Nuvectra Corp - FORM 10-Q

Attached files

file	filename
EX-32.1 - EXHIBIT 32.1 - Nuvectra Corp	ex_111049.htm
EX-31.2 - EXHIBIT 31.2 - Nuvectra Corp	ex_111048.htm
EX-31.1 - EXHIBIT 31.1 - Nuvectra Corp	ex_111047.htm
EX-4.22 - EXHIBIT 4.2.2 - Nuvectra Corp	ex_111167.htm

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 or 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2018

Commission File Number 001-37525

Nuvectra Corporation

(Exact name of Registrant as specified in its charter)

Delaware		30-0513847
(State of Incorporation)		(I.R.S. Employer Identification No.)

5830 Granite Parkway, Suite 1100

Plano, Texas 75024

(Address of principal executive offices) (Zip code)

(214) 474-3103

(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 ☒ No ☐

Indicate by checkmark 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 ☒ No ☐

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer☐

Accelerated filer☒

Non-accelerated filer☐

(Do not check if a smaller reporting company)

Smaller reporting company☐

Emerging growth company☒

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☒

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

As of April 26, 2018, shares outstanding of the Company’s common stock, $0.001 par value per share, totaled 14,153,305.

Nuvectra Corporation

Table of Contents for Form 10-Q

As of and for the Quarterly Period Ended March 31, 2018

		Page No.
PART I—FINANCIAL INFORMATION

ITEM 1.	Condensed Consolidated Financial Statements	3

	Condensed Consolidated Balance Sheets—Unaudited	3

	Condensed Consolidated Statements of Operations and Comprehensive Loss—Unaudited	4

	Condensed Consolidated Statements of Cash Flows—Unaudited	5

	Condensed Consolidated Statement of Stockholders' Equity—Unaudited	6

	Notes to Condensed Consolidated Financial Statements—Unaudited	7

ITEM 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	23

ITEM 3.	Quantitative and Qualitative Disclosures About Market Risk	29

ITEM 4.	Controls and Procedures	29

PART II—OTHER INFORMATION

ITEM 1.	Legal Proceedings	31

ITEM 1A.	Risk Factors	31

ITEM 2.	Unregistered Sales of Equity Securities and Use of Proceeds	31

ITEM 3.	Defaults Upon Senior Securities	31

ITEM 4.	Mine Safety Disclosures	31

ITEM 5.	Other Information	31

ITEM 6.	Exhibits	32

SIGNATURES		33

EXHIBIT INDEX		34

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PART I—FINANCIAL INFORMATION

ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Nuvectra Corporation

CONDENSED CONSOLIDATED BALANCE SHEETS—Unaudited

(in thousands except share and per share data)

	As of
	March 31, 2018			December 31, 2017
ASSETS
Current assets:
Cash and cash equivalents	$	53,851		$	28,165
Trade accounts receivable, net of allowance for doubtful accounts of $417 in 2018 and 2017		9,080			10,875
Inventories		4,478			4,978
Prepaid expenses and other current assets		917			1,011
Total current assets		68,326			45,029
Property, plant and equipment, net		6,036			6,219
Intangible assets, net		1,353			1,428
Goodwill		38,182			38,182
Other long-term assets		109			245
Total assets	$	114,006		$	91,103

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	3,178		$	2,043
Accrued liabilities		6,438			8,827
Accrued compensation		2,798			4,392
Short-term debt		-			789
Total current liabilities		12,414			16,051
Other long-term liabilities		660			993
Long-term debt, net		38,409			25,886
Total liabilities		51,483			42,930

Commitments and contingencies (Note 8)
Stockholders’ equity:
Common stock, $0.001 par value, 100,000,000 shares authorized; 14,147,446 and 10,849,385 shares issued and outstanding in 2018 and 2017, respectively		14			11
Additional paid-in capital		150,878			125,999
Accumulated other comprehensive loss		—			(1	)
Accumulated deficit		(88,369	)		(77,836	)
Total stockholders’ equity		62,523			48,173

Total liabilities and stockholders’ equity	$	114,006		$	91,103

The accompanying notes are an integral part of these condensed consolidated financial statements.

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Nuvectra Corporation

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

AND COMPREHENSIVE LOSS — Unaudited

(in thousands except per share data)

	Three Months Ended
	March 31, 2018			March 31, 2017
Sales:
Product	$	10,118		$	4,588
Service		456			452
Total sales		10,574			5,040
Cost of sales:
Product		4,454			2,101
Service		354			310
Total cost of sales		4,808			2,411
Gross profit		5,766			2,629
Operating expenses:
Selling, general and administrative expenses		12,133			10,805
Research, development and engineering costs, net		3,280			4,373
Total operating expenses		15,413			15,178
Operating loss		(9,647	)		(12,549	)
Interest expense, net		850			370
Other expense, net		23			203
Loss before provision for income taxes		(10,520	)		(13,122	)
Provision for income taxes		13			—
Net loss	$	(10,533	)	$	(13,122	)

Basic and diluted net loss per share	$	(0.84	)	$	(1.27	)
Basic and diluted weighted average shares outstanding		12,509			10,335

The accompanying notes are an integral part of these condensed consolidated financial statements.

