UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

 

FORM 10-Q

(Mark One)

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

For the quarterly period ended June 30, 2006

or

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

For the transition period from                      to                     .

COMMISSION FILE NUMBER 001-31257

ADVANCED MEDICAL OPTICS, INC.

(Exact name of registrant as specified in its charter)

 

 

Registrant’s telephone number, including area code 714/247-8200

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes  x    No  o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer x            Accelerated filer o             Non-accelerated filer o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes  o    No  x

As of July 31, 2006, there were 59,324,607 shares of common stock outstanding.

 

 

ADVANCED MEDICAL OPTICS, INC.
FORM 10-Q FOR THE QUARTER ENDED JUNE 30, 2006

INDEX

 

PART I - FINANCIAL INFORMATION							3
		Item 1.		Financial Statements			3
		(A).		Unaudited Consolidated Statements of Operations - Three Months and Six Months Ended June 30, 2006 and June 24, 2005			3
		(B).		Unaudited Consolidated Balance Sheets — June 30, 2006 and December 31, 2005			4
		(C).		Unaudited Consolidated Statements of Cash Flows - Six Months Ended June 30, 2006 and June 24, 2005			5
		(D).		Notes to Unaudited Consolidated Financial Statements			6
		Item 2.		Management’s Discussion and Analysis of Financial Condition and Results of Operations			19
				Certain Factors and Trends Affecting AMO and Its Businesses			27
		Item 3.		Quantitative and Qualitative Disclosures About Market Risk			28
		Item 4.		Controls and Procedures			31
PART II - OTHER INFORMATION							31
	Item 1.		Legal Proceedings				31
	Item 1A.		Risk Factors				31
	Item 2.		Unregistered Sales of Equity Securities and Use of Proceeds				32
	Item 4.		Submission of Matters to a Vote of Security Holders				32
	Item 6.		Exhibits				33
	Note: Items 3 and 5 of Part II are omitted because they are not applicable.
Signatures							34
Exhibit Index
EXHIBIT 10.1
EXHIBIT 10.2
EXHIBIT 10.3
EXHIBIT 10.4
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1

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PART I - FINANCIAL INFORMATION

Item 1. Financial Statements

Advanced Medical Optics, Inc.
Unaudited Consolidated Statements of Operations
(In thousands, except per share data)

		Three Months Ended						Six Months Ended
		June 30, 2006			June 24, 2005			June 30, 2006			June 24, 2005
Net sales		$	257,041		$	227,092		$	495,269		$	419,610
Cost of sales (Note 3)		92,373			87,478			179,208			157,917
Gross profit		164,668			139,614			316,061			261,693
Selling, general and administrative		105,389			97,596			200,828			181,409
Research and development		16,565			13,948			33,538			26,300
Business repositioning (Note 3)		17,720			—			46,974			—
In-process research and development		—			451,450			—			451,450
Operating income (loss)		24,994			(423,380		)	34,721			(397,466		)
Non-operating expense (income):
Interest expense		8,028			8,911			12,535			14,738
Unrealized (gain) loss on derivative instruments		2,464			(458		)	2,902			(990		)
Loss due to early retirement of convertible senior subordinated notes		15,798			545			15,798			545
Other, net		544			(1,413		)	1,548			(1,742		)
		26,834			7,585			32,783			12,551
Earning (loss) before income taxes		(1,840		)	(430,965		)	1,938			(410,017		)
Provision for income taxes		863			7,150			2,012			14,273
Net loss		$	(2,703	)	$	(438,115	)	$	(74	)	$	(424,290	)
Net loss per share :
Basic and Diluted		$	(0.04	)	$	(9.53	)	$	—		$	(10.17	)
Weighted average number of shares outstanding:
Basic and Diluted		67,166			45,965			67,694			41,719

 

See accompanying notes to unaudited consolidated financial statements.

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Advanced Medical Optics, Inc.
Unaudited Consolidated Balance Sheets
(In thousands, except share data)

 

		June 30, 2006			December 31, 2005
ASSETS
Current assets
Cash and equivalents		$	40,843		$	40,826
Trade receivables, net		231,602			238,761
Inventories		118,583			104,820
Deferred income taxes		66,925			66,476
Other current assets		27,129			28,122
Income taxes		10,242			—
Total current assets		495,324			479,005
Property, plant and equipment, net		126,791			115,725
Deferred income taxes		12,099			12,626
Other assets		63,366			52,473
Intangibles assets, net		486,125			495,609
Goodwill		842,967			825,284
Total assets		$	2,026,672		$	1,980,722
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities
Short-term borrowings		$	155,000		$	60,000
Accounts payable		60,592			64,045
Accrued compensation		43,844			43,406
Other accrued expenses.		85,114			90,666
Income taxes		—			1,434
Deferred income taxes		775			565
Total current liabilities		345,325			260,116
Long-term debt		871,105			500,000
Deferred income taxes		179,427			182,179
Other liabilities		30,445			28,365
Commitments and contingencies
Stockholders’ equity
Preferred stock, $.01 par value; 5,000,000 shares authorized; none issued		—			—
Common stock, $.01 par value; 240,000,000 shares authorized; 59,294,365 and 67,832,010 shares issued		593			678
Additional paid-in capital		1,394,699			1,586,864
Accumulated deficit		(819,630		)	(557,586		)
Accumulated other comprehensive income (loss)		24,732			(19,870		)
Less treasury stock, at cost (1,397 shares)		(24		)	(24		)
Total stockholders’ equity		600,370			1,010,062
Total liabilities and stockholders’ equity		$	2,026,672		$	1,980,722

 

See accompanying notes to unaudited consolidated financial statements.

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Advanced Medical Optics, Inc.
Unaudited Consolidated Statements of Cash Flows
(In thousands)

 

		Six Months Ended
		June 30, 2006			June 24, 2005
Cash flows from operating activities:
Net loss		$	(74	)	$	(424,290	)
Adjustments to reconcile net loss to net cash provided by (used in) operating activities:
Amortization of debt issuance costs		4,207			3,733
Depreciation and amortization		33,856			18,863
In-process research and development		—			451,450
Loss due to early retirement of convertible senior subordinated notes		15,798			545
Loss on investments and assets		2,481			264
Tax benefit from issuance of stock under stock plans		—			3,520
Excess tax benefits from stock-based compensation		(5,458		)	—
Unrealized loss (gain) on derivatives		2,902			(990		)
Expense of compensation plan		10,262			267
Changes in assets and liabilities:
Trade receivables, net		13,549			(15,065		)
Inventories		(11,626		)	(24,389		)
Other current assets		(851		)	3,506
Accounts payable		(6,511		)	(8,631		)
Accrued expenses and other liabilities		(3,474		)	(30,039		)
Income taxes		(1,110		)	6,943
Other non-current assets and liabilities		(8,620		)	4,887
Net cash provided by (used in) operating activities		45,331			(9,426		)
Cash flows from investing activities:
Acquisition of businesses, net of cash acquired		—			(36,867		)
Additions to property, plant and equipment		(15,140		)	(7,608		)
Proceeds from sale of property, plant and equipment		—			167
Additions to capitalized internal-use software		(1,201		)	(7,085		)
Additions to demonstration and bundled equipment		(5,446		)	(5,391		)
Net cash used in investing activities		(21,787		)	(56,784		)
Cash flows from financing activities:
Short-term borrowings		95,000			105,000
Repayment of long-term debt		(144,693		)	(44,495		)
Financing related costs		(10,284		)	(2,959		)
Proceeds from issuance of long-term debt		500,000			—
Proceeds from issuance of common stock		29,488			10,204
Net proceeds from settlement of interest rate swaps		—			777
Repurchase and retirement of common stock		(500,000		)	—
Excess tax benefits from stock-based compensation		5,458			—
Net cash (used in) provided by financing activities		(25,031		)	68,527
Effect of exchange rates on cash and equivalents		1,504			(2,327		)
Net increase (decrease) in cash and equivalents		17			(10
Cash and equivalents at beginning of period		40,826			49,455
Cash and equivalents at end of period		$	40,843		$	49,445
Supplemental non-cash investing and financing activities:
Exchange of convertible notes into common stock		$	—		$	3,000
Acquisition of VISX, Incorporated		$	—		$	1,203,185

 

See accompanying notes to unaudited consolidated financial statements.

 

5

 

Advanced Medical Optics, Inc.
Notes to Unaudited Consolidated Financial Statements

Note 1: Basis of Presentation

In the opinion of management, the accompanying unaudited consolidated financial statements contain all adjustments necessary (consisting only of normal, recurring adjustments) for a fair statement of the financial information contained therein. These statements do not include all disclosures required by accounting principles generally accepted in the United States of America for annual financial statements and should be read in conjunction with the audited consolidated financial statements of Advanced Medical Optics, Inc. (the “Company” or “AMO”) for the year ended December 31, 2005. The results of operations for the three and six months ended June 30, 2006 are not necessarily indicative of the results to be expected for the year ending December 31, 2006.

All material intercompany balances have been eliminated.

