana facility, and believe that the Tijuana facility can produce any products that Kawasumi supplied and/or was unable to supply, there is no guarantee that we will not experience any interruption in our ability to supply any of our bloodlines, or that the transition of this supply will not increase our product costs or impair our product quality or reliability, at least in the near term.

We also have manufacturing facilities in Mexico Germany and Italy. The loss of any of these facilities due to fire, natural disaster, war, strike, or other cause beyond our control could cause significant production delays, an inability to meet customer demand, and a substantial loss in revenues. The earthquakes experienced in northern Italy during the second quarter of 2012 resulted in the temporary suspension of manufacturing within our facility in Italy. Since that time, we have made both repairs and improvements at this facility and were fully operational by the end of the second quarter 2012. Although supply to our customers has not been interrupted to date, natural disasters, such as the earthquake, highlight the risks associated with key manufacturing facilities. In 2011, we decided not to renew our agreement with Entrada. As a result of that decision, we have transitioned the activities from Entrada’s facilities to our Tijuana facility. The consolidation of bloodline manufacturing and manufacturing and service of the System One to our facility in Tijuana has increased the risks associated with any loss of that facility for any reason.

Our In-Center segment relies heavily upon third-party distributors.

We sell the majority of our In-Center segment products through several distributors, which collectively account for substantially all of In-Center revenues, with Gambro and Henry Schein being our most significant distributors. Our distribution agreement with Henry Schein expires in April 2013, which term shall be automatically extended for additional one year periods until either party provides prior notice of its intent to terminate. Our distribution agreement with Gambro expires in June 2014. The loss of Gambro or Henry Schein as our distributors for any reason could materially adversely affect our business, at least in the near term.

Unless we can demonstrate sufficient product differentiation in our In-Center segment products that we introduce in the future, we will continue to be susceptible to further pressures to reduce product pricing and more vulnerable to the loss of our blood tubing set business to competitors in the dialysis industry.

Our blood tubing set business has historically been a commodities business. Our products continue to compete favorably in the dialysis blood tubing set business, but are increasingly subject to pricing pressures, especially given recent market consolidation in the U.S. dialysis services industry, with Fresenius and DaVita collectively controlling over two-thirds of the U.S. dialysis services business. Unless we can successfully demonstrate to customers the differentiating features of the Streamline product or products that we introduce in the future, we may be susceptible to further pressures to reduce our product pricing and more vulnerable to the loss of our blood tubing set business to competitors in the dialysis industry.

The activities of our business involve the import of finished goods into the U.S. from foreign countries, subject to customs inspections and duties, and the export of components and certain other products from other countries into Germany, Mexico, Thailand and Italy. To a lesser, but increasing degree, our business also involves the export of finished goods from the U.S. to foreign countries. If we misinterpret or violate these laws, or if laws governing our exemption from certain duties change, we could be subject to significant fines, liabilities or other adverse consequences.

We import into the U.S. disposable medical supplies from Germany, Thailand and Mexico. We also import into the U.S. disposable medical components from Germany and Italy and export components and assemblies into Mexico, Thailand and

 

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Italy. We also import into Mexico components and assemblies from the U.S., Germany, Italy and Thailand. To a lesser, but increasing degree, our business also involves the export of finished goods from the U.S. to foreign countries. The import and export of these items are subject to extensive laws and regulations with which we need to comply. To the extent we fail to comply with these laws or regulations, or fail to interpret our obligations accurately, we may be subject to significant fines, liabilities, import holds and a disruption to our ability to deliver product, which could cause our combined businesses and operating results to suffer. To the extent there are modifications to the Generalized System of Preferences or cancellation of the Nairobi Protocol Classification such that our products would be subject to duties, our profitability would also be negatively impacted.

The success of our business depends on the services of each of our senior executives as well as certain key engineering, scientific, manufacturing, clinical and marketing personnel, the loss of whom could negatively affect the combined businesses.

Our success has always depended upon the skills, experience and efforts of our senior executives and other key personnel, including our research and development and manufacturing executives and managers. Much of our expertise is concentrated in relatively few employees, the loss of whom for any reason could negatively affect our business. Competition for our highly skilled employees is intense and we cannot prevent the future resignation of any employee. We maintain key person insurance for only one of our executives, Jeffrey Burbank, our Chief Executive Officer.

The relocation of our headquarters to a new facility in Lawrence, Massachusetts may disrupt our ability to perform critical functions, which could negatively affect our business, at least in the near term.

In July 2012, we relocated our corporate headquarters to a new facility in Lawrence, Massachusetts. Critical functions are performed at our corporate headquarters, including research and development, general and administrative support functions, customer service and IT support services. The transition to our new facility may delay or disrupt our ability to perform critical functions, distract our management and employees or result in unanticipated expenses, all of which could negatively affect our business, at least in the near term.

Risks Related to the Regulatory Environment

We are subject to significant regulation, primarily by the FDA. We cannot market or commercially distribute our products without obtaining and maintaining necessary regulatory clearances or approvals.