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Nuvectra Corporation

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS—Unaudited

(in thousands)

	Three Months Ended
	March 31, 2018			March 31, 2017
Cash flows from operating activities:
Net loss	$	(10,533	)	$	(13,122	)
Adjustments to reconcile net loss to net cash used in operating activities:
Provision for uncollectible accounts		-			44
Write-downs of excess and obsolete inventories		101			156
Depreciation and amortization		445			359
Debt related amortization included in interest expense		268			163
Stock-based compensation		551			477
Changes in operating assets and liabilities:
Trade accounts receivable		1,795			(1,276	)
Inventories		399			1,056
Prepaid expenses and other current assets		94			238
Accounts payable and other current liabilities		(1,350	)		(3,240	)
Accrued compensation		(1,594	)		(152	)
Other long-term liabilities		13			178
Net cash used in operating activities		(9,811	)		(15,119	)
Cash flows from investing activities:
Acquisition of property, plant and equipment		(90	)		(531	)
Net cash used in investing activities		(90	)		(531	)
Cash flows from financing activities:
Borrowings under credit facility, net		11,711			—
Proceeds from the sale of common stock		24,046			—
Payments of financing costs related to issuance of common stock		(246	)		—
Proceeds from the exercise of stock options		76			49
Payment of debt issuance costs and other financing activities		—			(42	)
Net cash provided by financing activities		35,587			7
Net increase (decrease) in cash and cash equivalents		25,686			(15,643	)
Cash and cash equivalents, beginning of period		28,165			63,710
Cash and cash equivalents, end of period	$	53,851		$	48,067

Supplemental Disclosure of Cash Flow Information:
Income Taxes Paid	$	—		$	—
Interest Paid		622			294
Acquisition of property, plant and equipment accrued not paid		96			51

The accompanying notes are an integral part of these condensed consolidated financial statements.

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Nuvectra Corporation

CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY — Unaudited

(in thousands)

					Additional					Accumulated Other			Total
	Common Stock				Paid-In		Accumulated			Comprehensive			Stockholders’
	Shares		Amount		Capital		Deficit			Loss			Equity
At December 31, 2017		10,849	$	11	$	125,999	$	(77,836	)	$	(1	)	$	48,173
Issuance of common stock, net of issuance costs of $2,190		3,249		3		23,797		-			-			23,800
Issuance of common stock warrants		-		-		455		-			-			455
Option exercises		11		-		76		-			-			76
Restricted stock issued, net of stock forfeited		38		-		-		-			-			-
Stock-based compensation		-		-		551		-			-			551
Unrealized holding period gain		-		-		-		-			1			1
Net loss		-		-		-		(10,533	)		-			(10,533	)
At March 31, 2018		14,147	$	14	$	150,878	$	(88,369	)	$	-		$	62,523

The accompanying notes are an integral part of these condensed consolidated financial statements.

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NUVECTRA CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - Unaudited

1.	SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Nature of Operations – Nuvectra Corporation, together with its wholly-owned subsidiaries (i) Algostim, LLC (“Algostim”), (ii) PelviStim LLC (“PelviStim”), and (iii) NeuroNexus Technologies, Inc. (“NeuroNexus”) (collectively “Nuvectra” or the “Company”), is a neurostimulation company committed to helping physicians improve the lives of people with chronic conditions. The Algovita® Spinal Cord Stimulation (“SCS”) System (“Algovita”) is the Company’s first commercial offering and is Conformité Européene (“CE”) marked and United States Food & Drug Administration (“FDA”) approved for the treatment of chronic pain of the trunk and/or limbs. Nuvectra’s innovative technology platform also has capabilities under development to support other neurological indications such as sacral neuromodulation (“SNM”) for the treatment of overactive bladder and deep brain stimulation (“DBS”) for the treatment of Parkinson’s disease and Essential Tremor. In addition, the Company’s NeuroNexus subsidiary designs, manufactures and markets neural-interface technologies for the neuroscience clinical research market.

In March 2016, the Company was formed as a separate public company as a result of a spin-off from Integer Holdings Corporation (“Integer”) (the “Spin-off”).