Stock-Based Compensation

AMO has an Incentive Compensation Plan (“ICP”) that provides for the granting of stock options, restricted stock and restricted stock units to directors, employees and consultants. The Company has two Employee Stock Purchase Plans (“ESPP”) for United States and international employees, respectively, which allow employees to purchase AMO common stock. A total of 5 million shares of common stock have been authorized for issuance under the ICP. Effective January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123R, “Share-Based Payment” (“SFAS 123R”) as discussed below.

Adoption of SFAS 123R

Prior to January 1, 2006, the Company’s stock-based compensation plans were accounted for under the recognition and measurement provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) and the disclosure only provisions of SFAS 123. Accordingly, no compensation expense was recorded for stock options granted with exercise prices greater than or equal to the fair value of the underlying common stock at the option grant date. The fair value, as determined on the date of grant, of restricted stock awards was recognized as compensation expense ratably over the respective vesting period. Additionally, the ESPP qualified as non-compensatory plans under APB 25; therefore, no compensation cost was recorded in relation to the discount offered to employees for purchases made under the ESPP. In addition, the Company’s unearned compensation balance at January 1, 2006 was reclassified to additional paid-in capital upon the adoption of SFAS 123R.

On January 1, 2006, the Company adopted the fair value recognition provisions of SFAS 123R, requiring recognition of expenses equivalent to the fair value of stock-based compensation awards. The Company has elected to use the modified prospective application transition method as permitted by SFAS 123R and therefore has not restated the financial results reported in prior periods. Under this transition method, stock-based compensation expense for the three and six months ended June 30, 2006 includes compensation expense for all stock-based compensation awards granted prior to, but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS 123, as adjusted for estimated forfeitures. Compensation expense for all stock-based compensation awards granted subsequent to January 1, 2006 are based on the grant-date fair value estimated in accordance with the provisions of SFAS 123R.

Additionally, under SFAS 123R, the ESPP is considered a compensatory plan and requires recognition of compensation expense for purchases of common stock made under the ESPP. The Company recognizes compensation expense for stock option and ESPP awards on a straight-line basis over the vesting period. Compensation expense related to the restricted stock and restricted stock units is recognized over the requisite service periods of the awards, consistent with the Company’s practices under SFAS 123 prior to January 1, 2006.

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Stock-Based Compensation Expense

Total stock-based compensation expense included in the unaudited consolidated statements of operations for the three and six months ended June 30, 2006 is as follows (in thousands):

 

 

At June 30, 2006, total pre-tax compensation costs related to unvested stock-based awards granted to employees and directors under the Company’s stock option plan, ESPP and restricted stock awards which are not yet recognized were approximately $36.6 million, net of estimated forfeitures. These costs are expected to be recognized over a weighted-average period of 3.0 years.

Net cash proceeds from the exercise of stock options were $27.1 million and $8.1 million for the six month periods ended June 30, 2006 and June 24, 2005, respectively. In accordance with SFAS 123R, the cash flows resulting from excess tax benefits (tax benefits related to the excess of proceeds from employees exercises of stock options over the stock-based compensation cost recognized for those options) are classified as financing cash flows in the Company’s  unaudited consolidated statement of cash flows. During the six months ended June 30, 2006, the Company recorded $5.5 million of excess tax benefits as a financing cash inflow. Prior to the adoption of SFAS 123R, excess tax benefits of $3.5 million during the six months ended June 24, 2005 were classified as an operating cash inflow.

The Company issues new shares to satisfy option exercises.

Determining Fair Value

Valuation Method - The Company estimates the fair value of stock options granted and ESPP purchase rights using the Black-Scholes option-pricing model and a single option award approach.

Expected Term - The expected term represents the period the Company’s stock-based awards are expected to be outstanding and was determined based on historical experience with similar awards, giving consideration to the contractual terms of the stock-based awards, vesting schedules and expectations of future employee behavior as influenced by changes to the terms of its stock-based awards.

Expected Volatility - The computation of expected volatility is based on a combination of historical and market-based implied volatility.  Implied volatility is based on publicly traded options of the Company’s common stock with a term of one year or greater.

Risk-Free Interest Rate - The risk-free interest rate used in the Black-Scholes valuation method is based on the implied yield currently available on U.S. Treasury securities with an equivalent remaining term.

Expected Dividend - No dividends are expected to be paid.

Estimated Forfeitures - When estimating forfeitures, the Company considers voluntary termination behavior as well as analysis of actual option forfeitures.

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The fair value of the Company’s stock based compensation granted to employees for the three and six months ended June 30, 2006 was estimated using the following weighted-average assumptions:

 

 

Stock Options

Stock options granted to employees are generally exercisable at a price equal to the fair market value of the common stock on the date of the grant and vest at a rate of 25% per year beginning twelve months after the date of grant. Grants under these plans expire ten years from the date of grant.

The following is a summary of stock option activity (in thousands, except per share amounts):

 

 

The aggregate intrinsic value in the table above represents the difference between the exercise price of the underlying awards and the quoted price of the company’s common stock for the options that were in-the-money at June 30, 2006. During the six months ended June 30, 2006, the aggregate intrinsic value of options exercised under the Company’s stock option plans was $30.3 million determined as of the date of option exercise.

Employee Stock Purchase Plans

Under the ESPP, eligible employees may authorize payroll deductions of up to 10% of their regular base salary to purchase shares at the lower of 85% of the closing price of the Company’s common stock on the first or last day of the six-month purchase period. In the second quarter of 2006, 78,000 shares of common stock were issued under the ESPP in the aggregate amount of $2.4 million as the most recent purchase period ended on April 28, 2006. As of June 30, 2006 employee withholdings under the ESPP aggregated $0.8 million.

Restricted Stock

Restricted stock awards are granted at a price equal to the fair market value of the common stock on the date of the grant, subject to forfeiture if employment terminates prior to the release of restrictions, which is generally three years from the date of grant. During this restriction period, ownership of the shares cannot be transferred. Restricted stock has the same cash dividend and voting rights as other common stock and is considered to be currently issued and outstanding. The cost of the awards, determined to be the fair market value of the shares at the date of grant, is expensed ratably over the period the restrictions lapse.

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The following table summarizes the restricted stock award activity for the six months ended June 30, 2006 (in thousands, except per share amounts):

 

 

Performance-Based Awards

In February 2006, the Company’s Board of Directors approved a 2006 performance award program under the Company’s incentive compensation plan (the “2006 Program”), which provides the opportunity for certain executives to earn long-term incentive compensation awards based upon specified measures. The potential maximum aggregate award value for the 2006 program is $2.7 million. The award determination will be based upon the Total Shareholder Return (“TSR”) (the increase or decrease in the Company’s common stock price) over a two-year period beginning January 1, 2005 compared to a peer group composed of various entities within the bio-technology and medical device industries. Awards will have been determined to be earned if the Company’s TSR is in excess of the 50th percentile of the peer group. When the TSR equals the 75th percentile of the peer group, the maximum amount will have been earned. Awards are to be settled in a number of restricted stock shares or units equal to the value of the award amount divided by the fair market value of the Company’s common stock on the date the performance criteria is deemed to have been met. The restricted stock shares or units will have the same terms and conditions as other restricted shares or units issued under the Company’s ICP. The estimated fair value of the 2006 Program was $0.8 million on the grant date using a lattice-based valuation model. Compensation expense is being recognized over a four-year period from the program approval date through the end of the expected vesting period of the restricted stock awards. The associated compensation expense during the three months and six months ended June 30, 2006 was less than $0.1 million.

Pro-forma Disclosures under SFAS 123 for Periods Prior to Fiscal 2006

The following table illustrates the effect on net loss and net loss per share as if the Company had applied the fair value recognition provisions of SFAS 123 to stock-based compensation during the three and six months period ended June 24, 2005 (in thousands, except per share amounts):

 

 

For the purpose of the weighted average estimated fair value calculations, the fair value of the Company’s stock based compensation granted to employees for the three and six months ended June 24, 2005 was estimated using the following weighted-average assumptions:

 

 

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Note 2: Acquisition of VISX, Incorporated (VISX)

On May 27, 2005, pursuant to the Agreement and Plan of Merger (Merger Agreement), dated as of November 9, 2004, as amended, by and among AMO, Vault Merger Corporation, a wholly owned subsidiary of AMO, and VISX, AMO completed its acquisition of VISX, for total consideration of approximately $1.38 billion, consisting of approximately 27.8 million shares of AMO common stock, the fair value of VISX stock options converted to AMO stock options and approximately $176.2 million in cash (VISX Acquisition). VISX products include the VISX STAR Excimer Laser System, the VISX WaveScan System and VISX treatment cards. As a result of the VISX Acquisition, the Company became a leader in the design and development of proprietary technologies and systems for laser vision correction of refractive vision disorders.

The VISX Acquisition has been accounted for as a purchase business combination. Under the purchase method of accounting, the assets acquired and liabilities assumed are recorded at the date of acquisition at their respective fair values.