Our products are medical devices subject to extensive regulation in the U.S., and in foreign markets in which we are currently present or which we may wish to enter. To market a medical device in the U.S., approval or clearance by the FDA is required, either through the pre-market approval process or the 510(k) clearance process. We have obtained the FDA clearance necessary to sell our current products under the 510(k) clearance process. Medical devices may only be promoted and sold for the indications for which they are approved or cleared. In addition, even if the FDA has approved or cleared a product, it can take action affecting such product approvals or clearances if serious safety or other problems develop in the marketplace. We may be required to obtain 510(k) clearances or pre-market approvals for additional products, product modifications, or for new indications of our products. Regulatory pathways for such clearances may be difficult to define and could change. For example, in 2010 we completed an approved IDE study intended to support a home nocturnal indication for the System One. Enrollment started in the first quarter of 2008 and we submitted the associated 510(k) to the FDA in 2010. We met our primary safety and efficacy endpoints for the study; nevertheless, in 2011, the FDA notified us that their standards for what will be required for a home nocturnal clearance may change from what was required in our approved IDE . As a result, the FDA did not clear our 510(k) application for home nocturnal use. In July 2012, the FDA approved a continuation of our IDE study designed to support a nocturnal indication for the System One. We have not yet restarted the trial. Although we do not see the delay in timing for our home nocturnal clearance as material to our opportunities, we cannot be certain when this clearance will be obtained. We also cannot provide assurance of when this or other clearances or approvals might be issued, if at all. Delays in obtaining clearances or approvals could adversely affect our ability to introduce new products or modifications to our existing products in a timely manner, which would delay or prevent commercial sales of our products. Although the 510(k) regulation has not been formally changed, the FDA has announced that it is intending to implement modifications to the 510(k) process. Any changes in regulatory policies could have an adverse effect on our ability to sell and promote our products and our business as a whole.

The regulatory approval procedure in the EU differs from the FDA clearance process. Manufacturers are required to demonstrate compliance of their medical devices with the essential requirements provided in the medical devices directives and related guidance. Although conformity assessment procedures are conducted by notified bodies, the decision to affix the CE mark to a medical device and related responsibility and liability for devices marketed in the EU remains with the manufacturer of the devices. Although we take all available measures to ensure compliance with applicable regulatory obligations in the EU extensive forthcoming revisions to current EU medical device legislation may impose additional obligations. We cannot provide assurance that we will be able to comply with any such new obligations imposed on medical devices currently on the EU market within the deadlines imposed by the new legislation. New obligations may also adversely affect our ability to introduce new products onto the EU market in a timely manner.

 

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Modifications to our marketed devices may require new regulatory clearances or pre-market approvals, or may require us to cease marketing or recall the modified devices until clearances or approvals are obtained.

Any modifications to a 510(k) cleared device that could significantly affect its safety or effectiveness, or would constitute a major change in its intended use, requires the submission of another 510(k) pre-market notification to address the change. Although in the first instance we may determine that a change does not rise to a level of significance that would require us to make a pre-market notification submission, the FDA may disagree with us and can require us to submit a 510(k) for a significant change in the labeling, technology, performance specifications or materials or major change or modification in intended use, despite a documented rationale for not submitting a pre-market notification. We have modified various aspects of our products and have filed and received clearance from the FDA with respect to some of the changes in the design of our products. If the FDA requires us to submit a 510(k) for any modification to a previously cleared device, or in the future a device that has received 510(k) clearance, we may be required to cease marketing the device, recall it, and not resume marketing until we obtain clearance from the FDA for the modified version of the device. Also, we may be subject to regulatory fines, penalties and/or other sanctions authorized by the Federal Food, Drug, and Cosmetic Act. In the future, we intend to introduce new products and enhancements and improvements to existing products. We cannot provide assurance that the FDA will clear any new product or product changes for marketing or what the timing of such clearances might be. In addition, new products or significantly modified marketed products could be found to be not substantially equivalent and classified as products requiring the FDA’s approval of a pre-market approval application, or PMA, before commercial distribution would be permissible. PMAs usually require substantially more data than 510(k) submissions and their review and approval or denial typically takes significantly longer than a 510(k) decision of substantial equivalence. Also, PMA products require approval supplements for any change that affects safety and effectiveness before the modified device may be marketed. Delays in our receipt of regulatory clearance or approval will cause delays in our ability to sell our products, which will have a negative effect on our revenues growth.

Any substantial modification to a CE marked device may require further conformity assessment of the device by a notified body before the modified device is introduced onto the EU market. Delays in conduct of any conformity assessment will cause delays in our ability to sell our products in the EU which will have a negative effect on our revenues growth.

Even if we obtain the necessary regulatory clearances or approvals, if we or our suppliers fail to comply with ongoing regulatory requirements our products could be subject to restrictions or withdrawal from the market.

We are subject to the Medical Device Reporting, or MDR, regulations that require us to report to the FDA if our products may have caused or contributed to patient death or serious injury, or if our device malfunctions and a recurrence of the malfunction would likely result in a death or serious injury. Similar obligations are imposed in foreign countries. We must also file reports of device corrections and removals and adhere to the FDA’s rules on labeling and promotion. Our failure to comply with these or other applicable regulatory requirements could result in enforcement action by the FDA, which may include any of the following:

 

   

untitled letters, warning letters, fines, injunctions and civil penalties;

 

   

administrative detention, which is the detention by the FDA of medical devices believed to be adulterated or misbranded;

 

   

customer notification, or orders for repair, replacement or refund;

 

   

voluntary or mandatory recall or seizure of our products;

 

   

operating restrictions, partial suspension or total shutdown of production;

 

   

refusal to review pre-market notification or pre-market approval submissions;

 

   

rescission of a substantial equivalence order or suspension or withdrawal of a pre-market approval; and

 

   

criminal prosecution.

We must file similar reporting outside of the U.S. where our products are distributed.

Our products are subject to market withdrawals or product recalls after receiving FDA clearance or approval, and market withdrawals and product recalls could cause the price of our stock to decline and expose us to product liability or other claims or could otherwise harm our reputation and financial results.

Medical devices can experience performance problems in the field that require review and possible corrective action by us or the product manufacturer. We cannot provide assurance that component failures, manufacturing errors, design defects and/or labeling inadequacies, which could result in an unsafe condition or injury to the operator or the patient will not occur. These

 

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could lead to a government mandated or voluntary recall by us. The FDA has the authority to require the recall of our products in the event a product presents a reasonable probability that it would cause serious adverse health consequences or death. Similar regulatory agencies in other countries have similar authority to recall devices because of material deficiencies or defects in design or manufacture that could endanger health. We believe that the FDA or foreign regulatory authorities would request that we initiate a voluntary recall if a product was defective or presented a risk of injury or gross deception. From time to time over our history we have chosen to voluntarily recall certain products that were defective. We have never had a mandatory government recall. Although we do not believe that any of our recent recalls have had any long term negative effect on our business, we cannot be sure that other recalls would not materially divert management attention and financial resources, cause the price of our stock to decline, expose us to product liability or other claims, or harm our reputation with customers.