Basis of Presentation – The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information (Accounting Standards Codification (“ASC”) 270, Interim Reporting) and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information necessary for a full presentation of financial position, results of operations, and cash flows in conformity with accounting principles generally accepted in the United States of America. Operating results for interim periods are not necessarily indicative of results that may be expected for the fiscal year as a whole. In the opinion of management, the condensed consolidated financial statements reflect all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation of the results of Nuvectra for the periods presented.

Liquidity and Capital Resources – The Company has incurred significant net losses and negative cash flows from operations since inception and expects to incur additional net losses for the foreseeable future. Cash on hand, inclusive of the proceeds from the Company’s follow-on common stock offering completed in the first quarter of 2018, prior Credit Facility draw-downs (and additional funds available under our Credit Facility in the future, subject to the satisfaction of certain conditions) and cash generated from sales, is an amount that the Company estimates will, based on its current plans and expectations, meet its cash needs for at least the next twelve months. Based on the Company’s sequential quarterly revenue growth since the commercial release of its Algovita system into the United States market, and on its expectations of future and continued revenue growth, the Company believes that it should be able to achieve the Third Tranche Milestone (as further discussed in Note 6, “Debt”), although there can be no assurances that the Company will be able to do so due to unforeseen obstacles that may negatively affect its business. The Company periodically evaluates its liquidity requirements, alternative uses of capital, capital needs and available resources. As a result of this process, the Company has in the past sought, and may in the future seek, to explore strategic alternatives to finance its business plan, including but not limited to, a public offering of its common stock, private equity or debt financings, sale of non-strategic assets, or other sources, such as strategic partnerships. The Company has elected and may continue to elect to make near-term decisions, including engaging in various capital generating initiatives, to provide additional liquidity. If the Company is unable to raise additional funds when needed, it may be required to delay, reduce, or terminate some or all of its development plans. The Company is also focusing on increasing the sales of its products to generate cash flow to fund its operations. However, there can be no assurance that the Company will be successful in its plans described above or in attracting alternative debt or equity financing.

Use of Estimates – The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and reported amounts of sales and expenses during the reporting period. Actual results could differ materially from those estimates. Significant items subject to such estimates and assumptions include inventories, tangible and intangible asset valuations, revenue, stock-based compensation, warrants, and income tax accounts.

Inventories – The value of inventories, comprised solely of finished goods, are stated at the lesser of net realizable value or cost, determined using the first-in, first-out (“FIFO”) method. To value inventory, management must estimate excess or obsolete inventory, as well as inventory that is not of saleable quality. This valuation involves an inherent level of risk and uncertainty due to unpredictability of trends in the industry and customer demand for the Company’s products. In assessing the ultimate realization of inventories, management must make judgments as to future demand requirements and compare that with the current or committed inventory levels. Reserve requirements generally increase as demand decreases due to market conditions and technological and product life-cycle changes.

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NUVECTRA CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - Unaudited

Write-downs of excess and obsolete inventories were $0.1 million and $0.2 million in the first quarter of 2018 and 2017, respectively. Future events and variations in valuation methods or assumptions may cause significant fluctuations in this estimate and could have a material impact on the Company’s results.

Goodwill Valuation – The Company tests its goodwill balances for impairment on December 31, or more frequently if certain indicators are present or changes in circumstances suggest that impairment may exist. When evaluating goodwill for impairment, the Company compares the fair value of a reporting unit with its carrying amount. The Company recognizes an impairment charge for the amount by which the carrying amount of a reporting unit, including goodwill, exceeds its fair value; however, the loss recognized would not exceed the total amount of goodwill allocated to the reporting unit. The Company first assesses qualitative factors to determine whether it is necessary to perform the quantitative goodwill impairment test. If determined to be necessary, the quantitative impairment test is used to identify goodwill impairment and measure the amount for a goodwill impairment to be recognized, if any. In addition, the Company also performs impairment tests of its other long-lived assets in accordance with ASC 360-10, Impairment and Disposal of Long-Lived Assets, when indicators of impairment exist. The Company completed its annual impairment test of goodwill as of December 31, 2017 and the Company determined that it was more likely than not that the fair value of both reporting units exceeded their carrying value. The Company did not identify any indicators of impairment that required an impairment test as of March 31, 2018 for its Nuvectra reporting unit. In the first quarter of 2018, the Company evaluated strategic alternatives with respect to its NeuroNexus reporting unit which triggered an interim impairment test. Upon completing the first step of the goodwill impairment test for NeuroNexus, the Company determined that its fair value exceeded its carrying value.