The following unaudited pro forma information assumes the VISX Acquisition occurred on January 1, 2005. These unaudited pro forma results have been prepared for informational purposes only and do not purport to represent what the results of operations would have been had the VISX Acquisition occurred as of the date indicated, nor of future results of operations. The unaudited pro forma results for the three and six months ended June 24, 2005 are as follows (in thousands, except per share data):

 

 

(1)             The unaudited pro forma information for the three months and six months ended June 24, 2005 includes a $6.6 million and a $13.3 million increase in amortization related to management’s estimate of the fair value of intangible assets acquired as the result of the VISX Acquisition and a $2.8 million and $5.7 million increase in interest expense resulting from additional borrowings incurred to fund the cash portion of the VISX Acquisition and related costs and amortization of deferred financing costs.

(2)             The weighted average number of shares outstanding used for the computation of basic earnings per share for the three and six months ended June 24, 2005 reflects the issuance of 27.8 million shares of AMO’s common stock to VISX stockholders.

(3)             The weighted average number of shares outstanding used for the computation of diluted earnings per share for the three and six months ended June 24, 2005 reflects the issuance of 27.8 million shares of AMO’s common stock to VISX shareholders and the dilutive effect of approximately 3.4 million shares and 3.5 million shares of VISX options exchanged for AMO stock options.

Note 3:  Product Rationalization and Business Repositioning

On October 31, 2005, the Company’s Board of Directors approved a product rationalization and repositioning plan covering the discontinuation of non-strategic cataract surgical and eye care products and the elimination or redeployment of resources that support these product lines. The plan also includes organizational changes and potential reductions in force in manufacturing, sales and marketing associated with these product lines, as well as organizational changes in research and development and other corporate functions designed to align the organization with our strategy and strategic business unit organization.

The plan further calls for increasing the Company’s investment in key growth opportunities, specifically the Company’s refractive implant product line and international laser vision correction business, and accelerating the implementation of productivity initiatives. Following an analysis of its IOL manufacturing capabilities in the second quarter of 2006, the Company has decided to consolidate certain operations. In addition, the Company expanded the scope of its eye care rationalization initiatives in order to maximize manufacturing capacity and seize growth opportunities.  Total cumulative charges of $99.8 million have been incurred through June 30, 2006.

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Certain foreign jurisdictions have laws and regulations which require consultations and negotiations with works councils, labor organizations and local authorities. The outcome of these discussions will determine, in part, the restructuring steps to be implemented and the associated costs. Therefore, the final costs of the business repositioning plan may be significantly different from the Company’s initial estimates.

In the three months ended June 30, 2006, the Company incurred $25.1 million of pre-tax charges, which included $7.4 million for inventory, manufacturing related and other charges included in cost of sales and $17.7 million included in operating expenses. Charges included in operating expenses comprised severance, relocation and other one-time termination benefits of $11.9 million, productivity and brand repositioning costs of $4.9 million, asset write-downs of $0.7 million and contractual obligations of $0.2 million.  In the six months ended June 30, 2006, the Company incurred $57.5 million of pre-tax charges, which included $10.5 million for inventory, manufacturing related and other charges included in cost of sales and $47.0 million included in operating expenses. Charges included in operating expenses comprised productivity and brand repositioning costs of $31.1 million, severance, relocation and other one-time termination benefits of $13.5 million, asset write-downs of $2.1 million and contractual obligations of $0.3 million

Business repositioning charges and related activity in the accrual balances during the six months ended June 30, 2006 were as follows (in thousands):

 

Business Repositioning Costs Reported In:		Balance at December 31, 2005			Costs Incurred			Cash Payments			Non-Cash Adjustments			Balance at June 30, 2006
Cost of sales -
Inventory, manufacturing and other charges		$	—		$	10,513		$	—		$	(10,513	)	$	—
Operating Expenses -
Severance, relocation and related costs		8,779			13,497			(9,972		)	—			12,304
Asset write-downs		—			2,096			—			(2,096		)	—
Contractual obligations		2,641			250			(141		)	—			2,750
Productivity initiatives and brand repositioning costs		883			31,131			(29,641		)	—			2,373
		12,303			46,974			(39,754		)	(2,096		)	17,427
		$	12,303		$	57,487		$	(39,754	)	$	(12,609	)	$	17,427

 

Productivity initiatives and brand repositioning costs resulted from the Company’s investment in key growth opportunities, specifically the Company’s refractive implant product line, international laser vision correction business and expanded eye care rationalization, and the implementation of productivity improvements in manufacturing operations, distribution, customer service and corporate functions. Severance, relocation and related costs were incurred for worldwide workforce reductions due to the Company’s discontinuing certain non-core products and infrastructure and process improvements associated with the Company’s productivity initiatives. The majority of these costs in the three and six months ended June 30, 2006 occurred in Europe. Asset write-downs resulted from the impairment and disposal of long-lived assets from the reduction in expected future cash flows from certain discontinued non-core products and relocation of certain facilities. The fair values of impaired assets were based on probability weighted expected cash flows as determined in accordance with Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-lived Assets”.

Note 4: Composition of Certain Financial Statement Captions

Inventories:

 

 

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Intangible assets, net

 

 

The amortizable intangible assets balance increased due to the impact of foreign currency fluctuation. Amortization expense was $10.2 million and $19.9 million for the three and six months ended June 30, 2006, $4.7 million and $7.6 million for the three and six months ended June 24, 2005, respectively, and is recorded in selling, general and administrative in the accompanying unaudited consolidated statements of operations. Amortization expense is expected to be $39.7 million in 2006, $38.5 million in 2007 and 2008, $38.3 million in 2009 and $35.7 million in 2010. Actual amortization expense may vary due to the impact of foreign currency fluctuations.

Goodwill

 

Effective January 1, 2006, the Company’s reportable segments are represented by three business units: Cataract/Implant, Laser Vision Correction and Eye Care (See Note 9, “Business Segment Information”). The change in goodwill during the six months ended June 30, 2006 is due to an adjustment of Laser Vision Correction goodwill of $4.5 million as a result of excess tax benefits from the exercise of converted VISX stock options that were fully vested at the acquisition date and the impact of foreign currency fluctuations on the Eye Care and Cataract/Implant segments.  The Company performed its annual impairment test of goodwill during the second quarter of 2006 and determined there was no impairment.

Note 5: Debt

At June 30, 2006, an aggregate principal amount of $251.1 million of 2½ % convertible senior subordinated notes due July 15, 2024 (“2½ % Notes”), an aggregate principal amount of $120.0 million of 1.375% convertible senior subordinated notes due July 1, 2025 (“1.375% Notes”), an aggregate principal amount of $500.0 million of 3.25% of convertible senior subordinated notes due 2026 (“3.25% Notes”), and a balance of $155.0 million under the senior revolving credit facility were outstanding. The convertible notes may be converted, at the option of the holders, on or prior to the final maturity date under certain circumstances, none of which had occurred as of June 30, 2006. Upon conversion of the convertible notes, the Company will satisfy in cash the conversion obligation with respect to the principal amount of the convertible notes, with any remaining amount of the conversion obligation to be satisfied in shares of common stock. As a result of this election, the Company also is required to satisfy in cash its obligations to repurchase any convertible notes that holders may put to the Company on January 15, 2010, July 15, 2014 and July 15, 2019 for the 2½ % Notes, on July 1, 2011, July 1, 2016 and July 1, 2021 for the 1.375% Notes, and on August 1, 2014, August 1, 2017, and August 1, 2021 for the 3.25% Notes.

At June 30, 2006, approximately $8.6 million of the senior revolving credit facility was reserved to support letters of credit issued on the Company’s behalf for normal operating purposes and the Company has approximately $146.4 million undrawn and available revolving loan commitments.

Borrowings under the revolving credit facility, if any, bear interest at current market rates plus a margin based upon the Company’s ratio of debt to EBITDA, as defined. The incremental interest margin on borrowings under the revolving credit facility decreases as the Company’s ratio of debt to EBITDA decreases to specified levels. Under the senior credit facility, certain transactions may trigger mandatory prepayment of borrowings, if any. Such transactions may include equity or debt offerings, certain asset sales and extraordinary receipts. The Company pays a quarterly fee (2.95% per annum at June 30, 2006) on the average balance of outstanding letters of credit and a quarterly commitment fee (0.50% per annum at June 30, 2006) on the average unused portion of the revolving credit facility.

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The senior credit facility provides that the Company will maintain certain financial and operating covenants which include, among other provisions, maintaining specific leverage and coverage ratios. Certain covenants under the senior credit facility may limit the incurrence of additional indebtedness. The senior credit facility prohibits dividend payments. The Company was in compliance with these covenants at June 30, 2006. The senior credit facility is collateralized by a first priority perfected lien on, and pledge of, all of the combined Company’s present and future property and assets (subject to certain exclusions), 100% of the stock of the domestic subsidiaries, 66% of the stock of foreign subsidiaries and all present and future intercompany debts.