If we or our contract manufacturers fail to comply with FDA’s Quality System Regulations, our manufacturing operations could be interrupted, and our product sales and operating results could suffer.

Our finished goods manufacturing processes, and those of some of our contract manufacturers, are required to comply with the FDA’s Quality System Regulations, or QSRs, which cover the procedures and documentation of the design, testing, production, control, quality assurance, labeling, packaging, sterilization, storage and shipping of our devices. Foreign regulatory authorities impose similar obligations. The FDA enforces its QSRs through periodic unannounced inspections of manufacturing facilities. We and our contract manufacturers have been, and anticipate in the future being, subject to such inspections. The FDA has inspected our Lawrence, Massachusetts facility and quality system multiple times. In our first inspection, one observation was made, but was rectified during the inspection, requiring no further response from us. Our subsequent inspections, including our most recent inspection in 2010, resulted in no inspectional observations. Medisystems has been inspected by the FDA on multiple occasions, and all inspections resulted in no action indicated. While all of our previous inspections have resulted in no significant observations, we cannot provide assurance that we can maintain a comparable level of regulatory compliance in the future at our facilities, or that future inspections would have the same result.

If one of our manufacturing facilities or those of any of our contract manufacturers fails to take satisfactory corrective action in response to an adverse QSR inspection, the FDA could take enforcement action, including issuing a public warning letter, shutting down our manufacturing operations, embargoing the import of components from outside of the U.S., recalling our products, refusing to approve new marketing applications, instituting legal proceedings to detain or seize products or imposing civil or criminal penalties or other sanctions, any of which could cause our business and operating results to suffer.

We may be subject to fines, penalties or injunctions if we are determined to be promoting the use of our products in a manner not consistent with our products’ cleared indications for use or with other state or federal laws governing the promotion of our products.

Our promotional materials and other product labeling must comply with FDA and other applicable laws and regulations. If the FDA determines that our promotional materials or other product labeling constitute promotion of an unapproved, or uncleared use, it could request that we modify our materials or subject us to regulatory or enforcement actions, including the issuance of an untitled letter, a warning letter, injunction, seizure, civil fine and criminal penalties. Other regulatory agencies, federal, state and foreign, including the U.S. Federal Trade Commission, have issued guidelines and regulations that govern how we promote our product, including how we use endorsements and testimonials. If our promotional materials are inconsistent with these guidelines or regulations, we could be subject to enforcement actions, which could result in significant fines, costs and penalties. Our reputation could also be damaged and the adoption of our products could be impaired.

Failure to obtain regulatory approval in foreign jurisdictions would prevent us from marketing our products outside the U.S.

In 2009, we began entering into arrangements with distributors to sell the System One and certain of our other products outside of the U.S. We are currently selling the System One in Europe, Australia and other select markets. We are assessing other international markets for the System One as well. Our In-Center products are presently sold in the U.S. as well as in several other countries, through distributors. We presently have CE marking as well as Canadian regulatory authority to sell our System One as well as certain other products in Canada, Europe, Australia and selected other geographies. However, in order to market directly our products in other foreign jurisdictions, we must obtain separate regulatory approvals and comply with numerous and varying regulatory requirements. The approval procedure varies from country to country and can involve additional testing. In addition, the time required to obtain approval abroad may be longer than the time required to obtain FDA clearance. The foreign regulatory approval process includes many of the risks associated with obtaining FDA clearance and we may not obtain foreign regulatory approvals on a timely basis, if at all. FDA clearance does not ensure approval by regulatory authorities in other countries, and approval by one foreign regulatory authority does not ensure approval by regulatory authorities in other foreign countries.

We may not be able to file for regulatory approvals and may not receive necessary approvals to commercialize our products in other markets beyond these we are currently in, which could negatively affect our overall market penetration. Additionally, any loss of foreign regulatory approvals, for any reason, could negatively affect our business.

 

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New regulatory requirements can impose additional burdens on us, and our business could be adversely affected if we are unable to timely satisfy all applicable new requirements.

New regulations impacting our product technologies are periodically adopted in the U.S. as well as other countries. These regulations may require us to change our existing product technologies in order to continue marketing our products. This may expose us to increased costs, as well as risks that we may be unable to satisfy the new regulatory requirements. One example of this type of new regulation is found in IEC 60601-1:2005 (3rd edition), which was published in December 2005. In this publication, new standards are listed as general requirements concerning basic product safety and the essential performance of equipment. Some of these new standards will become fully effective on June 1, 2012 in Europe and on June 30, 2013 in the U.S. Our ability to sell or market product in certain foreign jurisdictions could be negatively affected and if we are unable to adhere to this or other regulations. This would have a negative impact on our business.

We have obligations under our contracts with dialysis clinics and hospitals to protect the privacy of patient health information.