Impairment of Long-Lived Assets – The Company assesses the impairment of definite-lived long-lived assets or asset groups when events or changes in circumstances indicate that the carrying value may not be recoverable. Factors that are considered in deciding when to perform an impairment review include: a significant decrease in the market price of the asset or asset group; a significant change in the extent or manner in which a long-lived asset or asset group is being used or in its physical condition; a significant change in legal factors or in the business climate that could affect the value of a long-lived asset or asset group, including an action or assessment by a regulator; an accumulation of costs significantly in excess of the amount originally expected for the acquisition or construction; a current-period operating or cash flow loss combined with a history of operating or cash flow losses or a projection or forecast that demonstrates continuing losses associated with the use of a long-lived asset or asset group; or a current expectation that, more likely than not, a long-lived asset or asset group will be sold or otherwise disposed of significantly before the end of its previously estimated useful life. The term more likely than not refers to a level of likelihood that is more than 50 percent.

Potential recoverability is measured by comparing the carrying amount of the asset or asset group to its related total future undiscounted cash flows. The projected cash flows for each asset or asset group considers multiple factors, including current revenue from existing customers, proceeds from the sale of the asset or asset group and expected profit margins giving consideration to historical and expected margins. If the carrying value is not recoverable, the asset or asset group is considered to be impaired. Impairment is measured by comparing the asset or asset group’s carrying amount to its fair value. When it is determined that useful lives of assets are shorter than originally estimated, and no impairment is present, the rate of depreciation is accelerated in order to fully depreciate the assets over their new shorter useful lives. The Company did not identify any indicators of impairment during the first quarter of 2018 for the Nuvectra asset group; however, as noted above, we performed an interim impairment test in the first quarter of 2018 for the NeuroNexus asset group and determined the undiscounted cash flows exceed the carrying amounts of long-lived assets.

Concentration of Credit Risk – Financial instruments that potentially subject the Company to concentration of credit risk consist principally of trade accounts receivable owed to the Company by its customers. The Company performs on-going credit evaluations of its customers. No customers individually accounted for more than 10% of the Company’s consolidated revenues in 2018 or 2017. No customers individually accounted for more than 10% of the Company’s accounts receivable at March 31, 2018 or December 31, 2017. Additionally, the Company maintains cash deposits with major banks, which from time to time may exceed insured limits. The Company performs on-going credit evaluations of its banks. See Note 11 “Business Segments, Geographic and Concentration Risk Information” for additional information.

Warranty Reserve – The Company offers a warranty on certain of its products and has established a warranty reserve, as a component of other current liabilities, for any potential claims. The Company estimates its warranty reserve based upon an analysis of all identified or expected claims and an estimate of the cost to resolve those claims. Factors that affect the Company’s warranty liability include the number of units sold, historical and anticipated rates of warranty claims, and differences between actual and expected warranty costs per claim. The Company periodically assesses the adequacy of its warranty liabilities and adjusts the amounts as necessary.

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NUVECTRA CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - Unaudited

Subsequent Events – The Company considers events or transactions that occur after the balance sheet date but prior to the issuance of the financial statements to provide additional evidence relative to certain estimates or to identify matters that require additional disclosure.

2.	REVENUE FROM CONTRACTS WITH CUSTOMERS

The Company adopted ASC 606, Revenue From Contracts With Customers, on January 1, 2018 using the modified retrospective method for all contracts not completed as of the date of adoption. The adoption of ASC 606 did not have a material impact on the Company’s consolidated financial statements. The reported results for 2018 reflect the application of ASC 606 guidance while the reported results for 2017 were prepared under the guidance of ASC 605, Revenue Recognition (ASC 605), which is also referred to herein as "legacy GAAP" or the "previous guidance." The adoption of ASC 606 represents a change in accounting principle that will more closely align revenue recognition with the delivery of the Company's goods and services and will provide financial statement readers with enhanced disclosures. In accordance with ASC 606, revenue is recognized when a customer obtains control of promised goods or services. The amount of revenue recognized reflects the consideration to which the Company expects to be entitled to receive in exchange for these goods or services, and excludes any sales incentives or taxes collected from a customer which are subsequently remitted to government authorities. To achieve this core principle, the Company applies the following five steps:

1) Identify the contract(s) with a customer - A contract with a customer exists when (i) the Company enters into an enforceable contract with a customer that defines each party’s rights regarding the goods or services to be transferred and identifies the payment terms related to those goods or services, (ii) the contract has commercial substance and, (iii) the Company determines that collection of substantially all consideration for goods or services that are transferred is probable based on the customer’s intent and ability to pay the promised consideration.

2) Identify the performance obligations in the contract - Performance obligations promised in a contract are identified based on the goods or services that will be transferred to the customer that are both capable of being distinct, whereby the customer can benefit from the good or service either on its own or together with other resources that are readily available from third parties or from the Company, and are distinct in the context of the contract, whereby the transfer of the goods or services is separately identifiable from other promises in the contract. To the extent a contract includes multiple promised goods or services, the Company must apply judgment to determine whether promised goods or services are capable of being distinct and distinct in the context of the contract. If these criteria are not met the promised goods or services are accounted for as a combined performance obligation.