As of June 30, 2006, the aggregate maturities of total long-term debt of $871.1 million are due after 2010. Revolving loan borrowings of $155.0 million at June 30, 2006 have been classified as current liabilities in the accompanying unaudited  consolidated balance sheet.

3.25% Convertible Senior Subordinated Notes Due 2026

In June 2006, the Company completed a private placement of $500 million aggregate principal amount of its 3.25% Notes due August 1, 2026.  Interest on the 3.25% Notes is payable on February 1 and August 1 of each year, commencing on February 1, 2007.  The 3.25% Notes are convertible into 16.7771 shares of the Company’s common stock for each $1,000 principal amount of the 3.25% Notes (which represents an initial conversion price of approximately $59.61 per share), subject to adjustment. The 3.25% Notes may be converted, at the option of the holders, into cash or under certain circumstances, cash and shares of the Company’s common stock at any time on or prior to the trading day preceding July 1, 2014, only under the following circumstances:

·                  during the five business days after any five consecutive trading-day period in which the trading price per $1,000 principal amount of the 3.25% Notes for each day of such measurement period was less than 98% of the conversion value.  This conversion feature represents an embedded derivative.  However, based on the de minimis value associated with this feature, no value was assigned at issuance and at June 30, 2006;

·                  during any fiscal quarter subsequent to September 30, 2006, if the closing sale price of the Company’s common stock measured over a specified number of trading days is above 130% of the conversion  then in effect;

·                  if a fundamental change occurs; or

·                  upon the occurrence of specified corporate transactions.

On and after July 1, 2014, to (and including) the trading day preceding the maturity date, subject to prior redemption or repurchase, the 3.25% Notes will be convertible into cash and, if applicable, shares of the Company’s common stock regardless of the foregoing circumstances.

The Company may redeem some or all of the 3.25% Notes for cash, on or after August 4, 2014, for a price equal to 100% of the principal amount plus accrued and unpaid interest, including contingent interest, if any, to, but excluding the redemption date.

The 3.25% Notes contain put options, which may require the Company to repurchase in cash all or a portion of the 3.25% Notes on August 1, 2014, August 1, 2017, and August 1, 2021 at a repurchase price equal to 100% of the principal amount plus accrued and unpaid interest, including contingent interest, if any, to, but excluding the repurchase date.

Beginning with the six-month interest period commencing August 1, 2014, the Company will pay contingent interest during any six-month interest period if the trading price of the 3.25% Notes for each of the five trading-days ending on the second trading day immediately preceding the first day of the applicable six-month interest period equals or exceeds 120% of the principal amount of the 3.25% Notes.  The contingent interest payable will equal 0.25% of the average trading price of $1,000 principal amount of the 3.25% Notes during the five trading days immediately preceding the first day of the applicable six-month interest period.  This contingent interest payment feature represents an embedded derivative.  However, based on the de minimis value associated with this feature, no value has been assigned at issuance and at June 30, 2006.

On or prior to August 1, 2014, upon the occurrence of a fundamental change, under certain circumstances, the Company will provide for a make whole amount by increasing, for the time period described herein, the conversion rate by a number of additional shares for any conversion of the 3.25% Notes in connection with such fundamental change transactions.  The amount of additional shares will be determined based on the price paid per share of the Company’s common stock in the transaction constituting a fundamental change and the effective date of such transaction. This make whole premium feature represents an embedded derivative.  However, based on the de minimis value associated with this feature, no value has been assigned at issuance and at June 30, 2006.

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In connection with the sale of the 3.25% Notes, the Company entered into a registration rights agreement with the initial purchasers of the 3.25% Notes. Under the registration rights agreement, the Company has agreed to use its reasonable best efforts to file with the Securities and Exchange Commission within 90 days of the date thereof a shelf registration statement with respect to the resale of the 3.25% Notes and the shares of AMO common stock, if any, issuable upon conversion of the Notes, and to have the shelf registration statement declared effective within 180 days after the original issuance of the notes. If the Company fails to comply with certain of its obligations under the registration rights agreement, it will be required to pay additional interest on the notes.

In addition, the Company entered into an accelerated share repurchase arrangement with a third party to use the proceeds from the issuance of the 3.25% Notes to purchase $500.0 million of AMO common stock at a volume weighted price per share over the term of the agreement. As of June 30, 2006, the third party had delivered to the Company in the aggregate, 10.1 million shares of AMO common stock with future delivery of up to an additional 1.2 million shares, resulting in a total of up to 11.3 million shares, depending on the volume weighted average share price per share during a calculation period beginning June 14, 2006 and ending no later than March 7, 2007. Repurchased shares were retired upon delivery to the Company. The Company also repurchased $128.9 million of aggregate principal amount of convertible senior subordinated notes ($98.9 million of the principal amount of the 2.5% Notes and $30.0 million of the principal amount of the 1.375% Notes) utilizing borrowings under its senior credit facility. The Company incurred a loss on debt extinguishment of $15.8 million and wrote-off debt issuance costs of $2.4 million in the three months ended June 30, 2006 in conjunction with the note repurchases.

Note 6: Related Party Transactions

As of June 30, 2006, an interest-free relocation loan of $0.5 million, collateralized by real property, was outstanding from the chief executive officer. The principal amount of the loan is payable upon the earlier to occur of (a) 60 days following the chief executive officer’s termination of employment; (b) the date of the sale or other transfer of the property or (c) July 3, 2007. This relocation loan is evidenced by a promissory note dated July 3, 2002, prior to the adoption of the Sarbanes-Oxley Act of 2002.

Note 7: Earnings Per Share

Basic earnings per share is calculated by dividing net earnings by the weighted average number of common shares outstanding during the period. Diluted earnings per share is calculated by adjusting net earnings and the weighted average outstanding shares, assuming the conversion of all potentially dilutive convertible securities, stock options and stock purchase plan awards.

Statement of Financial Accounting Standards No. 128, “Earnings per Share,” requires that stock options, nonvested shares and similar equity instruments granted by the Company be treated as potential common shares outstanding in computing diluted earnings per share. Diluted shares outstanding include the dilutive effect of in-the-money options which is calculated based on the average market price of the Company’s common stock for each fiscal period using the treasury stock method. Under the treasury stock method, the amount the employee must pay for exercising stock options, the amount of compensation cost for future service that the Company has not yet recognized, and the amount of tax benefits that would be recorded in additional paid-in capital when the award becomes deductible are assumed to be used to repurchase shares.

The three and six month periods ended June 30, 2006 exclude the aggregate dilutive effect of approximately 2.4 million shares for stock options, ESPP and unvested restricted stock as the effect would be antidilutive due to the net loss in each of these periods.  The three and six month periods ended June 24, 2005 exclude the aggregate dilutive effect of approximately 2.7 million shares for stock options, ESPP unvested restricted stock and 3.5% convertible senior subordinated notes as the effect would be antidilutive due to the net loss in each of these periods.

The Company will settle in cash the principal amount of the 2 ½% Notes, 1.375% Notes, and the 3.25% Notes. In addition, there were no potentially dilutive common shares associated with the 2 ½% Notes, the 1.375% Notes, and the 3.25% Notes as the Company’s average stock prices during the three and six months ended June 30, 2006 were less than the conversion prices of the respective notes.

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Note 8: Other Comprehensive Income (Loss)

The following table summarizes the components of comprehensive income (loss) (in thousands):

 

		Three Months Ended
		June 30, 2006									June 24, 2005
		Before-tax amount			Income tax			Net-of-tax amount			Before-tax amount			Income Tax			Net-of-tax amount
Unrealized loss on derivatives		$	—		$	—		$	—		$	(563	)	$	192		$	(371	)
Foreign currency translation adjustments		37,023			—			37,023			(42,977		)	—			(42,977		)
Net loss								(2,703		)							(438,115		)
Total comprehensive income (loss)								$	34,320								$	(481,463	)

 

 

		Six Months Ended
		June 30, 2006									June 24, 2005
		Before-tax amount			Income tax			Net-of-tax amount			Before-tax amount			Income Tax			Net-of-tax amount
Unrealized gain on derivatives		$	—		$	—		$	—		$	454		$	(151	)	$	303
Foreign currency translation adjustments		44,603			—			44,603			(75,565		)	—			(75,565		)
Net loss								(74		)							(424,290		)
Total comprehensive income (loss)								$	44,529								$	(499,552	)

 

Note 9: Business Segment Information

The operating segments are segments for which separate financial information is available and upon which operating results are evaluated on a timely basis to assess performance and to allocate resources.

Through 2005, the Company’s reportable segments were based on geographic regions which comprised the Americas, which included North and South America, Europe/Africa/Middle East, Japan and Asia Pacific, which excluded Japan and included New Zealand and Australia.

