VOLC 9.30.2012 10Q
Table of Contents

 
 
 
 
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
þ
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2012
OR
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
Commission File Number 000-52045
Volcano Corporation
(Exact name of registrant as specified in its charter)
 
Delaware
 
33-0928885
(State or other jurisdiction of
 
(I.R.S. Employer
incorporation or organization)
 
Identification Number)
 
 
 
3661 Valley Centre Drive, Suite 200
San Diego, CA
 
92130
(Address of principal executive offices)
 
(Zip Code)
(800) 228-4728
(Registrant’s telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.     Yes  þ    No  ¨
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   þ    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  þ
  
Accelerated filer  ¨
  
Non-accelerated filer ¨
  
Smaller reporting company ¨
 
  
 
  
(Do not check if a 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 þ
Indicate the number of shares of each of the issuer’s classes of common stock, as of the latest practicable date:
Class
  
Outstanding at October 31, 2012
Common stock, $0.001 par value
  
53,900,233

 
 
 
 
 


Table of Contents

VOLCANO CORPORATION
Quarterly Report on Form 10-Q for the quarter ended September 30, 2012
Index
 
 
 
 
 
 
 
 
 
 
 
 
 


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Table of Contents


PART I. FINANCIAL INFORMATION
Item 1.
Financial Statements

VOLCANO CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except par values)
(unaudited)

 
September 30,
2012
 
December 31,
2011
Assets
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
68,707

 
$
107,016

Short-term available-for-sale investments
173,079

 
112,327

Accounts receivable, net
71,134

 
69,469

Inventories
49,392

 
41,306

Prepaid expenses and other current assets
19,797

 
19,939

Total current assets
382,109

 
350,057

Restricted cash
693

 
692

Long-term available-for-sale investments
17,348

 
30,919

Property and equipment, net
103,006

 
81,097

Intangible assets, net
15,865

 
15,245

Goodwill
2,487

 
2,487

Other non-current assets
17,463

 
16,227

Total assets
$
538,971

 
$
496,724

Liabilities and Stockholders’ Equity
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
14,160

 
$
12,911

Accrued compensation
18,655

 
20,251

Accrued expenses and other current liabilities
23,512

 
16,689

Deferred revenues
8,603

 
7,077

Current maturities of long-term debt
48

 
72

Total current liabilities
64,978

 
57,000

Convertible senior notes
99,238

 
95,663

Other long-term debt
38

 
74

Deferred revenues
3,719

 
3,168

Other non-current liabilities
1,801

 
1,582

Total liabilities
169,774

 
157,487

Commitments and contingencies (Note 3)
 
 
 
Stockholders’ equity:
 
 
 
Preferred stock, par value of $0.001; 10,000 shares authorized; no shares issued and outstanding at September 30, 2012 and December 31, 2011

 

Common stock, par value of $0.001; 250,000 shares authorized at September 30, 2012 and December 31, 2011; 53,835 and 52,651 shares issued and outstanding at September 30, 2012 and December 31, 2011, respectively
54

 
53

Additional paid-in capital
454,269

 
430,490

Accumulated other comprehensive loss
(747
)
 
(1,382
)
Accumulated deficit
(84,379
)
 
(89,924
)
Total stockholders’ equity
369,197

 
339,237

Total liabilities and stockholders’ equity
$
538,971

 
$
496,724

See notes to unaudited condensed consolidated financial statements.

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Table of Contents

VOLCANO CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
(unaudited)
 
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2012
 
2011
 
2012
 
2011
Revenues
$
93,656

 
$
85,767

 
$
279,389

 
$
250,798

Cost of revenues, excluding amortization of intangibles
33,248

 
29,538

 
94,797

 
84,175

Gross profit
60,408

 
56,229

 
184,592

 
166,623

Operating expenses:
 
 
 
 
 
 
 
Selling, general and administrative
40,699

 
36,034

 
127,035

 
106,982

Research and development
13,032

 
13,928

 
40,560

 
40,337

Amortization of intangibles
710

 
860

 
2,470

 
2,572

Total operating expenses
54,441

 
50,822

 
170,065

 
149,891

Operating income
5,967

 
5,407

 
14,527

 
16,732

Interest income
223

 
226

 
656

 
701

Interest expense
(1,844
)
 
(1,834
)
 
(4,993
)
 
(5,895
)
Exchange rate loss
(218
)
 
(502
)
 
(319
)
 
(1,181
)
Other expense, net
(23
)
 

 
(31
)
 
(2
)
Income before income tax
4,105

 
3,297

 
9,840

 
10,355

Income tax expense
2,130

 
669

 
4,295

 
1,684

Net income
$
1,975

 
$
2,628

 
$
5,545

 
$
8,671

Net income per share:
 
 
 
 
 
 
 
Basic
$
0.04

 
$
0.05

 
$
0.10

 
$
0.17

Diluted
$
0.04

 
$
0.05

 
$
0.10

 
$
0.16

Shares used in calculating net income per share:
 
 
 
 
 
 
 
Basic
53,659

 
52,517

 
53,309

 
52,188

Diluted
55,265

 
54,947

 
55,097

 
54,605

See notes to unaudited condensed consolidated financial statements.


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VOLCANO CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(in thousands)
(unaudited)
 
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2012
 
2011
 
2012
 
2011
Net income
$
1,975

 
$
2,628

 
$
5,545

 
$
8,671

Other comprehensive income:

 

 
 
 
 
   Foreign currency translation adjustments
51

 
1,129

 
546

 
1,701

   Changes in unrealized gain or loss on available-for-sale investments
100

 
(123
)
 
89

 
(17
)
Other comprehensive income
151

 
1,006

 
635

 
1,684

Comprehensive income
$
2,126

 
$
3,634

 
$
6,180

 
$
10,355

See notes to unaudited condensed consolidated financial statements.


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Table of Contents

VOLCANO CORPORATION
CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY
(in thousands)
(unaudited)
 
 
Common Stock
 
Additional
Paid-In
Capital
 
Accumulated
Other
Comprehensive
Loss
 
Accumulated
Deficit
 
Total
Stockholders’
Equity
 
Shares
 
Amount
 
 
 
 
Balance at December 31, 2011
52,651

 
$
53

 
$
430,490

 
$
(1,382
)
 
$
(89,924
)
 
$
339,237

Issuance of common stock under equity plans
1,184

 
1

 
12,287

 

 

 
12,288

Employee stock-based compensation cost

 

 
11,492

 

 

 
11,492

Net income

 

 

 

 
5,545

 
5,545

Other comprehensive income

 

 

 
635

 

 
635

Balance at September 30, 2012
53,835

 
$
54

 
$
454,269

 
$
(747
)
 
$
(84,379
)
 
$
369,197

See notes to unaudited condensed consolidated financial statements.


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VOLCANO CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)
 
Nine Months Ended
September 30,
 
2012
 
2011
Operating activities
 
 
 
Net income
$
5,545

 
$
8,671

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
Depreciation and amortization
17,448

 
17,159

Amortization of investment premium, net
2,023

 
2,727

Accretion of debt discount on convertible senior notes
3,700

 
3,470

Non-cash stock-based compensation expense
11,428

 
9,605

Other non-cash adjustments
2,502

 
80

Changes in operating assets and liabilities:
 
 
 
Accounts receivable
(2,119
)
 
(2,942
)
Inventories
(7,467
)
 
(4,624
)
Prepaid expenses and other assets
(1,840
)
 
(2,349
)
Restricted cash
(7
)
 
(89
)
Accounts payable
(521
)
 
(1,519
)
Accrued compensation
(1,573
)
 
(2,642
)
Accrued expenses and other liabilities
6,077

 
(7,964
)
Deferred revenues
2,088

 
970

Net cash provided by operating activities
37,284

 
20,553

Investing activities
 
 
 
Purchase of short-term and long-term available-for-sale investments
(237,669
)
 
(255,261
)
Sale or maturity of short-term and long-term available-for-sale investments
188,556

 
266,363

Capital expenditures
(36,589
)
 
(30,374
)
Cash paid for intangible assets and other investments
(3,107
)
 
(1,673
)
Proceeds from foreign currency exchange contracts
1,187

 
1,164

Payment for foreign currency exchange contracts
(215
)
 
(3,962
)
Net cash used in investing activities
(87,837
)
 
(23,743
)
Financing activities
 
 
 
Repayment of debt
(68
)
 
(46
)
Proceeds from sale of common stock under employee stock purchase plan
3,880

 
3,555

Proceeds from exercise of common stock options
8,408

 
9,065

Net cash provided by financing activities
12,220

 
12,574

Effect of exchange rate changes on cash and cash equivalents
24

 
278

Net (decrease) increase in cash and cash equivalents
(38,309
)
 
9,662

Cash and cash equivalents, beginning of period
107,016

 
43,429

Cash and cash equivalents, end of period
$
68,707

 
$
53,091

Supplemental disclosures of cash flow information:
 
 
 
Cash paid for interest
$
3,326

 
$
3,391

Cash paid for income taxes
$
2,337

 
$
842


See notes to unaudited condensed consolidated financial statements.