In the course of performing our business we obtain, from time to time, confidential patient health information. For example, we learn patient names and addresses when we ship our System One supplies to home hemodialysis patients. We may learn patient names and be exposed to confidential patient health information when we provide training on our products to our customer's staff. Our home hemodialysis patients may also call our customer service representatives directly and, during the call, disclose confidential patient health information. U.S. federal and state laws protect the confidentiality of certain patient health information, in particular individually identifiable information, and restrict the use and disclosure of that information. At the federal level, the Department of Health and Human Services promulgated health information and privacy and security rules under the Health Insurance Portability and Accountability Act of 1996, or HIPAA. HIPAA and the rules promulgated thereunder require certain entities, referred to as covered entities, to comply with established standards, including standards regarding the privacy and security of protected health information (PHI) known as the HIPAA Privacy and Security Rules. Most healthcare facilities that purchase and use our products are covered entities. We are not a covered entity but as our service offering is expanding to include other services and/or activities for or on behalf of covered entities, we will become a business associate, as such term is defined by HIPAA, with respect to these specific services and/or activities. HIPAA requires that covered entities enter into agreements meeting certain regulatory requirements with their business associates which, among other things, obligate the business associates to safeguard the covered entity's PHI against improper use and disclosure. We will enter into business associate agreements with respect to certain new services provided by us with certain of our customers that are also covered entities. Pursuant to the terms of these agreements, we will agree, among other things, not to use or further disclose the covered entity's PHI except as permitted or required by the agreements or as required by law, to use reasonable safeguards to prevent unauthorized disclosure of such PHI and to report to the covered entity any unauthorized uses or disclosures of such PHI. If we were to violate any of these agreements we could lose customers and be exposed to liability and/or our reputation and business could be harmed.

The Health Information Technology for Economic and Clinical Health Act, or HITECH made significant amendments to the HIPAA Privacy and Security Rules. Under HITECH, business associates' obligations with respect to PHI are no longer solely contractual in nature. HITECH strengthened and expanded HIPAA and made a number of HIPAA Privacy Rule requirements and a majority of HIPAA Security Rule requirements directly applicable to business associates. As a business associate, we will be subject to these laws and HIPAA civil and criminal penalties for violation of the Privacy and Security Rule requirements. HITECH increased civil penalty amounts for violations of HIPAA and significantly strengthened enforcement by requiring the U.S. Department of Health and Human Services (HHS) to conduct periodic audits to confirm compliance and authorizing state attorneys general to bring civil actions seeking either injunctions or damages in response to violations of HIPAA that threaten the privacy of state residents. As a business associate, these new provisions will require us to incur compliance related costs and could restrict our business operations. We are unable to predict what additional legislation or regulation in the area of privacy of personal information, including personal health information, could be enacted and what effect that could have on our operations and business.

In addition, many other state and federal laws regulate the use and disclosure of health information, including state medical privacy laws and federal and state consumer protection laws. In many cases, these laws are not necessarily preempted by HIPAA, particularly if they afford greater protection to the individual than does HIPAA. These various laws may be subject to varying interpretations by courts and government agencies creating potentially complex compliance issues for our business. The national legislation of foreign countries includes provisions that impose obligations equivalent to or, in some cases, more extensive than those provided in HIPAA. These provisions may impose obligations with which we are obliged to comply and related penalties if we fail to fulfill our obligations. Compliance with these obligations may require us to incur compliance related costs and may restrict our business operations. Concerns or allegations about our practices with regard to the privacy or security of personal health information or other privacy-related matters, even if unfounded or even if we are in compliance with applicable laws, could damage our reputation and harm our business.

 

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We are also subject to laws and regulations in foreign countries covering data privacy and other protection of health and employee information. Particularly within the EU, data protection legislation is comprehensive and complex and there has been a recent trend toward more stringent enforcement of requirements regarding protection and confidentiality of personal data. Data protection authorities from the different member states of the EU may interpret the legislation differently, which adds to this complexity, and data protection is a dynamic field where guidance is often revised. Failure to fully comply with data protection rules and regulations across the EU could result in monetary fines, damage our reputation and harm our business.

We are subject to federal and state laws prohibiting “kickbacks” and false and fraudulent claims which, if violated, could subject us to substantial penalties. Additionally, any challenges to or investigation into our practices under these laws could cause adverse publicity and be costly to respond to, and thus could harm our business.

The federal healthcare program Anti-Kickback Statute, and similar state laws, prohibit payments that are intended to induce health care professionals or others either to refer patients or to purchase, lease, order or arrange for or recommend the purchase, lease or order of healthcare products or services. A number of states have enacted laws that require pharmaceutical and medical device companies to monitor and report payments, gifts and other remuneration made to physicians and other health care professionals and health care organizations. In addition, some state statutes, most notably laws in Massachusetts, Minnesota and Vermont, impose outright bans on certain gifts to physicians. Some of these laws, referred to as “aggregate spend” or “gift” laws, carry substantial fines if they are violated. Recently, the federal Physician Payments Sunshine Act was enacted by Congress in 2010 as part of the comprehensive health care reform legislation, and it will require us to begin publicly disclosing certain payments and other transfers of value to physicians and teaching hospitals beginning in 2013. It is widely anticipated that public reporting under the Sunshine Act will result in increased scrutiny of the financial relationships between industry, physicians and teaching hospitals.

These anti-kickback, public reporting and aggregate spend laws affect our sales, marketing and other promotional activities by limiting the kinds of financial arrangements, including sales programs, we may have with hospitals, physicians or other potential purchasers or users of medical devices. They also impose additional administrative and compliance burdens on us. In particular, these laws influence, among other things, how we structure our sales and rental offerings, including discount practices, customer support, education and training programs and physician consulting and other service arrangements. Although we seek to structure such arrangements in compliance with all applicable requirements, these laws are broadly written, and it is often difficult to determine precisely how these laws will be applied in specific circumstances. If we were to offer or pay inappropriate inducements to purchase our products, we could be subject to a claim under the federal healthcare program Anti-Kickback Statute or similar state laws. If we fail to comply with particular reporting requirements, we could be subject to penalties under applicable federal or state laws.