Effective January 1, 2006, the Company’s reportable segments are represented by three business units: Cataract/Implant, Laser Vision Correction and Eye Care. Sales and operating results for the prior period have been conformed to reflect the current period presentation of reportable segments. The cataract/implant segment markets four key products required for cataract surgery — foldable intraocular lenses, or IOLs, implantation systems, phacoemulsification systems and viscoelastics. The laser vision correction segment markets laser systems, diagnostic devices, treatment cards and microkeratomes for use in laser eye surgery. The eye care segment provides a full range of contact lens care products for use with most types of contact lenses. These products include single-bottle, multi-purpose cleaning and disinfecting solutions, hydrogen peroxide-based disinfecting solutions, daily cleaners, enzymatic cleaners, contact lens rewetting drops and, in Europe and Asia, contact lenses.

The Company evaluates segment performance based on operating income (loss) excluding certain costs such as business repositioning costs, non-recurring acquisition-related costs and stock-based compensation expense. Research and development costs, manufacturing variances, inventory provision/repricing costs and supply chain costs are managed on a global basis and are considered corporate costs. The Company presents the measure which management believes is determined in accordance with the measurement principles consistent with those used in measuring the corresponding amounts in the unaudited consolidated financial statements. Because operating segments are generally defined by the products they design and sell, they do not make sales to each other. Depreciation and amortization related to the manufacturing of goods is included in gross profit. The Company does not discretely allocate assets to its operating segments, nor does the Company’s chief operating decision maker evaluate operating segments using discrete asset information.

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Business Segments

 

		Net Sales						Operating Income (Loss)
		Three Months Ended						Three Months Ended
(In thousands)		June 30, 2006			June 24, 2005			June 30, 2006			June 24, 2005
Operating segments:
Cataract/Implant		$	134,421		$	127,726		$	70,440		$	55,896
Laser Vision Correction		53,401			16,293			32,895			3,925
Eye Care		69,219			83,073			28,452			29,169
Total segments		257,041			227,092			131,787			88,990
Manufacturing operations		—			—			(1,747		)	(455,111		)
Research and development		—			—			(15,988		)	(14,657		)
Business repositioning		—			—			(22,187		)	—
Global supply chain		—			—			(15,970		)	(11,721		)
General corporate		—			—			(50,901		)	(30,881		)
Total		$	257,041		$	227,092		$	24,994		$	(423,380	)

 

 

		Net Sales						Operating Income (Loss)
		Six Months Ended						Six Months Ended
(In thousands)		June 30, 2006			June 24, 2005			June 30, 2006			June 24, 2005
Operating segments:
Cataract/Implant		$	254,865		$	244,456		$	129,022		$	107,869
Laser Vision Correction		114,356			18,235			73,683			3,660
Eye Care		126,048			156,919			50,211			56,684
Total segments		495,269			419,610			252,916			168,213
Manufacturing operations		—			—			(4,741		)	(455,824		)
Research and development		—			—			(32,961		)	(27,009		)
Business repositioning		—			—			(54,619		)	—
Global supply chain		—			—			(29,782		)	(23,234		)
General corporate		—			—			(96,092		)	(59,612		)
Total		$	495,269		$	419,610		$	34,721		$	(397,466	)

 

 

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Geographic Area Information

 

		Net Sales
		Three Months Ended						Six Months Ended
(In thousands)		June 30, 2006			June 24, 2005			June 30, 2006			June 24, 2005
United States:
Cataract/Implant		$	43,910		$	36,070		$	82,008		$	68,387
Laser Vision Correction		40,738			13,156			90,655			14,613
Eye Care		24,863			14,276			39,078			27,538
Total United States		109,511			63,502			211,741			110,538
Americas, excluding United States:
Cataract/Implant		9,077			6,955			17,489			12,776
Laser Vision Correction		2,360			545			4,470			680
Eye Care		3,340			2,101			6,025			4,732
Total Americas, excluding United States		14,777			9,601			27,984			18,188
Europe/Africa/Middle East:
Cataract/Implant		50,515			50,541			96,900			100,543
Laser Vision Correction		3,881			1,474			7,980			1,726
Eye Care		19,795			24,841			35,700			48,554
Total Europe/Africa/Middle East		74,191			76,856			140,580			150,823
Japan:
Cataract/Implant		17,756			20,124			32,714			37,046
Laser Vision Correction		995			233			1,811			235
Eye Care		11,656			30,929			27,785			54,503
Total Japan		30,407			51,286			62,310			91,784
Asia Pacific:
Cataract/Implant		13,163			14,036			25,754			25,704
Laser Vision Correction		5,427			885			9,440			981
Eye Care		9,565			10,926			17,460			21,592
Total Asia Pacific		28,155			25,847			52,654			48,277
Total		$	257,041		$	227,092		$	495,269		$	419,610

 

The United States information is presented separately as it is the Company’s headquarters country, and U.S. sales represented 42.6% and 42.8% of total net sales for the three and six months ended June 30, 2006 and 28.0% and 26.3% of total net sales for the three and six months ended June 24, 2005, respectively. Additionally, sales in Japan represented 11.8% and 12.6% of total net sales for the three and six months ended June 30, 2006 and 22.6% and 21.9% of total net sales for the three and six months ended June 24, 2005, respectively. No other country, or single customer, generated over 10% of total net sales in the periods presented.

Note 10: Commitments and Contingencies

On July 7, 2006, the Company entered into a settlement agreement with Alcon, Inc., Alcon Laboratories, Inc., and Alcon Manufacturing Ltd. (collectively, “Alcon”) regarding all pending patent litigation between AMO and Alcon. The settlement required Alcon to pay AMO a lump-sum payment of $121 million which was received in July 2006 and will be accounted for in the third quarter of 2006. The parties agreed to dismiss all pending patent litigation in Delaware and Texas, agreed not to sue each other regarding the patents at issue in those cases, and cross-licensed patents covering existing features of commercially available phacoemulsification products. As part of the settlement, the parties agreed to a dispute resolution process for future claims before litigation is commenced.

On January 4, 2005, Dr. James Nielsen filed a complaint against the Company and Allergan, Inc. in the U.S. District Court of the Northern District of Texas, Dallas Division, for infringement of U.S. Patent No. 5,158,572. Dr. Nielsen alleges that the Company’s Array multifocal intraocular lens infringes the patent. He is seeking damages and a permanent injunction. The trial in this matter is scheduled to begin on November 6, 2006.

The Company does not believe, based on current knowledge, that any of the foregoing legal proceedings or claims are likely to have a material adverse effect on its financial position, results of operations or cash flows. However, the Company may incur substantial expenses in defending against third party claims. In the event of a determination adverse to the Company or its subsidiaries, the Company may incur substantial monetary liability, and be required to change its business practices. Either of these could have a material adverse effect on the Company’s financial position, results of operations or cash flows.

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While the Company is involved from time to time in litigation arising in the ordinary course of business, including product liability claims, the Company is not currently aware of any other actions against AMO or Allergan relating to the optical medical device business that the Company believes would have a material adverse effect on the Company’s business, financial condition, results of operations or cash flows. The Company may be subject to future litigation and infringement claims, which could cause the Company to incur significant expenses or prevent the Company from selling its products. The Company operates in an industry susceptible to significant product liability claims. Product liability claims may be asserted against AMO in the future arising out of events not known to the Company at the present time. Under the terms of the contribution and distribution agreement affecting the spin-off, Allergan agreed to assume responsibility for, and to indemnify AMO against, all current and future litigation relating to its retained businesses and the Company agreed to assume responsibility for, and to indemnify Allergan against, all current and future litigation related to the optical medical device business.

Note 11: Pension Benefit Plans

The Company sponsors defined benefit pension plans in Japan and in certain European countries. Components of net periodic benefit cost under these plans were (in thousands):

 

 

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ADVANCED MEDICAL OPTICS, INC.

Item 2.                          Management’s Discussion and Analysis of Financial Condition and Results of Operations for the Quarter Ended June 30, 2006

The following discussion and analysis presents the factors that had a material effect on AMO’s cash flows and results of operations during the three and six months ended June 30, 2006, and the Company’s financial position at that date. Except for the historical information contained herein, the following discussion contains forward-looking statements that involve risk and uncertainties. Our actual results may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such differences include, but are not limited to, those discussed in the subsection entitled “Certain Factors and Trends Affecting AMO and Its Businesses.” The following discussion should be read in conjunction with the 2005 Form 10-K and the unaudited consolidated financial statements and notes thereto included elsewhere in this Form 10-Q.

OVERVIEW

We are a global leader in the development, manufacture and marketing of medical devices for the eye. Effective January 1, 2006, our reportable segments are represented by our three business units:  Cataract/Implant, Laser Vision Correction and Eye Care. Previously, our reportable segments were based on geographic regions which comprised the Americas, which included North and South America, Europe/Africa/Middle East, Japan and Asia Pacific, which excluded Japan and included New Zealand and Australia. Sales and operating results for the prior period have been conformed to reflect the current period presentation of reportable segments. Our Cataract/Implant business focuses on the four key products required for cataract surgery — foldable intraocular lenses, or IOLs, implantation systems, phacoemulsification systems and viscoelastics. Our Laser Vision Correction business markets laser systems, diagnostic devices, treatment cards and microkeratomes for use in laser eye surgery. Our Eye Care business provides a full range of contact lens care products for use with most types of contact lenses. These products include single-bottle, multi-purpose cleaning and disinfecting solutions, hydrogen peroxide-based disinfecting solutions, daily cleaners, enzymatic cleaners, contact lens rewetting drops, and in Europe and Asia, contact lenses. Our products are sold in approximately 60 countries and we have direct operations in over 20 countries.