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VOLCANO CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2012
1. Summary of Significant Accounting Policies
Basis of Presentation and Nature of Operations
The unaudited condensed consolidated financial statements of Volcano Corporation (“we,” “us,” “our,” “Volcano” or the “Company”) contained in this quarterly report on Form 10-Q include our financial statements and the financial statements of our wholly-owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.
The accompanying unaudited condensed consolidated financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission, or SEC. Pursuant to these rules and regulations, the Company has condensed or omitted certain information and footnote disclosures it normally includes in its annual consolidated financial statements prepared in accordance with accounting principles generally accepted in the U.S., or GAAP. In the opinion of management, the unaudited condensed consolidated financial statements include all adjustments necessary, which are of a normal and recurring nature, for the fair presentation of the Company’s financial position and of the results of operations and cash flows for the periods presented. These unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and the notes thereto included in our annual report on Form 10-K for the year ended December 31, 2011.
We design, develop, manufacture and sell a broad suite of precision guided therapy tools including intravascular ultrasound, or IVUS, and fractional flow reserve, or FFR, products that we believe enhance the diagnosis and treatment of vascular and structural heart disease. Our products consist of multi-modality consoles which are marketed as stand-alone units or as customized units that can be integrated into a variety of hospital-based interventional surgical suites called catheterization laboratories. Our consoles have been designed to serve as a multi-modality platform for our phased array and rotational IVUS catheters, FFR pressure wires, image-guided therapy catheters and Medtronic's Pioneer reentry device.
Our IVUS products include single-procedure disposable phased array and rotational IVUS imaging catheters, the VIBE RX image-guided therapy device, and additional functionality options such as virtual histology tissue characterization, and ChromaFlo stent apposition analysis. Our FFR offerings can be accessed through our multi-modality platforms, and we also provide FFR-only consoles. Our FFR disposables are single-procedure disposable pressure and flow guide wires used to measure the pressure and flow characteristics of blood around plaque enabling physicians to gauge the plaque's physiological impact on blood flow and pressure. We are developing additional offerings for integration into the platform, including adenosine-free Instant wave-free ratio FFR, forward-looking IVUS catheters, Forward-Looking Intra-Cardiac Echo catheters, Focal Acoustic Computed Tomography catheters and ultra-high resolution Optical Coherence Tomography, or OCT, systems and catheters.
We also develop and manufacture optical monitors for the telecommunications industry, laser and non-laser light sources, and optical engines used in the medical OCT imaging systems and advanced photonic components and sub-systems used in spectroscopy and other industrial applications.
The results of operations for the nine months ended September 30, 2012 are not necessarily indicative of the operating results for the full fiscal year or any future periods.
Reclassification
Certain reclassifications have been made to the prior year’s financial statements to conform to current year presentation.
Concentrations of Credit Risk
Financial instruments which subject us to potential credit risk consist of our cash and cash equivalents, short-term and long-term available-for-sale investments, and accounts receivable. We have established guidelines to limit our exposure to credit risk by placing our investments with high credit quality financial institutions, diversifying our investment portfolio and holding investments with maturities that maintain safety and liquidity. We also place our cash and cash equivalents with high credit quality financial institutions. Deposits with these financial institutions may exceed the amount of insurance provided; however, these deposits typically are redeemable upon demand. Therefore we believe the financial risks associated with these financial instruments are minimal.
Trade accounts receivable are recorded at the net invoice value and are not interest bearing. We consider receivables past due based on the contractual payment terms. We perform ongoing credit evaluations of our customers, and generally, we do not require collateral on our accounts receivable. We estimate the need for allowances for potential credit losses based on historical

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collection activity and the facts and circumstances relevant to specific customers. We record a provision for uncollectible accounts when collection is uncertain. To date, we have not experienced significant credit-related losses.
We currently hold foreign exchange forward contracts with two counterparties. The bank counterparties in these contracts expose us to credit-related losses in the event of their nonperformance and we do not require collateral for their performance. However, to mitigate that risk, we only contract with counterparties who meet our minimum credit quality guidelines.
In connection with the issuance of our 2.875% Convertible Senior Notes, or the Notes, we purchased call options from JPMorgan Chase Bank National Association, or JPMorgan Chase. Non-performance by JPMorgan Chase under these call options would potentially expose us to dilution of our common stock to the extent our stock price exceeds the conversion price. See Note 2 “Financial Statement Details — Convertible Debt” for additional information.
Net Income per Share
Basic earnings per share is computed by dividing net income attributable to common stockholders by the weighted-average number of common shares outstanding for the period. Diluted earnings per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock.
Our potentially dilutive shares include outstanding common stock options, restricted stock units, performance-based restricted stock units, incremental shares issuable upon the conversion of the Notes, or exercise of the warrants relating to the Notes (See Note 2 “Financial Statement Details — Convertible Debt”). Such potentially dilutive shares are excluded when the effect would be anti-dilutive or if the underlying obligation will be settled in cash as discussed in the following paragraph. We also exclude the performance-based restricted stock units when those shares are not contingently issuable. For the three and nine months ended September 30, 2012, potentially dilutive shares totaling 2.0 million and 2.1 million, respectively, have not been included in the computation of diluted net income per share as the result would be anti-dilutive. For the three and nine months ended September 30, 2011, potentially dilutive shares totaling 57,000 and 19,100, respectively, have not been included in the computation of diluted net income per share as the result would be anti-dilutive.
For the three and nine months ended September 30, 2012, zero incremental shares related to the Notes were included in the computation of the diluted net income per common share. For the three and nine months ended September 30, 2011, 49,000 and zero shares, respectively, related to the Notes were included in the computation of the diluted net income per common share. The shares were included in the computation for months ended September 30, 2011 because the average market price of our common stock during the three months ended September 30, 2011 exceeded the conversion price of the Notes. Because the principal amount of the Notes will be settled in cash upon conversion if a conversion occurs, only the conversion spread relating to the Notes will be included in our calculation of diluted net income per common share. As such, the Notes will have no impact on diluted net income per common share until the price of our common stock exceeds the conversion price (initially $29.64, subject to adjustments) of the Notes. In addition, the diluted net income per common share does not include any incremental shares related to the exercise of the warrants for the three and nine months ended September 30, 2012 and 2011. The warrants will not have an impact on diluted net income per common share until the price of our common stock exceeds the strike price of the warrants (initially $34.875, subject to adjustments). When the market price of our stock exceeds the conversion price of the Notes or the strike price of the warrants, as applicable, we will include, in the diluted net income per common share calculation, the effect of the additional shares that may be issued upon conversion of the Notes or exercise of the warrants using the treasury stock method.
In addition, the call options to purchase our common stock, which we purchased to hedge against potential dilution upon conversion of the Notes (see Note 2 “Financial Statement Details — Convertible Debt”), are not considered for purposes of calculating the total dilutive weighted average shares outstanding, as their effect would be anti-dilutive. Upon exercise, the call options will mitigate the dilutive effect of the Notes.

The basic and diluted net income per share calculations for the three and nine months ended September 30, 2012 and 2011 are as follows (in thousands, except per share data, unaudited):
 

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Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2012
 
2011
 
2012
 
2011
Net income
$
1,975

 
$
2,628

 
$
5,545

 
$
8,671

Weighted average common shares outstanding for basic
53,659

 
52,517

 
53,309

 
52,188

Dilutive potential common stock outstanding:
 
 
 
 
 
 
 
Stock options
1,376

 
2,001

 
1,481

 
2,023

Restricted stock units
222

 
361

 
300

 
380

Employee stock purchase plan
8

 
19

 
7

 
14

       Convertible senior notes

 
49

 

 

Weighted average common shares outstanding for diluted
55,265

 
54,947

 
55,097

 
54,605

Net income per share:
 
 
 
 
 
 
 
Basic
$
0.04

 
$
0.05

 
$
0.10

 
$
0.17

Diluted
$
0.04

 
$
0.05

 
$
0.10

 
$
0.16

Recent Accounting Pronouncements

During the nine months ended September 30, 2012, there were no other new accounting pronouncements or updates to the recently issued accounting pronouncements disclosed in our annual report on Form 10-K for the fiscal year ended December 31, 2011, that would materially affect our results of operations, financial condition, liquidity or disclosures.

2. Financial Statement Details
Cash and Cash Equivalents and Available-for-Sale Investments
We invest our excess funds in securities issued by the U.S. government, corporations, banks, municipalities, financial holding companies and in money market funds comprised of these same types of securities. Our cash and cash equivalents and investments are placed with high credit quality financial institutions. Additionally, we diversify our investment portfolio in order to maintain safety and liquidity. As of September 30, 2012, all of our investments will mature within 23 months. These investments are recorded at their estimated fair value including accrued interest receivable, with unrealized gains or losses reported as a separate component of accumulated other comprehensive income or loss.
Fair value is defined as an exit price that would be received from the sale of an asset or paid to transfer a liability in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. Authoritative guidance establishes a three-level hierarchy for disclosure that is based on the extent and level of judgment used to estimate the fair value of assets and liabilities.
Level 1 – Valuations based on quoted prices for identical assets or liabilities in active markets at the measurement date. Since valuations are based on quoted prices that are readily and regularly available in an active market, valuation of these products does not entail a significant degree of judgment. Our Level 1 assets consist of money market funds and U.S. Treasury and agency debt securities.
Level 2 – Valuations based on quoted prices for similar assets and liabilities in active markets; quoted prices for identical or similar assets and liabilities in markets that are not active; or other inputs that are observable or can be corroborated by observable market data, such as alternative pricing sources with reasonable levels of price transparency. Our Level 2 assets consist of corporate debt securities including commercial paper, corporate bonds, certificates of deposit and foreign currency forward contracts.
Level 3 – Valuations based on inputs that are unobservable and significant to the overall fair value measurement. We have not measured the fair value of any of our assets using Level 3 inputs.
We utilize a third-party pricing service to assist us in obtaining fair value pricing for our investments. Pricing for securities is based on proprietary models. Inputs are documented in accordance with the fair value disclosure hierarchy. We utilize a third-party financial institution to assist us in obtaining fair value pricing for our foreign currency forward contracts.
During the three and nine months ended September 30, 2012 and 2011, no transfers were made into or out of the Level 1, 2, or 3 categories. We will continue to review our fair value inputs on a quarterly basis.
Financial assets and liabilities measured at fair value on a recurring basis are summarized below at September 30, 2012 and December 31, 2011 (in thousands):

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Fair Value Measurements at September 30, 2012
 
Total
 
Level 1
 
Level 2
 
Level 3
Assets:
 
 
 
 
 
 
 
Current:
 
 
 
 
 
 
 
Cash
$
49,920

 
$
49,920

 
$

 
$

Money market funds
18,787

 
18,787

 

 

Sub-total cash and cash equivalents
68,707

 
68,707

 

 

Corporate debt securities
154,060

 

 
154,060

 

U.S. Treasury and agency debt securities
19,019

 
19,019

 

 

Sub-total short-term investments
173,079

 
19,019

 
154,060

 

Long-term:
 
 
 
 
 
 
 
Corporate debt securities
11,343

 

 
11,343

 