3) Determine the transaction price - The transaction price is determined based on the consideration to which the Company will be entitled in exchange for transferring goods or services to the customer. To the extent the transaction price includes variable consideration, the Company estimates the amount of variable consideration that should be included in the transaction price utilizing either the expected value method or the most likely amount method depending on the nature of the variable consideration. Variable consideration is included in the transaction price if, in the Company’s judgment, it is probable that a significant future reversal of cumulative revenue under the contract will not occur. Determining the transaction price requires significant judgment, which is discussed by revenue category in further detail below.

4) Allocate the transaction price to the performance obligations in the contract - If the contract contains a single performance obligation, the entire transaction price is allocated to the single performance obligation. Contracts that contain multiple performance obligations require an allocation of the transaction price to each performance obligation based on a relative standalone selling price (SSP) basis unless the transaction price is variable and meets the criteria to be allocated entirely to a performance obligation or to a distinct good or service that forms part of a single performance obligation. The Company determines standalone selling price based on the price at which the performance obligation is sold separately. If the standalone selling price is not observable through past transactions, the Company estimates the standalone selling price taking into account available information such as market conditions and internally approved pricing guidelines related to the performance obligations.

5) Recognize revenue when (or as) the Company satisfies a performance obligation - The Company satisfies performance obligations either over time or at a point in time as discussed in further detail below. Revenue is recognized at the time the related performance obligation is satisfied by transferring a promised good or service to a customer.

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NUVECTRA CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - Unaudited

Disaggregated Revenue - Revenue Streams & Timing of Revenue Recognition

The Company’s most significant revenue streams include (i) product sales, consisting of Nuvectra’s Algovita and NeuroNexus’s neural interface systems and (ii) development and engineering service revenue. Below describes the nature of the Company’s disaggregated revenue streams. Also see Note 11, “Business Segments, Geographic and Concentration Risk Information” for further disaggregation of revenue by reportable segment.

Product Sales

Our product sales revenues include sales of Algovita and neural interface systems and components to the neuroscience and clinical markets. Contracts may include one or more systems or components, each is determined to be a distinct performance obligation. Product revenue was $10.1 million for the first quarter of 2018.

Algovita - Generally, Algovita product sales are made through the Company’s trained personnel when the Company has the obligation to perform the initial programming and stimulation which occurs on the same day as the implementation. For these customers, the products and the programming and stimulation services are not separately distinct and are a combined performance obligation for which revenue is recognized upon completion of the procedure. In cases where the customer has a Clinician Programmer and has undergone the requisite training in order to perform the programming and stimulation services, the Company recognizes revenue upon shipment when control passes to the customer. Similarly, when the Company sells through distributors or ships product directly to the end user and has no additional obligations, revenue is recognized at the time of shipment when control passes to the customer. For the remaining sales that are sent from the Company’s distribution center directly to hospitals and medical facilities, where product is ordered in advance of an implantation procedure and a valid purchase order has been received, the Company defers revenue until all programming and stimulation obligations are fulfilled.

Neural interface systems and components – Each component is a separate distinct performance obligation. The customer obtains control of the individual components upon shipment, and therefore revenue is recognized at such point in time.

Shipping and handling costs – Costs associated with outbound freight after control over a product has transferred to a customer are accounted for as a fulfillment cost and are included in cost of revenues.

Warranty - The Company provides a standard warranty against defects but does not provide a general right of return.

Development and Engineering Service Revenue

The Company’s development services are typically provided on a fixed-fee basis. Service revenue is recognized over time as the services are performed using an input method, on a cost-to-cost basis. In 2017 and 2018, the Company had one contract with development and engineering services revenue with Aleva Neurotherapeutics S.A. (“Aleva”). Under this contract, the Company is leveraging its neurostimulation technology platform in its performance of services in the development a deep brain stimulation (“DBS”) system for Aleva to treat Parkinson’s disease and Essential Tremor. If successful, the Company will provide Aleva a royalty bearing distribution license for commercialization by Aleva. The Company concluded that the licenses and the development services were not separately distinct given the proprietary nature of the Company’s technology. As such, the combined performance obligation will be recognized over time as costs are incurred. The transaction price includes a fixed fee, payable monthly based on the progress completion in satisfying the performance obligations in that month, royalties on future sales of the licensed technology, and non-cash consideration for the customer commitment to issue the Company a common stock warrant upon CE Mark approval in Europe. When consideration in the form of royalties for intellectual property licenses, the Company estimates the royalty revenue and recognizes in the period that the royalty-bearing event, a sale by the customer, occurs, however, the non-cash consideration is a form of variable consideration which must be estimated at contract inception which requires significant judgment. See the “Significant Judgments” section below for further discussion. Services revenue recognized over time was $0.5 million for the first quarter of 2018. The Company is still performing services and the client has yet to receive CE Mark approval and therefore, the Company has not yet billed or recognized any royalty revenue to date.