Other federal and state laws generally prohibit individuals or entities from knowingly presenting, or causing to be presented, claims for payments to Medicare, Medicaid or other third-party payors that are false or fraudulent, or for items or services that were not provided as claimed. Although we do not submit claims directly to government healthcare programs or other payors, manufacturers can be held liable under these laws if they are deemed to “cause” the submission of false or fraudulent claims by providing inaccurate billing or coding information to customers, by providing improper financial inducements, or through certain other activities. In providing billing and coding information to customers, we make every effort to ensure that the billing and coding information furnished is accurate and that treating physicians understand that they are responsible for all prescribing decisions, including the decision as to whether to order dialysis services more frequently than three times per week. Nevertheless, we cannot provide assurance that the government will regard any billing errors that may be made as inadvertent or that the government will not examine our role in providing information to our customers and physicians concerning the benefits of daily therapy. Likewise, our financial relationships with customers, physicians, or others in a position to influence the purchase or use of our products may be subject to government scrutiny or be alleged or found to violate applicable fraud and abuse laws. False claims laws prescribe civil, criminal and administrative penalties for noncompliance, which can be substantial. Moreover, an unsuccessful challenge or investigation into our practices could cause adverse publicity, and be costly to respond to, and thus could harm our business and results of operations.

Increasingly, foreign countries are adopting laws similar in application and consequence to the anti-kickback and false claims laws in the U.S. If we fail to comply with these laws we may face civil or criminal penalties. The negative consequences of any failure to comply with these laws may also harm our ability to operate in foreign countries and have a negative effect on our reputation that discourages third parties from doing business with us.

Foreign governments tend to impose strict price controls, which may adversely affect our future profitability.

Historically, our marketing efforts had been confined nearly exclusively to the U.S. In 2009, we began entering into arrangements with distributors to sell the System One and certain of our other products internationally. In some foreign countries, particularly in the EU, the pricing of medical devices is subject to governmental control. In these countries, pricing negotiations with governmental authorities can take considerable time after a device has been CE marked. To obtain reimbursement or pricing approval in some countries, we may be required to supply data that compares the cost-effectiveness of our products to other available therapies. If reimbursement of our products is unavailable or limited in scope or amount, or if

 

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pricing is set at unsatisfactory levels, it may not be profitable to sell our products outside of the U.S., which would negatively affect the long-term growth of our business. Further, reimbursement provided to our products in other jurisdictions could change, positively or negatively. In the event reimbursements were to be negatively changed, such as, for example, in the United Kingdom, our ability to sell our products could be impaired.

Failure to comply with the U.S. Foreign Corrupt Practices Act could subject us to penalties and other adverse consequences.

We are subject to the United States Foreign Corrupt Practices Act which generally prohibits U.S. companies from engaging in bribery or other prohibited payments to foreign officials for the purpose of obtaining or retaining business and requires companies to maintain accurate books and records and internal controls, including at foreign controlled subsidiaries. Through our international activities, we are also subject to the UK Anti-Bribery Act and other similar anti-bribery laws. While we have policies and procedures in place designed to prevent noncompliance, we can make no assurance that our employees or other agents will not engage in prohibited conduct under these laws for which we might be held responsible. If our employees or other agents are found to have engaged in such practices, we could suffer severe penalties and other consequences that may have a material adverse effect on our business, financial condition and results of operations.

Our business activities involve the use of hazardous materials, which require compliance with environmental and occupational safety laws regulating the use of such materials. If we violate these laws, we could be subject to significant fines, liabilities or other adverse consequences.

Our research and development programs as well as our manufacturing operations involve the controlled use of hazardous materials. Accordingly, we are subject to federal, state and local laws, as well as the laws of foreign countries, governing the use, handling and disposal of these materials. Although we believe that our safety procedures for handling and disposing of these materials comply in all material respects with the standards prescribed by state and federal regulations or foreign country laws, we cannot completely eliminate the risk of accidental contamination or injury from these materials. In the event of an accident or failure to comply with environmental laws, we could be held liable for resulting damages, and any such liability could exceed our insurance coverage.

Risks Related to Operations

Resin is a key input material to the manufacture of our products and System One cartridge. Oil prices affect both the pricing and availability of this material. Escalation of oil prices could affect our ability to obtain sufficient supply of resin at the prices we need to manufacture our products at current rates of profitability.

We currently source resin from a small number of suppliers. Rising oil prices over the last several years have resulted in significant price increases for this material. We cannot guarantee that prices will not continue to increase. Our contracts with customers restrict our ability to immediately pass on these price increases, and we cannot guarantee that future pricing to customers will be sufficient to accommodate increasing input costs.

Distribution costs represent a significant percentage of our overall costs, and these costs are dependent upon fuel prices. Increases in fuel prices could lead to increases in our distribution costs, which, in turn, could impair our ability to achieve profitability.

We currently incur significant inbound and outbound distribution costs. Our distribution costs are dependent upon fuel prices. Increases in fuel prices could lead to increases in our distribution costs, which could impair our ability to achieve profitability.

We have labor agreements with our production employees in Italy and in Mexico. We cannot guarantee that we will not in the future face strikes, work stoppages, work slowdowns, grievances, complaints, claims of unfair labor practices, other collective bargaining disputes or in Italy, anti-union behavior, that may cause production delays and negatively impact our ability to deliver our products on a timely basis.

Our wholly-owned subsidiary in Italy has a national labor contract with Contratto collettivo nazionale di lavoro per gli addetti all’industria della gomma cavi elettrici ed affini e all’industria delle materie plastiche, and our wholly-owned subsidiary in Mexico has entered into a collective bargaining agreement with a Union named Mexico Moderno de Trabajadores de la Baja California C.R.O.C. We have not to date experienced strikes, work stoppages, work slowdowns, grievances, complaints, claims of unfair labor practices, other collective bargaining disputes, or in Italy, anti-union behavior, however we cannot guarantee that we will not be subject to such activity in the future. Any such activity would likely cause production delays, and negatively affect our ability to deliver our production commitments to customers, which could adversely affect our reputation and cause our combined businesses and operating results to suffer. Additionally, some of our key single source suppliers have labor agreements. We cannot guarantee that we will not have future disruptions, which could adversely affect our reputation and cause our business and operating results to suffer

 

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We do not have long-term supply contracts with many of our third-party suppliers.