U.S. Treasury and agency debt securities
6,005

 
6,005

 

 

Sub-total long-term investments
17,348

 
6,005

 
11,343

 

Total assets measured at fair value
$
259,134

 
$
93,731

 
$
165,403

 
$

Liabilities:
 
 
 
 
 
 
 
       Foreign currency forward contracts
$
1,077

 
$

 
$
1,077

 
$


 
Fair Value Measurements at December 31, 2011
 
Total
 
Level 1
 
Level 2
 
Level 3
Assets:
 
 
 
 
 
 
 
Current:
 
 
 
 
 
 
 
Cash
$
41,744

 
$
41,744

 
$

 
$

Money market funds
65,272

 
65,272

 

 

Sub-total cash and cash equivalents
107,016

 
107,016

 

 

Corporate debt securities
74,274

 

 
74,274

 

U.S. Treasury and agency debt securities
38,053

 
38,053

 

 

Sub-total short-term investments
112,327

 
38,053

 
74,274

 

Foreign currency forward contracts
92

 

 
92

 

Long-term:
 
 
 
 
 
 
 
Corporate debt securities
20,898

 

 
20,898

 

U.S. Treasury and agency debt securities
10,021

 
10,021

 

 

Sub-total long-term investments
30,919

 
10,021

 
20,898

 

Total assets measured at fair value
$
250,354

 
$
155,090

 
$
95,264

 
$

Liabilities:
 
 
 
 
 
 
 
Foreign currency forward contracts
$
71

 
$

 
$
71

 
$


Our investments have been classified as available-for-sale. At September 30, 2012 and December 31, 2011, available-for-sale investments are detailed as follows (in thousands):
 

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At September 30, 2012
 
Amortized
Cost
 
Gross Unrealized
Gains
 
Gross Unrealized
Losses
 
Estimated
Fair Value
Short-term:
 
 
 
 
 
 
 
Corporate debt securities
$
153,969

 
$
94

 
$
3

 
$
154,060

U.S. Treasury and agency debt securities
19,005

 
14

 

 
19,019

Short-term available-for-sale investments
$
172,974

 
$
108

 
$
3

 
$
173,079

Long-term:
 
 
 
 
 
 
 
Corporate debt securities
$
11,343

 
$
6

 
$
6

 
$
11,343

U.S. Treasury and agency debt securities
6,004

 
1

 

 
6,005

Long-term available for sale investments
$
17,347

 
$
7

 
$
6

 
$
17,348

 
 
At December 31, 2011
 
Amortized
Cost
 
Gross Unrealized
Gains
 
Gross Unrealized
Losses
 
Estimated
Fair Value
Short-term:
 
 
 
 
 
 
 
Corporate debt securities
$
74,233

 
$
44

 
$
3

 
$
74,274

U.S. Treasury and agency debt securities
38,050

 
4

 
1

 
38,053

Short-term available-for-sale investments
$
112,283

 
$
48

 
$
4

 
$
112,327

Long-term:
 
 
 
 
 
 
 
Corporate debt securities
$
20,930

 
$
1

 
$
33

 
$
20,898

U.S. Treasury and agency debt securities
10,017

 
4

 

 
10,021

Long-term available for sale investments
$
30,947

 
$
5

 
$
33

 
$
30,919

Available-for-sale investments that are in an unrealized loss position at September 30, 2012 and December 31, 2011 are detailed as follows (in thousands):
 
 
At September 30, 2012
 
Estimated
Fair Value
 
Gross Unrealized
Losses
Corporate debt securities
$
34,029

 
$
9


 
At December 31, 2011
 
Estimated
Fair Value
 
Gross Unrealized
Losses
Corporate debt securities
$
27,664

 
$
36

U.S. Treasury and agency debt securities
$
9,502

 
$
1

 
$
37,166

 
$
37

Derivative Financial Instruments
Our derivative financial instruments are composed of foreign currency forward contracts. We record derivative financial instruments as either assets or liabilities in our unaudited condensed consolidated balance sheets and measure them at fair value. At September 30, 2012 and December 31, 2011, notional amounts of our outstanding contracts were $64.2 million and $59.3 million, respectively. At September 30, 2012, the outstanding derivatives had maturities of 187 days or less. At September 30, 2012 and December 31, 2011, the fair value of our foreign currency forward contracts of $0 and $92,000 was included in prepaid and other current assets and $1.1 million and $71,000, respectively, was included in accrued expenses and other current liabilities in our unaudited condensed consolidated balance sheets. For the three and nine months ended September 30, 2012, $1.3 million and $155,000, respectively, of net losses related to our derivative financial instruments are included in our unaudited condensed consolidated statements of operations. For the three and nine months ended September 30, 2011, $572,000 and $2.3 million, respectively, of net losses related to our derivative financial instruments are included in our unaudited condensed consolidated statements of operations.
In connection with our convertible debt offering (discussed in more detail below) we purchased call options on our common

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stock from JPMorgan Chase. The call options give us the right to purchase up to approximately 3.9 million shares of our common stock at $29.64 per share subject to certain adjustments that generally correspond to the adjustments to the conversion rate for the underlying debt. Additionally, we sold warrants to JPMorgan Chase, which give JPMorgan Chase the right to purchase up to approximately 3.9 million shares of our common stock at $34.875 per share, subject to certain adjustments. In accordance with the authoritative guidance, we concluded that the call options and warrants were indexed to our stock. Therefore, the call options and warrants were classified as equity instruments and are not being marked to market prospectively as long as they continue to meet the conditions for equity classification.

Inventories
Inventories consist of the following (in thousands):
 
 
September 30,
2012
 
December 31,
2011
Finished goods (1)
$
20,473

 
$
17,770

Work-in-process
12,965

 
9,419

Raw materials
15,954

 
14,117

 
$
49,392

 
$
41,306

 _______________________ 
(1)
Finished goods inventory includes consigned inventory of $4.0 million and $4.9 million at September 30, 2012 and December 31, 2011, respectively.
Property and Equipment
Property and equipment consists of the following (in thousands):
 
 
September 30,
2012
 
December 31,
2011
Medical diagnostic equipment
$
67,029

 
$
64,375

Other equipment
41,496

 
33,953

Leasehold improvements
9,410

 
8,514

Software
5,632

 
5,113

Land
3,046

 
3,046

Building
29,098

 

Construction-in-progress (1)
25,374

 
31,123

 
181,085

 
146,124

Accumulated depreciation and amortization
(78,079
)
 
(65,027
)
 
$
103,006

 
$
81,097

 _______________________ 
(1)
Construction-in-progress at September 30, 2012 includes $789,000 of capitalized interest related to the Enterprise Resource Planning, or ERP, system implementation worldwide. Construction-in-progress at December 31, 2011 includes $1.2 million of capitalized interest related to the construction of our manufacturing facility in Costa Rica and ERP system implementation worldwide.

Intangible Assets
Intangible assets consist of developed technology, licenses, customer relationships, patents and trademarks which are amortized using the straight-line method over periods ranging from 3 to 20 years, representing the estimated useful lives of the assets. In-process research and development, or IPR&D, consists of in-process technology, which is still in the prototype phase and, therefore, amortization will not begin until such technology reaches market feasibility.
At September 30, 2012, intangible assets by major class consist of the following (in thousands):
 

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September 30, 2012
 
Cost
 
Accumulated
Amortization
 
Net
 
Weighted-
Average Life
(in years) (1)
Intangible assets subject to amortization:
 
 
 
 
 
 
 
Developed technology
$
23,451

 
$
17,021

 
$
6,430

 
8.1
Licenses
7,195

 
6,544

 
651

 
10.0
Customer relationships
4,171

 
3,662

 
509

 
3.5
Patents and trademarks
6,217

 
1,992

 
4,225

 
10.2
 
41,034

 
29,219

 
11,815

 
7.5
Intangible assets not yet subject to amortization:
 
 
 
 
 
 
 
In-process research and development (2)
4,050

 

 
4,050

 
n/a
 
$
45,084

 
$
29,219

 
$
15,865

 
 
At December 31, 2011, intangible assets by major class consist of the following (in thousands):
 
 
December 31, 2011
 
Cost
 
Accumulated
Amortization
 
Net
 
Weighted-
Average Life
(in years) (1)
Intangible assets subject to amortization:
 
 
 
 
 
 
 
Developed technology
$
22,651

 
$
15,995

 
$
6,656

 
8.2
Licenses
7,195

 
6,054

 
1,141

 
10.0
Customer relationships
4,082

 
3,067

 
1,015

 
3.3
Patents and trademarks
4,015

 
1,632

 
2,383

 
9.0
 
37,943

 
26,748


11,195

 
7.3
Intangible assets not yet subject to amortization:
 
 
 
 
 
 
 
In-process research and development (2)
4,050

 

 
4,050

 
n/a
 
$
41,993

 
$
26,748

 
$
15,245

 
 
 _______________________ 
(1)
Weighted average life of intangible assets is presented excluding fully amortized assets.
(2)
IPR&D represents an estimate of fair value of in-process technology, which is still in the prototype phase. As such, based on authoritative guidance, amortization of the IPR&D will not occur until it reaches market feasibility. In the event the project is abandoned, we will record an impairment charge accordingly.

At September 30, 2012, future amortization expense associated with our intangible assets is expected to be as follows (in thousands):
 
2012 (remaining three months)
$
762

2013
2,442

2014
1,785

2015
1,369

2016
1,206

Thereafter
4,251

 
$
11,815

Convertible Debt
In September 2010, we issued $115.0 million aggregate principal amount of 2.875% Convertible Senior Notes due September 1, 2015, or the Notes, in an offering registered under the Securities Act of 1933, as amended. Interest is payable semiannually in arrears on March 1 and September 1, commencing on March 1, 2011.
Prior to June 1, 2015, the Notes are convertible only upon certain events specified in the indenture governing the Note. The initial effective conversion price is approximately $29.64 per share of common stock. The conversion rate is subject to adjustment for certain events as outlined in the indenture governing the Notes but will not be adjusted for accrued and unpaid

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interest.
We received proceeds of $100.5 million from issuance of the Notes, net of debt issuance costs ($4.4 million) and net payments related to our hedge transactions ($10.0 million) which are described in more detail below. We recorded total debt issuance costs (including broker fees) of approximately $4.4 million, which were allocated on a pro-rata basis to the debt ($3.5 million) and equity ($866,000) components of the transaction. The debt component is primarily included in non-current liabilities and is being accreted to interest expense over five years, the term of the Notes. The equity component was netted against the proceeds and included in additional paid-in capital.
We may not redeem the Notes prior to maturity. However, in the event of a fundamental change, as defined in the indenture, the holders of the Notes may require us to purchase all or a portion of their Notes at a purchase price equal to 100% of the principal amount of the Notes, plus accrued and unpaid interest, if any, to the repurchase date. Holders who convert their Notes in connection with a make-whole fundamental change, as defined in the indenture, may be entitled to a make-whole premium in the form of an increase in the conversion rate.