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NUVECTRA CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - Unaudited

Significant judgments - The Company’s contracts with customers often include promises to transfer multiple products to a customer. Determining whether the promises are considered distinct performance obligations that should be accounted for separately versus together may require significant judgment, specifically for development and engineering service revenues. Once the performance obligations are identified, the Company determines the transaction price, which includes estimating the amount of variable consideration to be included in the transaction price, if any. The Company then allocates the transaction price to each performance obligation in the contract based on a relative stand-alone selling price method. The corresponding revenues are recognized as the related performance obligations are satisfied as discussed above. Judgment is required to determine the standalone selling price for each distinct performance obligation. The Company determines standalone selling prices based on the price at which the performance obligation is sold separately. If the standalone selling price is not observable through past transactions, the Company estimates the standalone selling price taking into account available information such as market conditions and internally approved pricing guidelines related to the performance obligations.

The Company’s service revenue is recognized over time using an input method based on costs incurred. As such, estimating the total costs to be incurred and progress to completion on the contract requires significant judgment. Management uses historical experience, project plans and an assessment of the risks and uncertainties inherent in the arrangements to establish these estimates. Various uncertainties may or may not be within the Company’s control.

Transaction Price Allocated to Future Performance Obligations

ASC 606 requires disclosure of the aggregate amount of transaction price that is allocated to performance obligations that have not yet been satisfied or are partially satisfied as of the balance sheet date. The Company has elected to apply certain optional exemptions that limit this requirement to exclude contracts which are expected to be satisfied within one year as well as the potential royalty license revenue. After considering these exemptions, the Company’s service revenue contract is subject to this disclosure for the portion of the transaction price not subject to royalties. As of March 31, 2018, the estimated revenue expected to be recognized in the future related to this contract totals $1.9 million and is expected to be recognized over the following 12 to 18 months.

Contract Balances

Timing of revenue recognition may differ from the timing of invoicing to customers. The Company records a receivable when revenue is recognized prior to invoicing when it has an enforceable right to payment and a contract asset when the Company does not. If invoicing occurs prior to revenue recognition, the unearned revenue is presented on the condensed consolidated balance sheet as a contract liability, referred to as deferred revenue. When invoicing occurs after revenue recognition, earned revenue is presented on the condensed consolidated balance sheet as a contract asset, referred to as unbilled receivables. The Company’s standard payment terms are 30 days.

Revenue recognized during the first quarter in 2018 from amounts included in deferred revenue at the beginning of the period was $0.1 million, which was related to product sales revenue. There was no revenue recognized during the first quarter in 2018 from performance obligations satisfied or partially satisfied in previous periods. During the three months ended March 31, 2018, there were no contract assets reclassified to receivables as a result of the right to the transaction consideration becoming unconditional.

Costs to Obtain and Fulfill a Contract

The Company has elected to apply the practical expedient and recognize the incremental costs of obtaining contracts as an expense when incurred if the amortization period of the assets that the Company otherwise would have recognized is one year or less, and therefore, the Company recognizes an asset for the incremental costs of obtaining a contract with a customer if the expected period of benefit of those costs is longer than one year. As of January 1, 2018 and March 31, 2018, all contract acquisition costs have been expensed as incurred as the period of benefit is less than one year.

- 11 -

NUVECTRA CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - Unaudited

Certain NeuroNexus contracts may include pre-production activities, design work for custom products. The Company’s policy is to capitalize incremental costs incurred to fulfill its contracts that (i) relate directly to the contract (ii) are expected to generate resources that will be used to satisfy the Company’s performance obligation under the contract and (iii) are expected to be recovered through revenue generated under the contract. These costs have historically been immaterial. Accordingly, there are no capitalized fulfillment costs as of January 1, 2018 or March 31, 2018.