Product Rationalization and Repositioning Plan

On October 31, 2005, our Board of Directors approved a product rationalization and repositioning plan covering the discontinuation of non-strategic cataract surgical and eye care products and the elimination or redeployment of resources that support these product lines. The plan also includes organizational changes and potential reductions in force in manufacturing, sales and marketing associated with these product lines, as well as organizational changes in research and development and other corporate functions designed to align the organization with our strategy and strategic business unit organization. A substantial portion of expected operating cost benefits will result from reductions in force and associated annualized employee compensation of approximately $17.9 million.

The plan further calls for increasing our investment in key growth opportunities, specifically our refractive implant product line and international laser vision correction business, and accelerating the implementation of productivity initiatives.

In the three months ended June 30, 2006, we incurred $25.1 million of pre-tax charges, which included $7.4 million for inventory, manufacturing related and other charges included in cost of sales and $17.7 million included in operating expenses. Charges included in operating expenses comprised severance, relocation and other one-time termination benefits of $11.9 million, productivity and brand repositioning costs of $4.9 million, asset write-downs of $0.7 million and contractual obligations of $0.2 million. In the six months ended June 30, 2006, we incurred $54.6 million of pre-tax charges, which included $7.6 million for inventory and manufacturing related charges included in cost of sales and $47.0 million included in operating expenses. Charges included in operating expenses comprised productivity and brand repositioning costs of $31.1 million, severance, relocation and other one-time termination benefits of $13.5 million, asset write-downs of $2.1 million and contractual obligations of $0.3 million.

Following an analysis of our IOL manufacturing capabilities in the second quarter of 2006, we have decided to consolidate certain operations. In addition, we expanded the scope of our eye care rationalization initiatives in order to maximize manufacturing capacity and seize growth opportunities. Together, these separate actions are expected to result in additional charges of approximately $20 million to $25 million in 2006.  When combined with the initial estimated charges of $70 million to $80 million, the estimated total charges for the expanded product rationalization and repositioning plan will be approximately $105 million.  Through June 30, 2006, we incurred cumulative charges of $99.8 million.  We expect to incur additional charges of approximately $5 million in the remainder of 2006.

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Certain foreign jurisdictions have laws and regulations which require consultations and negotiations with works councils, labor organizations and local authorities. The outcome of these discussions will determine, in part, the restructuring steps to be implemented and the associated cost. Therefore, the final costs of the business repositioning plan may be significantly different from our initial estimates.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

The preparation of consolidated financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires management to make judgments, assumptions and estimates that affect the amounts reported. Certain of these significant accounting policies are considered to be critical accounting policies, as defined below.

A critical accounting policy is defined as one that is both material to the presentation of AMO’s consolidated financial statements and requires management to make difficult, subjective or complex judgments that could have a material effect on AMO’s financial condition or results of operations. Specifically, these policies have the following attributes: (1) AMO is required to make assumptions about matters that are highly uncertain at the time of the estimate; and (2) different estimates AMO could reasonably have used, or changes in the estimate that are reasonably likely to occur, would have a material effect on AMO’s financial condition or results of operations.

Estimates and assumptions about future events and their effects cannot be determined with certainty. AMO bases its estimates on historical experience and on various other assumptions believed to be applicable and reasonable under the circumstances. These estimates may change as new events occur, as additional information is obtained and as AMO’s operating environment changes. These changes have historically been minor and have been included in the consolidated financial statements as soon as they became known. In addition, management is periodically faced with uncertainties, the outcomes of which are not within its control and will not be known for prolonged periods of time. These uncertainties are discussed in the section of our 2005 Form 10-K entitled “Risk Factors” and the section below entitled “Certain Factors and Trends Affecting AMO and Its Businesses.” Based on a critical assessment of its accounting policies and the underlying judgments and uncertainties affecting the application of those policies, management believes that AMO’s consolidated financial statements are fairly stated in accordance with accounting principles generally accepted in the United States of America, and provide a meaningful presentation of AMO’s financial condition and results of operations.

Revenue Recognition and Accounts Receivable

Revenue is realized or realizable and earned when persuasive evidence of an arrangement exists, delivery has occurred, the price to the buyer is fixed or determinable and collectibility is reasonably assured. We record revenue from product sales when title and risk of ownership have been transferred to the customer, which is typically upon delivery to the customer, with the exception of intraocular lenses distributed on a consignment basis, which is upon notification of implantation in a patient. We recognize license fees and revenues from the sale of treatment cards to direct customers when we ship the treatment cards as we have no continuing obligations or involvement subsequent to shipment.

Some customers finance the purchase or rental of their VISX equipment directly from us over periods ranging from one to three years. These financing agreements are classified as either rental or operating leases or sales type leases as prescribed by Statement of Financial Accounting Standards No. 13, “Accounting for Leases.” Under sales type leases, system revenues are recognized based on the net present value of the expected cash flow after installation to direct customers in the United States and Japan or after shipment to international distributors. Under rental or operating lease arrangements, rental revenue is recognized over the term of the agreement.

We generally permit returns of product if such product is returned in a timely matter, in good condition, and through the normal channels of distribution. However, we do not accept returns of treatment cards and we do not provide rights of return or exchange, price protection or stock rotation rights to any of our VISX product distributors. Return policies in certain international markets can be more stringent and are based on the terms of contractual agreements with the customers. Allowances for returns are provided for based upon an analysis of our historical patterns of returns matched against the sales from which they originated. To date, historical product returns have been within our estimates.

When we recognize revenue from the sale of our products, certain allowances known and estimable at time of sale are recorded as a reduction to sales. These items include cash discounts, allowances and rebates. These items are reflected as a reduction to accounts receivable to the extent the customer will or is expected to reduce its payment on the related invoice amounts. In addition, certain items such as rebates provided to customers that meet certain buying targets are paid to the customer subsequent to customer payment. Thus, such amounts are recorded as accrued liabilities. These provisions are estimated based on historical payment experience, historical relationship to revenues and estimated customer inventory levels. If the historical data and inventory estimates used to calculate these provisions do not properly reflect future activity, our financial position, results of operations and cash flows could be impacted. To date, historical sales allowances have been within our estimates.

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The allowance for doubtful accounts is determined by analyzing specific customer accounts and assessing the risk of uncollectibility based on insolvency, disputes or other collection issues. In addition, we routinely analyze the different aging categories and establish allowances based on the length of time receivables are past due.

Inventories

Inventories are valued at the lower of first-in, first-out cost or market. On a regular basis, we evaluate inventory balances for excess quantities and obsolescence by analyzing estimated demand, inventory on hand, sales levels and other information. Based on these evaluations, inventory balances are reduced, if necessary.

Goodwill and Long-Lived Assets

On January 1, 2002, we adopted Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets”, whereby goodwill is no longer amortized, but instead is subject to a periodic impairment review performed during the second quarter of each fiscal year. In a business combination, goodwill is allocated to our various reporting units based on relative fair value of the assets acquired and liabilities assumed. We review the recoverability of goodwill by comparing each unit’s fair value to the net book value of its assets. If the book value of the reporting unit’s assets exceeds its fair value, the goodwill is written down to its implied fair value.

Additionally, we review the carrying amount of goodwill whenever events and circumstances indicate that the carrying amount of goodwill may not be recoverable. Impairment indicators include, among other conditions, cash flow deficits, historic or anticipated declines in annual revenue or operating profit and adverse legal or regulatory developments. If it is determined such indicators are present and the review indicates goodwill will not be fully recoverable, based upon discounted estimated cash flows, the carrying value is reduced to implied fair value.

The annual impairment review of goodwill was performed in the second quarter of 2006, and no impairment was indicated based on tests conducted during the review. The next annual impairment review of goodwill will be performed in the second quarter of 2007. Effective January 1, 2006, our operating segments consist of three businesses:  Cataract/Implant, Laser Vision Correction and Eye Care. Accordingly, the annual impairment review of goodwill in the second quarter of 2006 was based on reporting units that are aligned with the current operating segments.

In accordance with Statement of Financial Accounting Standards No. 144 “Accounting for the Impairment or Disposal of Long-lived Assets”, we assess potential impairment to our long-lived assets when events or changes in circumstances indicate that the carrying amount of an asset may not be fully recoverable. If required, an impairment loss is recognized as the difference between the carrying value and the fair value of the assets.

Income Taxes

We account for income taxes under the asset and liability method, whereby deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. We evaluate the need to establish a valuation allowance for deferred tax assets based upon the amount of existing temporary differences, the period in which they are expected to be recovered and expected levels of taxable income. A valuation allowance to reduce deferred tax assets is established when it is “more likely than not” that some or all of the deferred tax assets will not be realized.