In connection with the offering of the Notes, to hedge against potential dilution upon conversion of the Notes, we also purchased call options on our common stock from JPMorgan Chase. The call options give us the right to purchase up to approximately 3.9 million shares of our common stock at $29.64 per share subject to certain adjustments that generally correspond to the adjustments to the conversion rate for the Notes. We paid an aggregate of $27.2 million to purchase these call options. The call options will expire on September 1, 2015, unless earlier terminated or exercised. To reduce the cost of the hedge, in a separate transaction we sold warrants to JPMorgan Chase. These warrants give JPMorgan Chase the right to purchase up to approximately 3.9 million shares of our common stock at $34.875 per share, subject to certain adjustments. These warrants will be exercisable and will expire in equal installments for a period of 50 trading days beginning on December 1, 2015. We received an aggregate of $17.1 million from the sale of these warrants. In accordance with the applicable authoritative guidance, we concluded that the call options and warrants were indexed to our stock. Therefore, the call options and warrants were classified as equity instruments and will not be marked to market prospectively as long as they continue to meet the condition for equity classification. The net amount of $10.0 million paid to JPMorgan Chase was recorded as a reduction to additional paid-in capital. The settlement terms of the call options provide for net share settlement and the settlement terms of the warrants provide for net share or cash settlement at our option. The carrying values of the liability and equity components of the Notes are reflected in our unaudited condensed consolidated balance sheets as follows (in thousands):
 
 
September 30,
2012
 
December 31,
2011
Liabilities:
 
 
 
Principal amount of the 2.875% Convertible Senior Notes
$
115,000

 
$
115,000

Unamortized discount of liability component
(14,121
)
 
(17,275
)
Unamortized debt issuance costs
(1,641
)
 
(2,062
)
Carrying value of liability component
$
99,238

 
$
95,663

Equity — net carrying value
$
22,263

 
$
22,263

The fair value of the Notes at September 30, 2012 was $128.0 million.
Other Long-Term Debt
The amounts outstanding for other long-term debt at September 30, 2012 and December 31, 2011 relate to capital leases.

3. Commitments and Contingencies
Litigation — LightLab
On January 7, 2009, LightLab Imaging, Inc., or LightLab, filed a complaint against us and our wholly owned subsidiary, Axsun, in the Superior Court of Massachusetts, Suffolk County, seeking injunctive relief and unspecified damages (the Massachusetts Action). LightLab develops and sells OCT products for cardiovascular imaging and other medical uses. On July 6, 2010, LightLab was acquired by St. Jude Medical, Inc., or St. Jude.
Prior to our acquisition of Axsun, Axsun had entered into a development and supply agreement, or the Agreement, with LightLab, in which, among other things, Axsun agreed to supply tunable lasers to LightLab for use in LightLab’s OCT imaging products until April 2016, with exclusivity in the field of coronary artery imaging expiring in April 2014. Since the acquisition, Axsun has continued to supply lasers to LightLab. The complaint includes allegations that Volcano interfered with the

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Agreement and with LightLab’s advantageous business relationship with Axsun, that Axsun breached the Agreement, that Axsun and Volcano misappropriated LightLab’s confidential information and trade secrets, and violated Chapter 93A, a Massachusetts statute that provides for recovery of up to three times damages plus attorneys fees (93A).
The Judge ordered that the trial in the Massachusetts Action proceed in separate phases, with a jury trial first on liability, followed by a jury trial on damages, and then non-jury hearings on liability under 93A and on injunctive relief. The jury trial on liability commenced on January 4, 2010 and the jury returned a verdict on February 4, 2010 that included findings that the contract specifications for the lasers Axsun supplies and previously supplied to LightLab are trade secrets of LightLab, that Axsun agreed not to sell any tunable lasers to Volcano for any purpose or to third parties for use in cardiology imaging during the exclusivity period in the contract, and that Axsun breached its contract with LightLab. The jury further found that Volcano intentionally interfered with LightLab’s advantageous business relationship with Axsun.

A trial in the Massachusetts Action with respect to damages was set to commence on April 7, 2010 (Damages Trial). In lieu of conducting the Damages Trial, the parties agreed and stipulated that the sum of $200,000 would be treated as if it were the jury’s verdict against the defendants in the Damages Trial (the Stipulation).
Upon the entry of the Stipulation, LightLab waived its rights, if any, to make any additional claims for special damages relating to lasers received in 2009 that do not meet the version 6 specification, for special damages claimed by LightLab in prior pleadings, and for the repair and/or replacement of any of the lasers specified in the Stipulation. In addition, Axsun waived its rights, if any, to make any claim for recovery from LightLab for certain engineering charges in connection with a development and supply agreement with LightLab, and for return by LightLab of any of the lasers specified in the Stipulation.
Under the Stipulation, all parties expressly reserved their otherwise properly preserved rights of appeal. These rights include LightLab’s appellate rights, if any, regarding its claim for alleged lost profits in excess of the above-referenced $200,000 stipulated amount to the extent LightLab is able to establish that it has properly preserved such rights.
The injunctive relief phase of the Massachusetts Action commenced on April 12, 2010. In a ruling issued October 5, 2010, the Court rejected LightLab’s claims for protection of five alleged trade secrets relating to laser technologies, and denied all of LightLab’s requests for permanent injunctions with respect to those trade secrets. The ruling followed a two-week trial on five of a number of trade secret claims alleged by LightLab.
In a summary judgment ruling issued January 26, 2011, the Court rejected the remainder of LightLab’s claims for protection of its remaining trade secrets, and denied all of LightLab’s claims for permanent injunctions with respect to those trade secrets. This judgment completed the trade secret portion of the Massachusetts Action.
In a ruling issued January 28, 2011, the Court found that Volcano and Axsun violated 93A, and awarded LightLab additional damages of $400,000 and reasonable attorneys’ fees.
On February 10, 2011, and on April 7, 2011, the Court entered a Final Judgment and an Amended Final Judgment, respectively, in the Massachusetts Action: a) in favor of Volcano and Axsun on LightLab’s claims for trade secret misappropriation on items 1-30 on LightLab’s list of alleged trade secrets, b) ordered Volcano and Axsun to collectively pay $600,000 in damages (which amount includes the $200,000 agreed to in the Stipulation and the $400,000 ordered in the 93A ruling) and $4.5 million in attorneys’ fees (resulting in a total of $4.9 million recorded to selling, general and administrative expense and accrued in other current liabilities during the fourth quarter of 2010), c) in favor of LightLab on its claims against Axsun for breach of contract, breach of implied covenant of good faith and fair dealing, for violation of 93A, and misappropriation of trade secrets for disclosing three particular items to Volcano in December 2008 – the specifications for the two lasers provided by Axsun to LightLab and one Axsun laser prototype made in 2008, d) in favor of LightLab on its claims against Volcano for intentional interference with a contract and advantageous business relationship, unjust enrichment, violation of 93A, and misappropriation of trade secrets for the same three trade secrets described above. In addition, the Court denied a majority of LightLab’s requested injunctions, and entered limited injunctive relief, none of which management believes have a material effect upon Volcano. The Final Judgment and Amended Final Judgment are substantially similar. The Amended Final Judgment corrects non-substantive clerical errors. On April 15, 2011, LightLab filed a notice of appeal, with respect to various decisions of the Court, including, a) the Court’s decisions adverse to LightLab’s claims for trade secret misappropriation in items 1-30 of LightLab’s alleged list of trade secrets, including the Court’s post-trial finding of fact and rulings of law adverse to LightLab on items 1 – 5, the Court’s two summary judgment decisions adverse to LightLab on items 6 – 23 and 25 – 30 (item 24 having been voluntarily dismissed by LightLab), and various rulings requiring evidence of use or intent to use as a prerequisite for injunctive relief; b) the Court’s post-trial decisions denying permanent injunctive relief that LightLab requested as terms of the Final Judgment; c) the Court’s pre-trial rulings excluding certain lost profits damages evidence that LightLab sought to introduce at trial; d) various discovery and pre-trial orders denying LightLab discovery about Axsun’s work for Volcano; e) the Court’s order barring LightLab from claiming that the sale of Axsun to Volcano itself constituted a breach of the LightLab-

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Axsun supply contract; and f) the denial of LightLab’s motion to alter or amend the Final Judgment, which motion sought to obtain additional declaratory relief barring Axsun from “supplying” tunable lasers to Volcano. Volcano and Axsun do not intend to cross appeal the Amended Final Judgment, and on July 5, 2011, Volcano and Axsun satisfied their payment obligations under the Amended Final Judgment by making a payment to Lightlab in the amount of approximately $5.4 million.
On February 5, 2010, Volcano and our wholly owned subsidiary, Axsun, commenced an action in the Delaware Chancery Court, or the Chancery Court Action, against LightLab seeking a declaration of Volcano and Axsun’s rights with respect to certain OCT technology, the High Definition Swept Source. The complaint was served on LightLab on March 19, 2010. LightLab then filed a counter-claim that included a claim against Axsun and Volcano for violations of 93A. Volcano and Axsun moved to dismiss LightLab’s 93A counter-claim, and LightLab responded to that motion by amending its 93A counter-claim. The 93A counterclaim has been stayed pending further action by the Chancery Court. This case has been stayed until such time as Volcano has achieved certain development and regulatory milestones.