We purchase raw materials and components from third-party suppliers, including some single source suppliers, through purchase orders and do not have long-term supply contracts with many of these third-party suppliers. Many of our third-party suppliers are not obligated to perform services or supply products for any specific period, in any specific quantity or at any specific price, except as may be provided in a particular purchase order. We do not maintain large volumes of inventory from most of our suppliers. If we inaccurately forecast demand for finished goods, our ability to meet customer demand could be delayed or interrupted and our competitive position and reputation could be harmed. In addition, if we fail to effectively manage our relationships with these suppliers, we may be required to change suppliers, which would be time consuming and disruptive and could lead to disruptions in product supply, which could permanently impair our customer base and reputation. Although we believe our supply chain has sufficient inventory of raw materials, components and finished goods to withstand a temporary disruption in supply from any single source supplier, any permanent or long term disruption in supply from any single source supplier could lead to supply delays or interruptions which would damage our business, at least in the near term.

Risks Related to Intellectual Property

If we are unable to protect our intellectual property and prevent its use by third parties, we will lose a significant competitive advantage.

We rely on patent protection, as well as a combination of copyright, trade secret and trademark laws to protect our proprietary technology and prevent others from duplicating our products. However, these means may afford only limited protection and may not:

 

   

prevent our competitors from duplicating our products;

 

   

prevent our competitors from gaining access to our proprietary information and technology; or

 

   

permit us to gain or maintain a competitive advantage.

Any of our patents, including those we may license, may be challenged, invalidated, circumvented or rendered unenforceable. We cannot provide assurance that we will be successful should one or more of our patents be challenged for any reason. If our patent claims are rendered invalid or unenforceable, or narrowed in scope, the patent coverage afforded our products could be impaired, which could make our products less competitive.

We cannot specify which, if any, of our patents individually or as a group will permit us to gain or maintain a competitive advantage. We cannot provide assurance that any pending or future patent applications we hold will result in an issued patent or that if patents are issued to us, that such patents will provide meaningful protection against competitors or against competitive technologies. The issuance of a patent is not conclusive as to its validity or enforceability. The U.S. federal courts or equivalent national courts or patent offices elsewhere may invalidate our patents or find them unenforceable. Competitors may also be able to design around our patents. Our patents and patent applications cover particular aspects of our products. Other parties may develop and obtain patent protection for more effective technologies, designs or methods for treating kidney failure. If these developments were to occur, it would likely have an adverse effect on our sales.

The laws of foreign countries may not protect our intellectual property rights effectively or to the same extent as the laws of the U.S. If our intellectual property rights are not adequately protected, we may not be able to commercialize our technologies, products or services and our competitors could commercialize similar technologies, which could result in a decrease in our revenues and market share.

Our products could infringe the intellectual property rights of others, which may lead to litigation that could itself be costly, could result in the payment of substantial damages or royalties, and/or prevent us from using technology that is essential to our products.

The medical device industry in general has been characterized by extensive litigation and administrative proceedings regarding patent infringement and intellectual property rights. Products to provide kidney replacement therapy have been available in the market for more than 30 years and our competitors hold a significant number of patents relating to kidney replacement devices, therapies, products and supplies. Although no third party has threatened or alleged that our products or methods infringe their patents or other intellectual property rights, we cannot provide assurance that our products or methods do not infringe the patents or other intellectual property rights of third parties. If our business is successful, the possibility may increase that others will assert infringement claims against us.

Infringement and other intellectual property claims and proceedings brought against us, whether successful or not, could result in substantial costs and harm to our reputation. Such claims and proceedings can also distract and divert management and key personnel from other tasks important to the success of the business. In addition, intellectual property litigation or claims could force us to do one or more of the following:

 

   

cease selling or using any of our products that incorporate the asserted intellectual property, which would adversely affect our revenues;

 

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pay substantial damages for past use of the asserted intellectual property;

 

   

obtain a license from the holder of the asserted intellectual property, which license may not be available on reasonable terms, if at all and which could reduce profitability; and

 

   

redesign or rename, in the case of trademark claims, our products to avoid infringing the intellectual property rights of third parties, which may not be possible and could be costly and time-consuming if it is possible to do so.

Confidentiality agreements with employees and others may not adequately prevent disclosure of trade secrets and other proprietary information.

In order to protect our proprietary technology and processes, we also rely in part on confidentiality agreements with our corporate partners, employees, consultants, outside scientific collaborators and sponsored researchers, advisors and others. These agreements may not effectively prevent disclosure of confidential information and trade secrets and may not provide an adequate remedy in the event of unauthorized disclosure of confidential information. In addition, others may independently discover or reverse engineer trade secrets and proprietary information, and in such cases we could not assert any trade secret rights against such party. Costly and time consuming litigation could be necessary to enforce and determine the scope of our proprietary rights, and failure to obtain or maintain trade secret protection could adversely affect our competitive position.

We may be subject to damages resulting from claims that our employees or we have wrongfully used or disclosed alleged trade secrets of other companies.

Many of our employees were previously employed at other medical device companies focused on the development of dialysis products, including our competitors. Although no claims against us are currently pending, we may be subject to claims that these employees or we have inadvertently or otherwise used or disclosed trade secrets or other proprietary information of their former employers. Litigation may be necessary to defend against these claims. If we fail in defending such claims, in addition to paying monetary damages, we may lose valuable intellectual property rights. Even if we are successful in defending against these claims, litigation could result in substantial costs, damage to our reputation and be a distraction to management.

Risks Related to our Common Stock

Our stock price is likely to be volatile, and the market price of our common stock may drop.