We record a liability for potential tax assessments based on our estimate of the potential exposure. New laws and new interpretations of laws and rulings by tax authorities may affect the liability for potential tax assessments. Due to the subjectivity and complex nature of the underlying issues, actual payments or assessments may differ from estimates. To the extent our estimates differ from actual payments or assessments, income tax expense is adjusted. Our income tax returns in several locations are being examined by the local taxation authorities. Management believes that adequate amounts of tax and related interest, if any, have been provided for any adjustments that may result from these examinations.

Stock-Based Compensation

Effective January 1, 2006, we began accounting for stock options and employee stock purchase plan (ESPP) shares under the provisions of Statement of Financial Accounting Standards No. 123R, “Share-Based Payment” (SFAS 123R). SFAS 123R requires entities to recognize the cost of employee services received in exchange for awards of equity instruments based on the grant-date fair value of those awards. The fair value of stock options and ESPP purchase rights are

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estimated using a Black-Scholes option valuation model. This model requires the input of subjective assumptions, including expected stock price volatility, estimated life and estimated forfeitures of each award. The fair value of equity-based awards is amortized over the vesting period of the award, and we have elected to use the straight-line method. We make quarterly assessments of the adequacy of the tax credit pool to determine if there are any deficiencies which require recognition in the consolidated statement of operations. Prior to the implementation of SFAS 123R, we accounted for stock options and ESPP shares under the provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” and made pro forma disclosures as required by SFAS No. 148, “Accounting For Stock-Based Compensation — Transition and Disclosure,” which amended SFAS No. 123, “Accounting For Stock-Based Compensation.” Pro forma net loss and pro forma net loss per share disclosed in the footnotes to the consolidated financial statements were estimated using a Black-Scholes option valuation model. The fair value of restricted stock and restricted stock units was calculated based upon the fair market value of our common stock at the date of grant.

We also have an annual performance stock incentive program which provides the opportunity for certain executives to earn long-term incentive compensation awards based upon specified market performance measures. Awards are to be settled in a number of restricted stock shares or units equal to the value of the award amount divided by the fair market value of our common stock on the date the performance criteria is deemed to have been met. The fair value of the awards on the grant date is estimated using a lattice-based valuation model. The associated expense is recognized on a straight-line basis over the period which starts from the date the annual program is approved by the Board of Directors through the end of the expected vesting period of the restricted stock awards.

RESULTS OF OPERATIONS

The following table presents net sales and operating income by operating segment for the three and six months ended June 30, 2006 and June 24, 2005, respectively:

 

 

 

 

Net sales. Total net sales increased 13.2% and 18.0% in the three and six months ended June 30, 2006, compared to the same periods last year. The increases in net sales were primarily the result of sales of acquired VISX products and strong demand for our core brands, partially offset by negative foreign currency impact of 0.4% and 2.5% in the three and six months ended June 30, 2006, respectively. Our sales and earnings may be negatively impacted during times of a strengthening U.S. dollar. Total net sales in the U.S. and Japan represented 42.6% and 11.8%, respectively, of total net sales in the three months ended June 30, 2006. Total net sales in the U.S. and Japan represented 42.8% and 12.6%, respectively, of total net sales in the six months ended June 30, 2006. No other country, or any single customer, generated over 10% of total net sales in the periods presented.

Net sales from our Cataract/Implant business increased by 5.2% and 4.3% in the three and six months ended June 30, 2006, compared with the same periods last year. The increases in net sales were primarily the result of sales of our branded promoted products, including Tecnis and ReZoom intraocular lenses and phacoemulsification systems, partially offset by a decrease in sales of non-promoted older-technology intraocular lenses and viscoelastics and reimbursement pressures in

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certain European markets and in Japan for viscoelastic products. Net sales growth in the Americas of 23.2% and 22.6% in the three and six months ended June 30, 2006, respectively, were due to strong demand for our core products, partially offset by decreases in sales of non-promoted older-technology intraocular lenses and viscoelastics.  Sales in Europe/Africa/Middle East were flat in the three months ended June 30, 2006 and declined by 3.6% in the six months ended June 30, 2006.  Sales in Japan declined by 11.8% and 11.7% in the three and six months ended June 30, 2006.  The sales declines in Europe/Africa/Middle East and Japan were due to decreasing sales of older generation intraocular lenses, rationalized viscoelastics and reimbursement pressures, as well as the negative impact of foreign currency fluctuations. The differences in net sales in our Cataract/Implant business reflect unfavorable foreign currency impacts of 0.5% and 2.7% in the three and six months ended June 30, 2006, largely from fluctuations of the euro and Japanese yen versus the U.S. dollar.

Net sales from our Laser Vision Correction (LVC) business increased by $37.1 million and $96.1 million in the three and six months ended June 30, 2006, respectively, compared with the same periods last year.  These increases were primarily the result of sales of acquired VISX products. Net sales of acquired VISX products were $50.8 million and $108.5 million in the three and six months ended June 30, 2006, respectively, compared with $13.4 million in the three and six months ended June 24, 2005. See Note 2 to the unaudited consolidated financial statements for the proforma impact of VISX net sales for the same period last year. Net sales in the Americas increased by $29.4 million and $79.8 million in the three and six months ended June 30, 2006, respectively, compared with the same periods last year, due to acquired VISX products and strong demand for our custom LASIK procedures and system sales. As a result of our international expansion strategy for the LVC business, we saw net sales in Europe/Africa/Middle East of $3.9 million and $8.0 million in the three and six months ended June 30, 2006, respectively and Asia Pacific sales of $5.4 million and $9.4 million in the three and six months ended June 30, 2006, compared to significantly lower amounts in the same periods last year. The difference in net sales in our LVC business also includes an unfavorable foreign currency impact of $0.2 million, or 1.3% in the six months ended June 30, 2006, largely from fluctuations of the euro and Japanese yen versus the U.S. dollar.  The foreign currency impact in the three months ended June 30, 2006 was negligible.

Net sales from our Eye Care business decreased by 16.7% and 19.7% in the three and six months ended June 30, 2006, respectively, compared with the same periods last year. The decreases in sales of eye care products were primarily due to lower sales of hydrogen peroxide-based products caused by continued shrinkage of this market as contact lens wearers gravitate increasingly to more convenient multipurpose solutions, decreased sales of multipurpose products primarily due to rapid growth of daily disposable lenses, particularly in the Japan market, and a provision of $3.9 million in the current quarter for expected sales returns for discontinued products. These factors contributed significantly to net sales declines of 62.3% in Japan, 20.3% in Europe/Africa/Middle East and 12.5% in Asia Pacific during the three months ended June 30, 2006 and 49.0% in Japan, 26.5% in Europe/Africa/Middle East and 19.1% in Asia Pacific during the six months ended June 30, 2006, compared with the same periods last year. These declines were partially offset by increases in the Americas of 72.2% and 39.8% in the three and six months ended June 30, 2006, respectively, due to increasing demand for our multipurpose products, largely attributable to our strategy to increase our sampling programs, selling efforts to practitioners and their staffs and the withdrawal of a competitor’s product in the second quarter of 2006. The difference in net sales in our Eye Care business also include unfavorable foreign currency impacts of 0.5% and 2.3% in the three and six months ended June 30, 2006, respectively, largely resulting from fluctuations of the euro and Japanese yen versus the U.S. dollar.

As part of our product rationalization and repositioning plan to maximize our competitive advantage as the global refractive leader and improve the global penetration of our core cataract, refractive and eye care brands, we have discontinued a variety of non-strategic cataract surgical and eye care products that lack critical revenue mass, have experienced steadily declining sales trends and/or have generated relatively unattractive margins. The decreases in total net sales resulting from the product rationalization were approximately $13 million and $21 million in the three and six months ended June 30, 2006.  We expect the growth of our promoted products to offset the decline in net sales related to these discontinued products.

Gross margin and gross profit. Our gross margin percentage was 64.1% and 63.8% in the three and six months ended June 30, 2006, respectively, compared with 61.5% and 62.4% in the same periods last year due to sales growth in the higher margin Tecnis and ReZoom intraocular lenses and VISX products, along with manufacturing productivity improvements. These improvements were offset by lower eye care sales, as described above, and approximately $7.4 million, or 2.9 percentage points, for inventory, manufacturing related and other charges incurred in connection with our business repositioning plan in the three months ended June 30, 2006.  Total charges included in gross profit that were incurred in connection with the business repositioning plan were $10.5 million in the six months ended June 30, 2006.  Gross profit for the three and six months ended June 24, 2005 was negatively impacted by approximately $1.9 million, or 0.8 percentage points and 0.5 percentage points, respectively, related to acquisition and integration-related charges.

As described earlier, we expect to incur additional charges of approximately $5 million under our product rationalization and repositioning strategy and supplemental consolidation of certain operations due to IOL manufacturing capabilities and eye care product rationalizations which could have a significant negative impact on our gross margin through the remainder of 2006.