3.	INTANGIBLE ASSETS

Intangible assets are comprised of the following (in thousands):

Gross

Carrying

Amount

Accumulated

Amortization

Net

Carrying

Amount

At March 31, 2018

Technology and patents

1,058

(659

)

399

Customer lists

1,869

(915

)

954

Total intangible assets

2,927

(1,574

)

1,353

At December 31, 2017

Technology and patents

1,058

(624

)

434

Customer lists

1,869

(875

)

994

Total intangible assets

2,927

(1,499

)

1,428

Aggregate intangible asset amortization expense is classified as follows (in thousands):

	Three Months Ended
	March 31, 2018		March 31, 2017
Cost of sales	$	35	$	32
Selling, general and administrative expenses		40		40
Total intangible asset amortization expense	$	75	$	72

Estimated future intangible asset amortization expense based on the current carrying value is as follows (in thousands):

	Estimated Amortization Expense
Remainder of 2018	$	223
2019		293
2020		209
2021		194
2022		108
Thereafter		326
Total estimated amortization expense	$	1,353

- 12 -

NUVECTRA CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - Unaudited

4.	Accrued Liabilities

Accrued liabilities consisted of the following (in thousands):

	At
	March 31, 2018		December 31, 2017
Inventory purchases	$	3,209	$	5,825
Regulatory, clinical and quality		468		358
Deferred revenue		383		335
Sales and marketing		346		321
Interest		298		199
Research and development		238		164
Operations engagement fee		200		200
Warranty reserve		200		195
Legal		180		358
Sales and use tax		121		145
Information technology system and infrastructure implementations		62		114
Insurance		-		127
Accrued other		733		486
Total accrued liabilities	$	6,438	$	8,827

5.	EMPLOYEE BENEFIT PLANS

Nuvectra Corporation 2016 Equity Incentive Plan – The Nuvectra Corporation 2016 Equity Incentive Plan (the “2016 Equity Plan”) provides that the Compensation and Organization Committee of the Board of Directors (the “Compensation Committee”) may award eligible participants, as it may determine from time to time, the following types of awards: stock options, stock appreciation rights, restricted stock, restricted stock units and stock bonuses. Subject to adjustment provisions in the 2016 Equity Plan, the total number of shares of Nuvectra common stock reserved for issuance under the 2016 Equity Plan is 1,963,614.

During the three months ended March 31, 2018, the Compensation Committee granted equity awards aggregating 26,716 shares of common stock under the 2016 Equity Plan in the form of both restricted stock units and non-qualified stock options to its directors and certain officers and key employees. Compensation cost related to the 2016 Equity Plan for the first quarter of 2018 was approximately $0.6 million.

During the three months ended March 31, 2017, the Compensation Committee granted equity awards aggregating 112,300 shares of common stock under the 2016 Equity Plan in the form of both restricted stock units and non-qualified stock options to its directors and certain officers and key employees. Compensation cost related to the 2016 Equity Plan for the three months ended March 31, 2017 was approximately $0.4 million.

Stock-Based Compensation – Certain of the Company’s employees participated in the stock-based compensation programs of Integer and prior to the Spin-off received awards of time-based stock options and time- and performance-based restricted stock units, which typically vest over a three-year period and are settled in shares of Integer common stock. The stock-based payment compensation expense includes the compensation expense directly attributable to Nuvectra employees from these Integer equity incentives. In addition, certain incentive awards that were originally granted under an Integer equity incentive award plan adjusted into an incentive award of Nuvectra common stock at the time of the Spin-off. Compensation cost related to these Integer equity incentives was approximately $0.1 million for the first quarter of 2017. There was no compensation cost related to these equity incentives in the first quarter of 2018.

- 13 -

NUVECTRA CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - Unaudited

The components and classification of stock-based compensation expense were as follows (in thousands):

	Three Months Ended
	March 31, 2018		March 31, 2017
Stock options	$	206	$	171
Restricted stock and restricted stock units		345		306
Total stock-based compensation expense	$	551	$	477

	Three Months Ended
	March 31, 2018		March 31, 2017
Selling, general and administrative expense	$	473	$	442
Research, development and engineering costs, net		78		35
Total stock-based compensation expense	$	551	$	477

The fair value of each stock option grant is estimated on the date of grant using the Black-Scholes option-pricing model with weighted-average assumptions based on the grant date. The weighted average fair value and assumptions used to value options granted under the 2016 Equity Plan were as follows:

	Three Months Ended
	March 31, 2018			March 31, 2017
Weighted average fair value	$	5.92		$	3.38
Risk-free interest rate		2.60	%		2.17	%
Expected volatility		66	%		55	%
Holding period (in years)		6			6
Expected dividend yield		—	%		—	%

The following table summarizes the stock option activity during the first quarter of fiscal year 2018:

Number of

Time-Vested

Stock

Options

Weighted

Average

Exercise

Price

Weighted

Average

Remaining

Contractual

Life (Years)

Aggregate

Intrinsic

Value

(in thousands)

Outstanding at December 31, 2017

870,820

6.78

Granted

23,444

9.66

Exercised

(11,404

)

6.69

Forfeited or expired

(21,873

)

9.43

Outstanding at March 31, 2018

860,987

6.79

7.41

5,366

Exercisable at March 31, 2018

433,054

6.56

6.10

2,800

The Company received proceeds totaling $76 thousand upon the exercise of 11,404 stock options during the first quarter of 2018.