Additionally, on May 24, 2011, LightLab commenced a separate action in Delaware Chancery Court, or the Second Chancery Court Action, against Volcano and Axsun alleging that Axsun is inappropriately assisting Volcano in the development of a third-party laser. The complaint seeks injunctive relief and unspecified damages. After Volcano and Axsun moved to dismiss the Second Chancery Court Action, LightLab filed an amended complaint against Volcano and Axsun, adding additional allegations regarding misappropriation of trade secrets. This case has been stayed indefinitely.
Litigation — St. Jude Medical
On July 27, 2010, St. Jude Medical filed a lawsuit against Volcano in federal district court in Delaware (collectively, with the counterclaims described below, the Delaware Patent Action), alleging that our pressure guide wire products infringe five patents owned by St. Jude Medical. St. Jude Medical is seeking injunctive relief and monetary damages. This action does not involve OCT technology and is separate from the Massachusetts Action.
On September 20, 2010, Volcano filed its response, in which we denied the allegations that our PrimeWire® products infringe any valid claim of St. Jude Medical’s asserted patents. In addition, Volcano filed a counterclaim in which we have alleged that St. Jude Medical’s PressureWire® products and its RadiAnalyzer® Xpress product infringe three Volcano patents. In our counterclaim, Volcano is seeking injunctive relief and monetary damages. A trial on the St. Jude Medical patents has been scheduled for October 15, 2012 and a trial on Volcano's patents has been scheduled for October 22, 2012.
On October 12, 2012, the court entered summary judgment for Volcano with respect to one of St. Jude Medical's asserted patents. On October 19, 2012, a jury found in favor of Volcano on the remaining four St. Jude Medical patents, finding that two of the patents were invalid and that Volcano did not infringe two of the patents. On October 22, 2012, Volcano voluntarily dismissed its claims against St. Jude Medical with respect to one of Volcano's patents. On October 25, 2012, a jury found in favor of St. Jude Medical with respect to Volcano's asserted patents. In conjunction with the trial, St. Jude Medical agreed that previous versions of its PressureWire® products infringed Volcano's 6,976,965 patent (a pressure sensing guide wire patent). Proceedings on damages have not yet been scheduled. Post-trial motions are pending or remain available to the parties in the case.
On April 9, 2012, St. Jude Medical, Cardiology Division, Inc., St. Jude Medical Systems AB and St. Jude Medical S.C. filed a sealed complaint in the United States District Court for the District of Delaware alleging that Volcano Corporation infringes United States Patent No. 6565514. A claim construction hearing has been set for March 7, 2013. No trial date has been set in this case.

Litigation - CardioSpectra
On March 27, 2012, Christopher E. Banas, et al., filed a lawsuit against Volcano in federal district court in the Northern District of California, alleging claims for breach of contract, breach of fiduciary duty, and breach of the implied covenant of good faith and fair dealing based on Volcano's acquisition of CardioSpectra in 2007. Specifically, plaintiffs assert that Volcano has failed to comply with the terms and the alleged implied obligations of the Merger Agreement relating to potential milestone payments. CardioSpectra was in the business of developing OCT technology, however, this litigation is separate from the Massachusetts Action.

On May 14, 2012, Volcano moved to dismiss the complaint in its entirety. The motion sought to dismiss the breach of fiduciary duty and implied covenant claims without leave for amendment, and to dismiss the breach of contract claim with leave to amend. By order dated August 6, 2012, the Court granted Volcano's motion as to all issues with leave to amend. The plaintiffs filed a Second Amended Complaint on August 20, 2012, which included a single claim for breach of the Merger Agreement. In addition, the plaintiffs identified in the Second Amended Complaint are listed as Christopher E. Banas and Paul Castella in

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their respective capacities as Shareholder Representatives under the Merger Agreement. Volcano answered the Second Amended Complaint on September 4, 2012, and in the same document Volcano asserted several affirmative defenses. The court has scheduled a case management conference on December 3, 2012. A trial date has not yet been scheduled in this matter.

The Company believes the lawsuits described above are without merit, and intends to vigorously defend against or prosecute, as applicable, the matters described above.
Litigation — Other
We may also be a party to various other claims in the normal course of business. Legal fees and other costs associated with such actions are expensed as incurred and were not material in any period reported. Additionally, we assess, in conjunction with our legal counsel, the need to record a liability for litigation and contingencies. Reserve estimates are recorded when and if it is determined that a loss related matter is both probable and reasonably estimable. Any provisions are reviewed at least quarterly and are adjusted to reflect the impact and status of settlements, rulings, advice of counsel and other information and events pertinent to a particular matter. Based on its experience, the Company also believes that the damage amounts claimed in the lawsuits disclosed above are not a meaningful indicator of the Company's potential liability. At this time, we are not able to predict or estimate the ultimate outcome or range of possible losses relating to the lawsuits, claims or counterclaims described above. However, we believe that the ultimate disposition of these matters, individually and in the aggregate, including the matters discussed above, will not have a material impact on our consolidated results of operations, financial position or cash flows. Our evaluation of the likely impact of these matters could change in the future, as litigation is inherently unpredictable, and unfavorable outcomes and/or defense costs, depending upon the amount and timing, could have a material adverse effect on our results of operations, financial position, or cash flows in future periods.
Operating Leases
Rent expense for our facilities leases is being recognized on a straight-line basis over the respective minimum lease terms.
Commitments
We have obligations under non-cancelable purchase commitments. The majority of these obligations relate to the purchase of raw materials inventory. At September 30, 2012, the future minimum payments under these non-cancelable purchase commitments totaled $43.1 million, of which $32.9 million will require payments at various dates through December 31, 2012. The remaining amount will require payments at various dates through 2016.
In October 2007, we signed a clinical research support agreement with a third party in which the third party will conduct clinical studies concerning drug eluting stents. We have agreed to provide a total of $4.6 million to fund clinical study activities. At September 30, 2012, we have a remaining obligation of up to $2.1 million and we will be billed as services are performed under the agreement. In addition, we have entered into agreements with other third parties to sponsor clinical studies. Generally, we contract with one or more clinical research sites for a single study and no one agreement is material to our consolidated results of operations or financial condition. We are usually billed as services are performed based on enrollment and are required to make payments over periods ranging from less than one year to three years. Our actual payments under these agreements will vary based on enrollment.
On December 18, 2007, we acquired CardioSpectra, a privately held corporation. Subject to the terms of the merger agreement, we may be required to make milestone payments. The remaining milestone payments of up to $17.0 million may be paid upon achievement of the respective revenue targets described in the merger agreement. As of September 30, 2012, we have not achieved the respective revenue targets. Therefore, we have not recorded any liability related to these milestones. The milestone payments are payable, at our sole discretion, in cash, shares of our common stock, or a combination of both and will be accounted for if and when the milestone payments become payable. We have used, and will continue to use, commercially reasonable efforts to cause the milestones to occur. However, if we reasonably determine that a technical failure or commercial failure has occurred with respect to all or a part of the OCT program, we may, at our sole discretion, terminate all or part of the OCT cardiovascular program.

Indemnification
Our supplier, distributor and collaboration agreements generally include certain provisions for indemnification against liabilities if our products are recalled, infringe a third party’s intellectual property rights or cause bodily injury due to alleged defects in our products. In addition, we have agreements with our present and former directors and executive officers indemnifying them against liabilities arising from service in their respective capacities to Volcano. We maintain directors’ and officers’ insurance policies that may limit our exposure to such liabilities. To date, we have not incurred any material costs as a result of such indemnifications and have not accrued any liabilities related to such obligations in the accompanying unaudited

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condensed consolidated financial statements.
Sole source suppliers
We rely on a number of sole source suppliers to supply transducers, substrates and processing for our scanners used in our catheters. With certain suppliers we have supply agreements, and with others we use purchase orders as needed.

4. Stockholders’ Equity
Stock Benefit Plans
Our 2005 Amended and Restated Equity Compensation Plan, or 2005 Amended Plan, provides for an aggregate of 16,212,558 shares of our common stock that may be issued or transferred to our employees, non-employee directors and consultants, including increases of 2,050,000 and 2,500,000 shares which were approved by our stockholders on July 29, 2009 and May 2, 2011, respectively. Commencing July 29, 2009, the number of shares of common stock available for issuance under the 2005 Amended Plan was reduced by one share for each share of stock issued pursuant to a stock option or a stock appreciation right and one and sixty-three hundredths (1.63) shares for each share of common stock issued pursuant to a restricted stock award, restricted stock unit award, or RSU, performance-based RSU or other stock award. Commencing May 2, 2011, the number of shares of common stock available for issuance under the 2005 Amended Plan was reduced by one share for each share of stock issued pursuant to a stock option or a stock appreciation right and two and twelve hundredths (2.12) shares for each share of common stock issued pursuant to a RSU, performance-based RSU or other stock award. Shares net exercised or retained to cover a participant’s minimum tax withholding obligations are not available for issuance under the 2005 Amended Plan.
At September 30, 2012, we have granted stock options, RSUs and performance-based RSUs under the 2005 Amended Plan. Stock options previously granted under the 2000 Long Term Incentive Plan that are canceled or expired will increase the shares available for grant under the 2005 Amended Plan. In addition, employees have purchased shares of the Company’s common stock under the 2007 Employee Stock Purchase Plan, or the Purchase Plan. At September 30, 2012, 3,078,072 shares and 251,380 shares remained available to grant under the 2005 Amended Plan and the Purchase Plan, respectively.
On February 27, 2012, our Section 162(m) Committee adopted, under the terms of the 2005 Amended Plan, the 2012 Long Term Incentive Plan, or LTI, and granted a maximum of 61,003 shares of performance-based RSUs under the terms of the LTI. The Committee established the LTI plan to align key management and senior leadership with stockholders' interests and to retain key employees. The measurement period for the LTI Plan is our 2012 fiscal year. If pre-determined performance goals are met, shares of stock subject to the performance-based RSUs granted to the recipient will begin to vest, with one third vesting on the date of certification of achievement of the pre-determined performance goals, and the remaining two thirds vesting evenly on each of December 31, 2013 and December 31, 2014, contingent upon the recipient’s continued service to the Company on each such date.
Fair Value Assumptions
The fair value of each stock option is estimated on the date of grant using the Black-Scholes-Merton option-pricing, or Black-Scholes, model utilizing the following weighted-average assumptions:
 