The market price of our common stock could be subject to significant fluctuations. Market prices for securities of early stage companies have historically been particularly volatile. As a result of this volatility, you may not be able to sell your common stock at or above the price you paid for the stock. Some of the factors that may cause the market price of our common stock to fluctuate include:

 

   

timing of market launch and/or market acceptance of our products;

 

   

timing of achieving profitability from operations;

 

   

changes in estimates of our financial results or recommendations by securities analysts or the failure to meet or exceed securities analysts’ expectations;

 

   

actual or anticipated variations in our quarterly operating results;

 

   

future debt or equity financings;

 

   

developments or disputes with key vendors or customers, or adverse changes to the purchasing patterns of key customers;

 

   

disruptions in product supply for any reason, including product recalls, our failure to appropriately forecast supply or demand, difficulties in moving products across the border, or the failure of third party suppliers to produce needed products or components;

 

   

reports by officials or health or medical authorities, the general media or the FDA regarding the potential benefits of the System One or of similar dialysis products distributed by other companies or of daily or home dialysis;

 

   

announcements by the FDA of non-clearance or non-approval of our products, or delays in the FDA or other foreign regulatory agency review process;

 

   

product recalls;

 

   

defaults under our material contracts, including without limitation our credit agreement;

 

   

regulatory developments in the United States and foreign countries;

 

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changes in third-party healthcare reimbursements, particularly a decline in the level of Medicare reimbursement for dialysis treatments, or the willingness of Medicare contractors to pay for more than three treatments a week where medically justified;

 

   

litigation involving our company or our general industry or both;

 

   

announcements of technical innovations or new products by us or our competitors;

 

   

developments or disputes concerning our patents or other proprietary rights;

 

   

our ability to manufacture and supply our products to commercial standards;

 

   

significant acquisitions, strategic partnerships, joint ventures or capital commitments by us or our competitors;

 

   

departures of key personnel; and

 

   

investors’ general perception of our company, our products, the economy and general market conditions.

The stock markets in general have experienced substantial volatility that has often been unrelated to the operating performance of individual companies. These broad market fluctuations may adversely affect the trading price of our common stock. In the past, following periods of volatility in the market price of a company’s securities, stockholders have often instituted class action securities litigation against those companies. Such litigation, if instituted, could result in substantial costs and diversion of management attention and resources, which could significantly harm our profitability and reputation.

Anti-takeover provisions in our restated certificate of incorporation and amended and restated bylaws and under Delaware law could make an acquisition of us more difficult and may prevent attempts by our stockholders to replace or remove our current management.

Provisions in our restated certificate of incorporation and our amended and restated bylaws may delay or prevent an acquisition of us. In addition, these provisions may frustrate or prevent attempts by our stockholders to replace or remove members of our board of directors. Because our board of directors is responsible for appointing the members of our management team, these provisions could in turn affect any attempt by our stockholders to replace current members of our management team. These provisions include:

 

   

a prohibition on actions by our stockholders by written consent;

 

   

the ability of our board of directors to issue preferred stock without stockholder approval, which could be used to institute a “poison pill” that would work to dilute the stock ownership of a potential hostile acquirer, effectively preventing acquisitions that have not been approved by our board of directors;

 

   

advance notice requirements for nominations of directors or stockholder proposals; and

 

   

the requirement that board vacancies be filled by a majority of our directors then in office.

In addition, because we are incorporated in Delaware, we are governed by the provisions of Section 203 of the Delaware General Corporation Law, which prohibits a person who owns in excess of 15% of our outstanding voting stock from merging or combining with us for a period of three years after the date of the transaction in which the person acquired in excess of 15% of our outstanding voting stock, unless the merger or combination is approved in a prescribed manner. These provisions would apply even if the offer may be considered beneficial by some stockholders.

If there are substantial sales of our common stock in the market by our large existing stockholders, our stock price could decline.

If our existing stockholders sell a large number of shares of our common stock or the public market perceives that existing stockholders might sell a large number of shares of common stock, the market price of our common stock could decline significantly. We have 58,849,585 shares of common stock outstanding as of June 30, 2012. Except where sales are made pursuant to an effective registration statement, shares held by our affiliates may only be sold in compliance with the volume limitations of Rule 144. These volume limitations restrict the number of shares that may be sold by an affiliate in any three-month period to the greater of 1% of the number of shares then outstanding, which approximates 588,496 shares, or the average weekly trading volume of our common stock during the four calendar weeks preceding the filing of a notice on Form 144 with respect to the sale. With the higher trading volumes we have recently observed in our stock, the number of shares that can be sold by our affiliates pursuant to Rule 144 is significantly above the 1% of shares outstanding limitation of Rule 144 as of the time of the filing of this report.

At June 30, 2012, subject to certain conditions, holders of an aggregate of approximately 8.6 million shares of our common stock have rights with respect to the registration of these shares of common stock with the Securities and Exchange Commission, or SEC. If we register their shares of common stock, they can more easily sell those shares in the public market.

 

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As of June 30, 2012, 8.0 million shares of common stock are authorized for issuance under our stock incentive plan, employee stock purchase plan and outstanding stock options. As of June 30, 2012, 5.0 million shares were subject to outstanding options, of which 3.9 million were exercisable and can be freely sold in the public market upon issuance, subject to the restrictions imposed on our affiliates under Rule 144.

We have filed resale registration statements covering both shares of our common stock that we sold in a May 2008 private placement and shares of our common stock issuable upon the exercise of a warrant held by DaVita. If the holders of these shares or shares issued pursuant to the terms of the warrant are unable to sell these shares under the respective registration statements, we may be obligated to pay them damages, which could harm our financial condition. Further, these resale registration statements could result in downward pressure on the price of our common stock and may affect the ability of our stockholders to realize the current trading price of our common stock.

In 2008, we sold an aggregate of 9,555,556 shares of our common stock and warrants to purchase an additional 1,911,111 shares of our common stock in a private placement. We were required to register the common stock and the common stock issuable upon exercise of the warrants with the Securities and Exchange Commission, which we did on August 8, 2008. If the holders of the shares or the accompanying warrant shares are unable to sell such shares or warrant shares under the registration statement for more than 30 days in any 365 day period after the effectiveness of the registration statement, we may be obligated to pay damages equal to up to 1% of the share purchase price per month that the registration statement is not effective and the investors are unable to sell their shares.