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Selling, general and administrative.  Selling, general and administrative expenses decreased as a percent of net sales by 2.0 percentage points to 41.0% and by 2.7 percentage points to 40.5% in the three and six months ended June 30, 2006, respectively, compared with 43.0% and 43.2% in the three and six months ended June 24, 2005, respectively. These decreases were largely driven by increased leverage from overall revenue growth as described previously and efficiency gains from our business repositioning strategy. Selling, general and administrative expenses for the three and six months ended June 30, 2006 include approximately $7.0 million and $14.1 million, respectively, in amortization expenses related to the acquired VISX intangible assets. In addition, selling, general and administrative expenses for the three months ended June 30, 2006 include $7.0 million in charges primarily for a contractual obligation associated with the VISX integration and $4.0 million in stock-based compensation expense under SFAS 123R. Selling, general and administrative expenses for the six months ended June 30, 2006 also includes a $2.3 million charge primarily associated with assets acquired in the termination of a distributor agreement in India.  Stock-based compensation expense under SFAS 123R included in selling, general and administrative expenses was $8.0 million for the six months ended June 30, 2006.  Selling, general and administrative expenses for the three and six months ended June 24, 2005 include approximately $2.8 million in acquisition and integration-related charges.

Research and development. Research and development expenditures increased as a percent of net sales by 0.3 percentage points to 6.4%, and by 0.5 percentage points to 6.8% in the three and six months ended June 30, 2006, respectively, compared with the same periods last year. The increases in research and development expenditures as a percentage of net sales were primarily the result of an increase in spending for research efforts in the Cataract/Implant and LVC businesses. We expect our research and development costs as a percentage of sales to be approximately 6.5% of net sales for 2006 as we continue to consolidate research and development costs from the VISX acquisition. Our research and development strategy is to develop proprietary products for vision correction that are safe and effective and address unmet needs. We are currently focusing on new advancements that build on our Tecnis, Healon and Sovereign technologies, corneal and lens-based solutions to presbyopia and dry eye products. Our research and development teams are actively pursuing new CustomVue indications in order to strengthen our LVC market position, particularly in the area of treatment for presbyopia.

In-process research and development.  In the three and six months ended June 24, 2005, we recorded a $451.5 million in-process research and development (IPR&D) charge primarily comprised of a $449.2 million charge resulting from the VISX acquisition.  This charge represented the estimated fair value of projects that, as of the acquisition date, had not reached technological feasibility and had no alternative future use.

Business repositioning costs. In the three months ended June 30, 2006, we incurred $25.1 million of pre-tax charges, which included $7.4 million for inventory, manufacturing related and other charges included in cost of sales and $17.7 million included in operating expenses. Charges included in operating expenses comprised severance, relocation and other one-time termination benefits of $11.9 million, productivity and brand repositioning costs of $4.9 million, asset write-downs of $0.7 million and contractual obligations of $0.2 million. In the six months ended June 30, 2006, we incurred $57.5 million of pre-tax charges, which included $10.5 million for inventory, manufacturing related and other charges included in cost of sales and $47.0 million included in operating expenses. Charges included in operating expenses comprised productivity and brand repositioning costs of $31.1 million, severance, relocation and other one-time termination benefits of $13.5 million, asset write-downs of $2.1 million and contractual obligations of $0.3 million.

Following an analysis of our IOL manufacturing capabilities in the second quarter of 2006, we have decided to consolidate certain operations. In addition, we expanded the scope of our eye care rationalization initiatives in order to maximize manufacturing capacity and seize growth opportunities. Together, these separate actions are expected to result in additional charges of approximately $20 million to $25 million in 2006.  When combined with the initial estimated charges of $70 million to $80 million, the estimated total charges for the expanded product rationalization and repositioning plan will be approximately $105 million.  Through June 30, 2006, we incurred cumulative charges of $99.8 million.  We expect to incur additional charges of approximately $5 million in the remainder of 2006.

Operating Income. Operating income as a percentage of net sales, or operating margin, was 9.7% and 7.0% in the three and six months ended June 30, 2006, respectively. Operating income of $25.0 million in the three months ended June 30, 2006 includes $25.1 million of business repositioning charges, $7.0 million primarily for a contractual obligation described above and $5.2 million in stock-based compensation expense under SFAS 123R. These charges reduced operating margin by 14.5% in the three months ended June 30, 2006.  Operating income of $34.7 million in the six months ended June 30, 2006 includes $57.5 million of business repositioning charges, $7.0 million primarily for a contractual obligation described above, $2.3 million of asset write-offs described above and $10.3 million in stock-based compensation expense under SFAS 123R. These charges reduced operating margin by 15.6% in the six months ended June 30, 2006.  Operating losses of $423.4 million and $397.5 million in the three and six months ended June 24, 2005 were primarily due to the IPR&D charge of $451.5 million from the VISX acquisition described above.

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Operating income from our Cataract/Implant business increased by $14.5 million and $21.2 million in the three and six months ended June 30, 2006, respectively, due to the increase in net sales and favorable mix of higher margin products discussed above, along with the favorable impact of cost containment measures taken in connection with our business repositioning plan. Operating income from our LVC business increased by $29.0 million and $70.0 million in the three and six months ended June 30, 2006, respectively, due to sales of products acquired from VISX in May 2005. Operating income from our Eye Care business decreased by $0.7 million and $6.5 million in the three and six months ended June 30, 2006, respectively, primarily due to the unfavorable impact from continued softness in the market for hydrogen peroxide based products, partially offset by strong sales of multi-purpose products in the Americas.

Non-operating expense. Interest expense was $8.0 million and $12.5 million in the three and six months ended June 30, 2006, respectively, compared with $8.9 million and $14.7 million in the three and six months ended June 24, 2005, respectively. Interest expense in the three and six months ended June 30, 2006 includes a pro-rata write-off of debt issuance costs of $2.4 million.  Interest expense in the three and six months ended June 24, 2005 includes a pro-rata write-off of debt issuance costs of $1.9 million.  We anticipate interest expense to increase in 2006 relative to 2005 due to the issuance of $500 million of 3.25% convertible senior subordinated notes in June 2006.

During the three and six months ended June 30, 2006, we recorded a loss of $15.8 million associated with the repurchase of $128.9 million aggregate principal amount of convertible notes.

We recorded an unrealized loss on derivative instruments of $2.4 million and $2.9 million in the three and six months ended June 30, 2006, respectively, compared to an unrealized gain of $0.5 million and $1.0 million in the three and six months ended June 24, 2005, respectively. We record as “unrealized (gain) loss on derivative instruments” the mark to market adjustments on the outstanding foreign currency options and forward contracts which we enter into as part of our overall risk management strategy to reduce the volatility of expected earnings in currencies other than the U.S. dollar.  The losses in the first six months of 2006 were largely attributable to euro and Japanese yen instruments.

Income taxes. We recorded a provision for income taxes of $0.8 million and $2.0 million in the three and six months ended June 30, 2006, respectively.  The effective tax rates for these periods were significantly impacted by the early retirement of convertible senior subordinated notes which resulted in a pre-tax charge of $15.8 million and the recognition of a partial deferred tax benefit of $3.6 million.  In addition, the effective tax rates reflect a benefit from stock-based compensation expense currently being recognized under SFAS 123R at an effective rate of approximately 33%, and a provision on all other pre-tax income at an effective rate of 32%.  We recorded a provision for income taxes of $7.2 million and $14.3 million in the three and six months ended June 24, 2005, respectively.  The effective tax rates for these periods were significantly impacted by the IPR&D charge of $451.5 million and a non-cash charge of $0.5 million related to the exchange of convertible notes, for which no tax benefit was provided.  We provided a tax provision at 34% on the remaining income.

The lower rate in 2006 reflects continuing implementation of our long-term tax strategies. Our future effective income tax rate may vary depending on our mix of domestic and international taxable income or loss and the various tax and treasury methodologies that we implement, including our policy regarding repatriation of future accumulated foreign earnings.

LIQUIDITY AND CAPITAL RESOURCES

Management assesses our liquidity by our ability to generate cash to fund operations. Significant factors in the management of liquidity are: funds generated by operations; levels of accounts receivable, inventories, accounts payable and capital expenditures; adequate lines of credit; and financial flexibility to attract long-term capital on satisfactory terms. As of June 30, 2006, we had cash and equivalents of $40.8 million.

Historically, we have generated cash from operations in excess of working capital requirements, and we expect to do so in the future. Net cash provided by operating activities was $45.3 million in the six months ended June 30, 2006 compared to cash used in operating activities of $9.4 million in the six months ended June 24, 2005. Operating cash flow improved in the six months ended June 30, 2006 compared to the six months ended June 24, 2005 primarily due to timing of accounts receivable collections, last year’s inventory buildup of “bridging” stock as we prepared for the transition of eye care manufacturing from Allergan and payments of merger related transaction costs incurred by VISX in 2005, partially offset by  the payment of annual incentive compensation, severance payments related to the product rationalization and business repositioning plan and interest payments on the 2½% convertible senior subordinated notes and the 1.375% convertible senior subordinated notes.

 

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