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2012
 
2011
 
2012
 
2011
Risk-free interest rate
0.7
%
 
1.9
%
 
0.8
%
 
2.1
%
Expected life (years)
4.1

 
4.5

 
4.1

 
4.4

Estimated volatility
46.1
%
 
46.8
%
 
47.0
%
 
47.4
%
Expected dividends

 

 

 

Weighted-average grant date fair value
$
10.89

 
$
13.10

 
$
10.83

 
$
11.52

The risk-free interest rate for periods within the contractual life of the stock option is based on the implied yield available on U.S. Treasury constant maturity securities with the same or substantially equivalent remaining terms at the time of grant. We use our historical stock option exercise experience to estimate the expected term of our stock options. The computation of the estimated volatility is based on the trading history of our common stock. We use a zero value for the expected dividend value factor since we have not declared any dividends in the past and we do not anticipate declaring any dividends in the foreseeable future.
The fair value of each purchase option under the Purchase Plan is estimated at the beginning of each purchase period using the

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Black-Scholes model utilizing the following weighted-average assumptions:
 
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2012
 
2011
 
2012
 
2011
Risk-free interest rate
0.1
%
 
0.1
%
 
0.1
%
 
0.2
%
Expected life (years)
0.5

 
0.5

 
0.5

 
0.5

Estimated volatility
36.8
%
 
35.7
%
 
39.1
%
 
35.7
%
Expected dividends

 

 

 

Fair value of purchase right
$
7.07

 
$
6.87

 
$
7.32

 
$
6.48

The risk-free interest rate is based on U.S. Treasury constant maturity securities with the same or substantially equivalent remaining term in effect at the beginning of the offering period. The expected life assumption is based on the six-month term of each offering period. The computation of the expected volatility is based on the trading history of our common stock. We use a zero value for the expected dividend value factor since we have not declared any dividends in the past and we do not anticipate declaring any dividends in the foreseeable future.
Stock-Based Compensation Expense
With the exception of performance-based RSUs, stock-based compensation expense is recognized on a straight-line basis over the requisite service period of the entire award, which is generally the vesting period.
We recognize the estimated compensation cost of performance-based RSUs, net of estimated forfeitures. The performance-based RSUs are earned upon attainment of identified performance goals, some of which contain discretionary metrics. As such, these award are re-valued based on our traded stock price at the end of each reporting period. If the discretion is removed, the award will be classified as a fixed equity award. The fair value of the awards will be based on the measurement date, which is the date the award becomes fixed. Expense is recognized on a straight-line basis over the requisite service period for each vesting tranche of the award.
The following table sets forth stock-based compensation expense included in our unaudited condensed consolidated statements of operations (in thousands):
 
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2012
 
2011
 
2012
 
2011
Cost of revenues
$
202

 
$
146

 
$
515

 
$
304

Selling, general and administrative
3,331

 
2,720

 
9,606

 
8,057

Research and development
403

 
450

 
1,307

 
1,244

 
$
3,936

 
$
3,316

 
$
11,428

 
$
9,605

We had no non-employee stock-based compensation in the three and nine months ended September 30, 2012. During the three and nine months ended September 30, 2011, $0 and $115,000, respectively, of stock-based compensation related to non-employees was included in our stock-based compensation expense.
In the three and nine months ended September 30, 2012, $316,000 and $965,000, respectively, stock-based compensation expense was related to the Purchase Plan, respectively. In the three and nine months ended September 30, 2011, $257,000 and $793,000, respectively, stock-based compensation expense was related to the Purchase Plan, respectively.
At September 30, 2012 and December 31, 2011, there was $267,000 and $202,000, respectively, of total stock-based compensation cost capitalized in inventories.
We estimate forfeitures and only recognize expense for those shares expected to vest. Our estimated forfeiture rates in the three and nine months ended September 30, 2012 and 2011 are based on our historical forfeiture experience.

5. Segment and Geographic Information
Our chief operating decision-maker reviews financial information presented on a consolidated basis, accompanied by disaggregated information about segment revenues by product and geographic region for purposes of making operating decisions and assessing financial performance. We have two reporting segments: medical segment and industrial segment. The

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medical segment includes the discovery, development, manufacture, and sale of precision guided therapy tools for the diagnosis of atherosclerosis in the coronary arteries and peripheral vascular system. The industrial segment includes the discovery, development, manufacture and sale of micro-optical spectrometers and optical channel monitors to telecommunications and other industrial companies.

We do not assess the performance of our segments on other measures of income or expense, such as depreciation and amortization, operating income or net income. We do not produce reports for, or measure the performance of, our segments on any asset-based metrics. Therefore, segment information is presented only for revenues by product.
The following table sets forth our revenues by segment and product (in thousands) :
 
 
Three Months Ended
September 30,
 
Percentage
Change
 
Nine Months Ended
September 30,
 
Percentage
Change
 
2012
 
2011
 
2011 to 2012
 
2012
 
2011
 
2011 to 2012
Medical segment:
 
 
 
 
 
 
 
 
 
 
 
Consoles
$
9,679

 
$
9,709

 
(0.3
)%
 
$
28,529

 
$
29,420

 
(3.0
)%
Single-procedure disposables:
 
 
 
 
 
 
 
 
 
 
 
IVUS
48,574

 
49,760

 
(2.4
)
 
153,683

 
147,384

 
4.3

FFR
24,585

 
16,653

 
47.6

 
67,652

 
47,954

 
41.1

Other
7,825

 
6,796

 
15.1

 
21,286

 
16,565

 
28.5

Sub-total medical segment
90,663

 
82,918

 
9.3

 
271,150

 
241,323

 
12.4

Industrial segment:
2,993

 
2,849

 
5.1

 
8,239

 
9,475

 
(13.0
)
 
$
93,656

 
$
85,767

 
9.2
 %
 
$
279,389

 
$
250,798

 
11.4
 %
The following table sets forth our revenues by geography expressed as dollar amounts (in thousands):
 
 
Three Months Ended
September 30,
 
Percentage
Change
 
Nine Months Ended
September 30,
 
Percentage
Change
 
2012
 
2011
 
2011 to 2012
 
2012
 
2011
 
2011 to 2012
Revenues (1):
 
 
 
 
 
 
 
 
 
 
 
United States
$
44,083

 
$
38,964

 
13.1
 %
 
$
130,152

 
$
113,201

 
15.0
 %
Japan
29,699

 
26,599

 
11.7

 
90,025

 
76,406

 
17.8

Europe, the Middle East and Africa
13,491

 
14,637

 
(7.8
)
 
42,507

 
45,534

 
(6.6
)
Rest of world
6,383

 
5,567

 
14.7

 
16,705

 
15,657

 
6.7

 
$
93,656

 
$
85,767

 
9.2
 %
 
$
279,389

 
$
250,798

 
11.4
 %
_______________________ 
(1)
Revenues are attributed to geographies based on the location of the customer, except for shipments to original equipment manufacturers, which are attributed to the country of origin of the equipment distributed.
At September 30, 2012, approximately 41.4% of our long-lived assets, excluding financial assets, were located in the U.S., approximately 40.5% were located in Costa Rica, 14.6% were located in Japan and less than 5.0% were located in our remaining geographies. At December 31, 2011, approximately 44.8% of our long-lived assets, excluding financial assets, were located in the U.S., approximately 30.2% were located in Costa Rica, 20.7% were located in Japan, and less than 5.0% were located in our remaining geographies.

At September 30, 2012 and December 31, 2011, goodwill of $2.5 million has been allocated entirely to our medical segment and relates to our U.S. operations.

6. Income Taxes

Income taxes are determined using an estimated annual effective tax rate applied against income, and then adjusted for the tax impacts of certain discrete items. The Company recorded income tax expense of $4.3 million and $1.7 million for the nine months ended September 30, 2012 and 2011, respectively. The effective income tax rate for the nine months ended September 30, 2012 and 2011 were 43.6% and 16.3%, respectively. The Company updates its annual effective income tax rate each quarter and if the estimated effective income tax rate changes, a cumulative adjustment is made. The annual effective

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income tax rate for 2012 is expected to be higher than the U.S. federal statutory rate of 35% primarily due to state income taxes, net of federal benefit, estimates for certain non-deductible expenses and foreign rate differentials. At the end of 2011, the federal research and development credit expired and has not yet been extended for 2012. If the research and development credit is extended, the annual effective tax rate for 2012 is expected to be slightly higher than the U.S. federal statutory rate of 35% . There was no material change to the Company's unrecognized tax benefits and interest accrued related to unrecognized tax benefits during the three and nine months ended September 30, 2012.

The Company carries a valuation allowance on net operating loss and other deferred tax assets in certain international jurisdictions.  Realization is dependent on generating sufficient taxable income and other available positive and negative evidence.  Management's assessment of the recoverability of these deferred tax assets may increase in the near term based on estimates of future taxable income in these specific jurisdictions, which may result in a reduction in the related valuation allowance. If the objective and quantitative criteria are met, a reduction of the valuation allowance by $3 million to $5 million could occur as soon as the fourth quarter of 2012.