On July 22, 2010, we issued to DaVita a warrant under which DaVita could have earned, subject to the achievement of certain System One growth targets, up to a cumulative total of 5,500,000 shares of our common stock. In connection with issuance of this warrant we entered into a registration rights agreement with DaVita, pursuant to which (subject to certain conditions) we agreed to file, on or prior to April 1, 2011, a registration statement on Form S-3 with respect to the resale by DaVita of any shares of our common stock issued to DaVita under the warrant. We registered the shares of common stock issuable upon the exercise of the warrant on February 16, 2011 on an automatic shelf registration statement on Form S-3 filed on November 17, 2010.

Investors should be aware that the current or future market price of their shares of our common stock could be negatively impacted by the sale or perceived sale of all or a significant number of these shares that are available for sale pursuant to these registration statements or that will be available for sale in the future.

Our outstanding warrants may result in substantial dilution to our stockholders.

Warrants held by certain investors in our 2008 private placement could result in the issuance of up to 1.4 million additional shares of common stock. Warrants held by DaVita could result in the issuance of up to 3.6 million additional shares of common stock. However, while DaVita continues to grow, it is unlikely they will achieve the level of performance needed to earn the remaining outstanding warrants. These warrants vest and become exercisable based upon the achievement of certain System One home patient growth targets at June 30, 2011, 2012 and 2013. The issuance and sale of any of these shares could result in substantial dilution to our stockholders in the form of immediate and substantial dilution in net tangible book value per share.

We may grow through additional acquisitions, which could dilute our existing shareholders and could involve substantial integration risks.

As part of our business strategy, we may acquire other businesses and/or technologies in the future. We may issue equity securities as consideration for future acquisitions that would dilute our existing stockholders, perhaps significantly depending on the terms of the acquisition. We may also incur additional debt in connection with future acquisitions, which, if available at all, may place additional restrictions on our ability to operate our business. Acquisitions may involve a number of risks, including:

 

   

difficulty in transitioning and integrating the operations and personnel of the acquired businesses, including different and complex accounting and financial reporting systems;

 

   

potential disruption of our ongoing business and distraction of management;

 

   

potential difficulty in successfully implementing, upgrading and deploying in a timely and effective manner new operational information systems and upgrades of our finance, accounting and product distribution systems;

 

   

difficulty in incorporating acquired technology and rights into our products and technology;

 

   

unanticipated expenses and delays in completing acquired development projects and technology integration;

 

   

management of geographically remote units both in the United States and internationally;

 

   

impairment of relationships with partners and customers;

 

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customers delaying purchases of our products pending resolution of product integration between our existing and our newly acquired products;

 

   

entering markets or types of businesses in which we have limited experience;

 

   

potential loss of key employees of the acquired company; and

 

   

inaccurate assumptions of the acquired company’s product quality and/or product reliability.

As a result of these and other risks, we may not realize anticipated benefits from our acquisitions. Any failure to achieve these benefits or failure to successfully integrate acquired businesses and technologies could seriously harm our business.

 

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Item 6. Exhibits

 

Exhibit
Number
    
10.35    Amendment, dated May 7, 2012, to the Loan and Security Agreement, dated March 10, 2010, as amended on March 29, 2011, by and among Silicon Valley Bank, as the Lender, and the Registrant, EIR Medical, Inc., Medisystems Corporation and Medisystems Services Corporation, as Borrowers. (Incorporated by reference to the Registrant’s Form 10-Q for the quarter ended March 31, 2012 (File No 000-51567))
10.36    Subscription, Sale and Purchase Agreement, dated as of May 4, 2012, by and between the Registrant and Asahi Kasei Medical Co., Ltd. (Incorporated by reference to the Registrant’s Form 10-Q for the quarter ended March 31, 2012 (File No 000-51567))
10.37    Registration Rights Agreement, entered into as of May 4, 2012, by and between the Registrant and Asahi Kasei Medical Co., Ltd. (Incorporated by reference to the Registrant’s Form 10-Q for the quarter ended March 31, 2012 (File No 000-51567))
31.1*    Certification of Chief Executive Officer pursuant to Exchange Act Rules 13a-14(a) or 15d-14(a), as adopted pursuant to Section 302 of Sarbanes-Oxley Act of 2002.
31.2*    Certification of Chief Financial Officer pursuant to Exchange Act Rules 13a-14(a) or 15d-14(a), as adopted pursuant to Section 302 of Sarbanes-Oxley Act of 2002.
32.1*    Certification of Chief Executive Officer pursuant to Exchange Act Rules 13a-14(b) or 15d-14(b) and 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of Sarbanes-Oxley Act of 2002.
32.2*    Certification of Chief Financial Officer pursuant to Exchange Act Rules 13a-14(b) or 15d-14(b) and 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of Sarbanes-Oxley Act of 2002.
101.INS*    XBRL Instance Document
101.SCH*    XBRL Taxonomy Extension Schema
101.CAL*    XBRL Taxonomy Extension Calculation Linkbase
101.DEF*    XBRL Taxonomy Extension Definition Linkbase
101.LAB*    XBRL Taxonomy Extension Label Linkbase
101.PRE*    XBRL Taxonomy Extension Presentation Linkbase

 

* Filed herewith.

 

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SIGNATURES

Pursuant to the requirements 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.

 

NXSTAGE MEDICAL, INC.

By:

 

/s/ Robert S. Brown

  Robert S. Brown
 

Chief Financial Officer

(Duly authorized officer and principal financial and accounting officer)

August 8, 2012

 

42

XNAS:NXTM NxStage Medical Inc Quarterly Report 10-Q Filling

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