7. Subsequent Events
None.


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

Forward-looking statements: This quarterly report on Form 10-Q (“Quarterly Report”) contains forward-looking statements regarding future events and our future results that are based on current expectations, estimates, forecasts, and projections about the industries in which we operate and the beliefs and assumptions of our management. In some cases, you can identify these “forward-looking statements” by words like “may,” “will,” “should,” “expects,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “potential” or “continue” or the negative of those words and other comparable words. These statements include, but are not limited to, those concerning the following: our intentions, beliefs and expectations regarding our future financial performance, anticipated growth, trends in our business, trends in the medical field related to our products and technology, and the performance and competitive advantages of our products; our beliefs with respect to the usefulness of anticipated clinical data; the timing and success of our clinical trials, data presentations, regulatory submissions and anticipated product launches; our belief that our cash and cash equivalents and available-for-sale investments will be sufficient to satisfy our anticipated cash requirements; our belief that our current and planned facilities are sufficient for our business; our operating results; timing, costs and outcomes of current or future litigation; our expectations regarding our revenues and costs of producing our products; our expectations regarding our customers and distributors; and our intentions, beliefs and expectations regarding market penetration and expansion efforts. These statements are not guarantees of future performance or events. Our actual results may differ materially from those discussed here. For a detailed discussion of the risks and uncertainties that could contribute to such differences see the “Risk Factors” section in Part II, Item 1A of this Quarterly Report and elsewhere throughout this Quarterly Report and in any other documents incorporated by reference into this Quarterly Report. Any forward-looking statement speaks only as of the date on which it is made, and except as required by law, we undertake no obligation to update forward-looking statements to reflect events or circumstances occurring after the date of this Quarterly Report.
Overview
We design, develop, manufacture and sell a broad suite of precision guided therapy tools including intravascular ultrasound, or IVUS, and fractional flow reserve, or FFR, products. We believe that these products enhance the diagnosis and treatment of vascular heart disease by improving the efficiency and efficacy of existing percutaneous interventional, or PCI, therapy procedures in the coronary or peripheral arteries. We market our products to physicians and technicians who perform PCI procedures in hospitals and to other personnel who make purchasing decisions on behalf of hospitals.
Our products consist of multi-modality consoles which are marketed as stand-alone units or as customized units that can be integrated into a variety of hospital-based interventional surgical suites called catheterization laboratories, or cath labs. We have developed customized cath lab versions of these consoles and are developing additional functionality options as part of our cath lab integration initiative. Our consoles have been designed to serve as a multi-modality platform for our phased array and rotational IVUS catheters, FFR pressure wires, image-guided therapy catheters and Medtronic's Pioneer reentry device. Our IVUS products include single-procedure disposable phased array and rotational IVUS imaging catheters, the VIBE RX image-guided therapy device, and additional functionality options such as virtual histology, or VH, IVUS tissue characterization and ChromaFlo stent apposition analysis. Our FFR offerings can be accessed through our multi-modality platforms, and we also provide FFR-only consoles. Our FFR disposables are single-procedure disposable pressure and flow guide wires used to measure the pressure and flow characteristics of blood around plaque enabling physicians to gauge the plaque's physiological impact on blood flow and pressure.
We are developing additional offerings for integration into the platform, including adenosine-free Instant wave-free ratio FFR, or iFR, forward-looking IVUS, or FL.IVUS, catheters, Forward-Looking Intra-Cardiac Echo, or FL.ICE, catheters, Focal Acoustic Computed Tomography, or FACT, catheters, and ultra-high resolution Optical Coherence Tomography, or OCT, systems and catheters. Our Valet Micro catheter received 510(k) clearance in January 2012 and CE Mark approval in August 2012. Our Visions® PV .035 catheter received 510(k) clearance in September 2012 and CE Mark approval in August 2012. Our Short Tip EEP products received 510(k) clearance in April 2012 and CE Mark approval in August 2012.
Through Axsun Technologies, Inc., or Axsun, one of our wholly owned subsidiaries, we also develop and manufacture optical monitors for the telecommunications industry, laser and non-laser light sources, and optical engines used in the medical OCT imaging systems and advanced photonic components and sub-systems used in spectroscopy and other industrial applications. We believe Axsun's proprietary OCT technology will provide us competitive advantages in the invasive imaging sector.
We have infrastructure in the U.S., Europe, Japan and Costa Rica. Our corporate office is located in California, U.S. Our manufacturing operations are located in California and Massachusetts, U.S. In addition, during the second quarter of 2012, we received FDA clearance and commenced manufacturing of disposables at our new plant in Costa Rica. We have research and development facilities in California, Massachusetts, Ohio and Georgia. We have sales offices in the U.S. and Japan; sales and distribution offices in Belgium and South Africa; and third-party distribution facilities in Japan.

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We have focused on building our domestic and international sales and marketing infrastructure to market our products to physicians and technicians who perform PCI procedures in hospitals and to other personnel who make purchasing decisions on behalf of hospitals. We sell our products directly to customers in the U.S., Japan, certain European markets and South Africa. We utilize distributors in other geographic areas, who are also involved in product launch planning, education and training, physician support and clinical trial management.
At September 30, 2012, we had a worldwide installed base of over 7,500 consoles. We intend to grow and leverage this installed base to drive recurring sales of our single-procedure disposable catheters and guide wires. In the nine months ended September 30, 2012, the sale of our single-procedure disposable catheters and guide wires accounted for $221.3 million, or 81.6% of our medical segment revenues, a $26.0 million, or 13.3% increase from the same period in 2011, in which the sale of our single-procedure disposable catheters and guide wires accounted for $195.3 million, or 80.9% of our medical segment revenues.
In the nine months ended September 30, 2012 and 2011, 46.1% and 47.4%, respectively, of our revenues and 23.1% and 22.3%, respectively, of our operating expenses were denominated in various non-U.S. dollar currencies, primarily the Japanese yen, or yen, and the euro. We expect that a significant portion of our revenue and operating expenses will continue to be denominated in non-U.S. dollar currencies. As a result, we are subject to risks related to fluctuations in foreign currency exchange rates, which could affect our operating results in the future. If our yen or euro denominated sales exceed our yen or euro denominated costs, and the U.S. dollar strengthens relative to the yen or euro, there is an adverse effect on our results of operations. Conversely, if the U.S. dollar weakens relative to the yen or euro, there is a positive effect on our results of operations. For example, the average exchange rate of one U.S. dollar to yen decreased 1.7% from 80.40 in the nine months ended September 30, 2011 to 79.03 in the nine months ended September 30, 2012, which resulted in a net positive impact to our operating results in the amount of approximately $1.1 million. On the other hand, the average exchange rate of one euro to U.S. dollar decreased 9.9% from 1.42 in the nine months ended September 30, 2011 to 1.28 in the nine months ended September 30, 2012, which resulted in a net negative impact to our operating results in the amount of approximately $2.4 million.
We use third-party manufacturing partners to produce circuit boards and mechanical sub-assemblies used in the manufacture of our consoles. We also use third-party manufacturing partners for certain proprietary components used in the manufacture of our single-procedure disposable products. We perform incoming inspection on these circuit boards, mechanical sub-assemblies and components, assemble them into finished products, and test the final product to assure quality control. We do not carry significant inventory of transducers, substrates or scanner subassemblies. If we had to change suppliers, we expect that it would take 6 to 24 months to identify appropriate suppliers, complete design work and undertake the necessary inspections and testing before the new transducers, substrates and subassemblies would be available.
External Factors

In September 2009, published findings from the Fractional Flow Reserve versus Angiography for Multivessel
Evaluation, or FAME, study demonstrated that patients in the study with multi-vessel coronary artery disease who were treated by FFR guidance had a 34% reduction in death and myocardial infarction compared to angiographic guidance alone. In August 2012, the results of the Fractional Flow Reserve-Guided PCI vs. Medical Therapy in Stable Coronary Disease, or FAME 2, study were published in the New England Journal of Medicine. FAME 2 showed that patients receiving PCI with proven ischemia by FFR had 66% fewer primary endpoint events including death, myocardial infarction and urgent vascularization's than those patients treated with optimal medical therapy alone. We believe these findings will continue to drive the growth and adoption of our disposable FFR wire products.

The Patient Protection and Affordable Care Act and Health Care and Education Affordability Reconciliation Act were enacted into law in the U.S. on March 23, 2010. The legislation imposes on medical device manufacturers a 2.3 percent excise tax on U.S. sales of Class I, II and III medical devices beginning January 1, 2013. We are continuing to evaluate this legislation and its potential impact on the Company and it may adversely affect our business and results of operations.
The economic conditions in many countries and regions where we generate our revenues remain uncertain. The challenging global economic conditions have also led to concerns over the solvency of certain European Union member states, including Greece, Ireland, Italy, Portugal and Spain. As of September 30, 2012, the total outstanding accounts receivable from customers in these countries was less than 4% of our total outstanding accounts receivable. If our customers do not obtain or do not have access to the necessary capital to operate their businesses, or are otherwise adversely affected by any deterioration in national and worldwide economic conditions, this could result in reductions in the sales of our products, longer sales cycles and slower adoption of new technologies by our customers, which would materially and adversely affect our business. In addition, our customers' and suppliers' liquidity, capital resources and credit may be adversely affected by their relative ability or inability to obtain capital and credit, which could adversely affect our ability to collect on our outstanding invoices and lengthen our

24

Table of Contents

collection cycles, or limit our timely access to important sources of raw materials necessary for the manufacture of our consoles and catheters.
In addition, the political unrest in the Middle East may have adverse consequences to the global economy or to our customers in the Middle East, which could negatively impact our business. Uncertainty about future economic conditions may make it more difficult for us to forecast operating results and to make decisions about future investments. For further discussion, see “Risk Factors-General national and worldwide economic conditions may materially and adversely affect our financial performance and results of operations.”
Financial Operations Overview
The following is a description of the primary components of our revenues and expenses.
Revenues. We derive our revenues from two reporting segments: medical and industrial. Our medical segment represents our core business, in which we derive revenues primarily from the sale of our consoles and single-procedure disposables. Our industrial segment derives revenues related to the sales of micro-optical spectrometers and optical channel monitors to telecommunications and other industrial companies. In the nine months ended September 30, 2012, we generated $279.4 million of revenues which is composed of $271.2 million from our medical segment and $8.2 million from our industrial segment. In the nine months ended September 30, 2012, 10.5% of our medical segment revenues were derived from the sale of our consoles, as compared with 12.2% in the nine months ended September 30, 2011. In the nine months ended September 30, 2012, IVUS single-procedure disposables accounted for 56.7% of our medical segment revenues, compared to 61.1% during the same period in 2011, while in the nine months ended September 30, 2012, 25.0% of our medical segment revenues were derived from the sale of our FFR single-procedure disposables, as compared with 19.9% in the nine months ended September 30, 2011. Other revenues consist primarily of revenue from rental revenues, service and maintenance revenues, other medical revenues, shipping and handling revenues, sales of distributed products, spare parts sales, and license fees.
We expect to continue to experience variability in our quarterly revenues from console sales due in part to the timing of hospital capital equipment purchasing decisions. Further, we expect variability of our revenues based on the timing of our new product introductions, which may cause our customers to delay their purchasing decisions until the new products are commercially available.

Our medical segment sales are generated by our direct sales representatives or through independent distributors and are shipped throughout the world from facilities in California, Massachusetts, Belgium, Japan and South Africa. Our industrial segment sales are generated by our direct sales representatives or through independent distributors and these products are shipped primarily to telecommunications and industrial companies domestically and abroad from our facility in Massachusetts.
Cost of Revenues. Cost of revenues consists primarily of material costs for the products that we sell and other costs associated with our manufacturing process, such as personnel costs, rent, depreciation related to our manufacturing equipment and utilities. In addition, cost of revenues includes depreciation of company-owned consoles, royalty expenses for licensed technologies included in our products, service costs, provisions for warranty, distribution, freight and packaging costs and stock-based compensation expense related to manufacturing employees. We expect a trend of improvement in our gross margin for IVUS and FFR products if we are successful in our ongoing efforts to streamline and improve our manufacturing processes, increase production volumes and transition a greater percentage of manufacturing operations to Costa Rica.
Selling, General and Administrative. Selling, general and administrative expenses consist primarily of salaries and other related costs for personnel serving the sales, administrative and marketing functions. Other costs include stock-based compensation expense, professional fees for legal and accounting services, travel and entertainment expenses, facility costs, trade shows, training and other promotional expenses. Due to ongoing litigation, legal expenses tend to be somewhat unpredictable in their timing and amount. We expect that our selling, general and administrative expenses will increase as we continue to expand our sales force and marketing efforts and invest in the necessary infrastructure to support our continued growth.
Research and Development. Research and development expenses consist primarily of salaries and related expenses for personnel, consultants, prototype materials, clinical studies, depreciation, regulatory filing fees, certain legal costs related to our intellectual property and stock-based compensation expense. We expense research and development costs as incurred. Due to product development timelines, research and development costs tend to be distributed unevenly between the periods. We expect our research and development expenses to increase as we continue to develop our products and technologies.
Amortization of Intangibles. We amortize intangible assets, consisting of our acquired developed technology, licenses, customer relationships, assembled workforce, patents and trademarks, using the straight-line method over their estimated useful lives of up to 20 years. These assets are regularly tested for impairment and abandonment.

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Table of Contents

Interest Income. Interest income is comprised of interest income earned from our cash and cash equivalents and our short-term and long-term available-for-sale investments.
Interest Expense. Interest expense is primarily comprised of interest expense related to our convertible debt, including coupon interest, accretion of debt discount, and amortization of issuance costs, offset by interest capitalization related to the Costa Rica plant construction, before the plant was placed into service in the second quarter of 2012, and our global Enterprise Resource Planning, or ERP, system implementation.
Exchange Rate Gain (Loss). Exchange rate loss is comprised of foreign currency transaction and remeasurement gains and losses, net, and the effect of changes in value and net settlements of our foreign currency forward contracts.
Income Tax Expense. Our effective tax rate is a blended rate resulting from the composition of taxable income in the global jurisdictions in which we conduct business. We apply the “with and without method — direct effects only”, in accordance with authoritative guidance, with respect to recognition of stock option excess tax benefits within stockholders equity (additional paid in capital). Therefore, provision for domestic income taxes is determined utilizing projected federal and state taxable income before the application of deductible excess tax benefits attributable to stock option exercises.

The Company carries a valuation allowance on net operating loss and other deferred tax assets in certain international jurisdictions.  Realization is dependent on generating sufficient taxable income and other available positive and negative evidence.  Management's assessment of the recoverability of these deferred tax assets may increase in the near term based on estimates of future taxable income in these specific jurisdictions, which may result in a reduction in the related valuation allowance. If the objective and quantitative criteria are met, a reduction of the valuation allowance by $3 million to $5 million could occur as soon as the fourth quarter of 2012.

Results of Operations

The following table sets forth items derived from our unaudited condensed consolidated statements of operations for the three months ended September 30, 2012 and 2011, presented in both absolute dollars (in thousands) and as a percentage of revenues:

 
Three Months Ended September 30,
 
Change
 
2012
 
2011
 
$
 
%
Revenues
$
93,656

 
100.0
 %
 
$
85,767

 
100.0
 %
 
$
7,889

 
9.2
 %
Cost of revenues, excluding amortization of intangibles
33,248

 
35.5

 
29,538

 
34.4

 
3,710

 
12.6

Gross profit
60,408

 
64.5


56,229


65.6

 
4,179

 
7.4

Operating expenses:
 
 
 
 
 
 
 
 
 
 
 
Selling, general and administrative
40,699

 
43.5

 
36,034

 
42.0

 
4,665

 
12.9

Research and development
13,032

 
13.9

 
13,928

 
16.2

 
(896
)
 
(6.4
)
Amortization of intangibles
710

 
0.8

 
860

 
1.0

 
(150
)
 
(17.4
)
Total operating expenses
54,441

 
58.2


50,822


59.2

 
3,619

 
7.1

Operating income
5,967

 
6.3


5,407


6.4

 
560

 
10.4

Interest income
223

 
0.2

 
226

 
0.3

 
(3
)
 
(1.3
)
Interest expense
(1,844
)
 
(2.0
)
 
(1,834
)
 
(2.1
)
 
(10
)
 
0.5

Exchange rate gain (loss)
(218
)
 
(0.2
)
 
(502
)
 
(0.6
)
 
284

 
(56.6
)
Other income (expense), net
(23
)
 

 

 

 
(23
)
 

Income before income taxes
4,105

 
4.3


3,297


4.0

 
808

 
24.5

Income tax expense
2,130

 
2.3

 
669

 
0.8

 
1,461

 
218.4

Net income
$
1,975

 
2.0
 %

$
2,628


3.2
 %
 
$
(653
)
 
(24.8
)%

The following table sets forth items derived from our unaudited condensed consolidated statements of operations for the nine months ended September 30, 2012 and 2011, presented in both absolute dollars (in thousands) and as a percentage of revenues:
 

26

Table of Contents

 
Nine Months Ended September 30,
 
Change
 
2012
 
2011
 
$
 
%
Revenues
$
279,389

 
100.0
 %
 
$
250,798

 
100.0
 %
 
$
28,591

 
11.4
 %
Cost of revenues, excluding amortization of intangibles
94,797

 
33.9

 
84,175

 
33.6

 
10,622

 
12.6

Gross profit
184,592

 
66.1

 
166,623

 
66.4

 
17,969

 
10.8

Operating expenses:
 
 
 
 
 
 
 
 
 
 
 
Selling, general and administrative
127,035

 
45.5

 
106,982

 
42.7

 
20,053

 
18.7

Research and development
40,560

 
14.5

 
40,337

 
16.1

 
223

 
0.6

Amortization of intangibles
2,470

 
0.9

 
2,572

 
1.0

 
(102
)
 
(4.0
)
Total operating expenses
170,065

 
60.9

 
149,891

 
59.8

 
20,174

 
13.5

Operating income
14,527

 
5.2

 
16,732

 
6.6

 
(2,205
)
 
(13.2
)
Interest income
656

 
0.2

 
701

 
0.3

 
(45
)
 
(6.4
)
Interest expense
(4,993
)
 
(1.8
)
 
(5,895
)
 
(2.4
)
 
902

 
(15.3
)
Exchange rate gain (loss)
(319
)
 
(0.1
)
 
(1,181
)
 
(0.5
)
 
862

 
(73.0
)
Other income (expense), net
(31
)
 

 
(2
)
 

 
(29
)
 
1,450.0

Income before income taxes
9,840

 
3.5

 
10,355

 
4.0

 
(515
)
 
(5.0
)
Income tax expense
4,295

 
1.5

 
1,684

 
0.7

 
2,611

 
155.0

Net income
$
5,545

 
2.0
 %
 
$
8,671

 
3.3
 %
 
$
(3,126
)
 
(36.1
)%

The following table sets forth our revenues by segment and product expressed as dollar amounts (in thousands) and the changes in revenues between the specified periods expressed as percentages:
 
 
Three Months Ended
September 30,
 
Change
 
Nine Months Ended
September 30,
 
Change
 
2012
 
2011
 
$
 
%
 
2012
 
2011
 
$
 
%
Medical segment:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Consoles
$
9,679

 
$
9,709

 
$
(30
)
 
(0.3
)%
 
$
28,529

 
$
29,420

 
$
(891
)
 
(3.0
)%
Single-procedure disposables:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
IVUS
48,574

 
49,760

 
(1,186
)
 
(2.4
)
 
153,683

 
147,384

 
6,299

 
4.3

FFR
24,585

 
16,653

 
7,932

 
47.6

 
67,652

 
47,954

 
19,698

 
41.1

Other
7,825

 
6,796

 
1,029

 
15.1

 
21,286

 
16,565

 
4,721

 
28.5

Sub-total medical segment
90,663

 
82,918

 
7,745

 
9.3

 
271,150

 
241,323

 
29,827

 
12.4

Industrial segment:
2,993

 
2,849

 
144

 
5.1

 
8,239

 
9,475

 
(1,236
)
 
(13.0
)
 
$
93,656

 
$
85,767

 
$
7,889

 
9.2
 %
 
$
279,389

 
$
250,798

 
$
28,591

 
11.4
 %
The following table sets forth our revenues by geography expressed as dollar amounts (in thousands) and the changes in revenues in the specified periods expressed as percentages:
 
 
Three Months Ended
September 30,
 
Change
 
Nine Months Ended
September 30,
 
Change
 
2012
 
2011
 
$
 
%
 
2012
 
2011
 
$
 
%
Revenues (1):
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
United States
$
44,083

 
$
38,964

 
$
5,119

 
13.1
 %
 
$
130,152

 
$
113,201

 
$
16,951