The following table summarizes the restricted stock and restricted stock unit activity during the first quarter of 2018:

	Time-Vested Activity			Weighted Average Fair Value
Non-vested at December 31, 2017		429,005		$	6.88
Granted		3,272			12.99
Vested		(38,299	)		8.25
Forfeited		(40,655	)		7.45
Non-vested at March 31, 2018		353,323		$	6.87

- 14 -

NUVECTRA CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - Unaudited

Nuvectra Bonus Plan – The terms of the Nuvectra Corporation Bonus Plan (the “Bonus Plan”) provide for both annual discretionary cash contribution-based bonuses and cash performance-based bonuses based upon Nuvectra’s company-wide performance measures and, for certain employees, individual performance measures that are set by Nuvectra’s executive management and, in some instances, members of the Board of Directors. Compensation cost related to the Bonus Plan for the first quarter of 2018 and 2017 were approximately $0.4 million and $0.7 million, respectively.

Defined Contribution Plans – The Company sponsors a defined contribution Section 401(k) plan for its employees. The plan provides for the deferral of employee compensation under Section 401(k) of the Internal Revenue Code of 1986, as amended (“Section 401(k)”), and a discretionary match. In the first quarter of 2018 this match was 25% per dollar of participant deferral, up to 6% of the total compensation for each participant. Direct costs related to this defined contribution plan were $0.1 million in the first quarter of 2018 and 2017.

6. DEBT

Long-term debt is comprised of the following (in thousands):

	At
	March 31, 2018			December 31, 2017
Term loan	$	43,100		$	29,631
Deferred financing fees		(893	)		(962	)
Discount on debt		(3,798	)		(1,994	)
Total debt		38,409			26,675
Less current portion of long-term debt		-			789
Total long-term debt	$	38,409		$	25,886

Credit Facility – The Company has a credit facility, originally entered into and funded in March 2016 and subsequently amended in February 2017 and February 2018 (the “Credit Facility”), that consists of term loan facilities in an aggregate maximum principal amount of $45 million comprised of (i) a $27.5 million Term Loan A Commitment, which replaces the previously existing $27.5 million term loan, (ii) a $12.5 million Term Loan B Commitment, which was funded in February 2018, and (iii) a $5 million Term Loan C Commitment, which is available commencing on the date of achieving consolidated trailing six-month product revenues of at least $25 million (the “Third Tranche Milestone”) and ending on the earlier of March 31, 2019 or sixty days following the Third Tranche Milestone (collectively, the “Term Loans”). Based on the Company’s sequential quarterly revenue growth since the commercial release of its Algovita system into the United States market, and on its expectations of future and continued revenue growth, the Company believes that it should be able to achieve the Third Tranche Milestone, although there can be no assurances that the Company will be able to do so due to unforeseen obstacles that may negatively affect its business. As discussed further below, the Term Loan A was treated as a modification of the existing debt.

The Term Loans bear interest at a floating rate equal to the prime rate plus 4.15%, with a floor of 8.65%. At March 31, 2018 the interest rate on borrowings under the Term Loan was 8.65%. The Company pays monthly accrued interest only on the Term Loans through March 2020 and thereafter the Company will pay monthly accrued interest on the Term Loans plus equal payments of principal for 30 months. At the maturity of the Term Loans, on September 1, 2022, all principal on the Term Loans then outstanding, plus an additional 7.75% of the funded loan amounts (the “Final Payment”), will be due and payable. This Final Payment has been treated as an in substance discount and is being amortized using the straight-line method over the life of the loan.

As a condition to the lenders’ funding the loans under the Credit Facility, concurrently with the initial funding of the initial Term Loan A Commitment on March 18, 2016 in the amount of $15 million, the Company issued to each of the lenders, Oxford Finance LLC and SVB Financial Group (successor by assignment to Silicon Valley Bank), a warrant to purchase 56,533 shares of Nuvectra common stock (a total of 113,066 shares) at an exercise price of $5.97 per share, which warrants are exercisable until March 18, 2026. Additionally, the Company incurred $1.5 million in fees and other direct costs of the debt transaction in connection with the initial funding. The fair value of the warrants on the date of grant totaled approximately $0.2 million and was recorded as a discount on long-term debt along with the cash issuance costs and as additional paid-in capital in the consolidated balance sheet, as the warrants met the criteria under the relevant accounting standard for treatment as an equity instrument. The related debt discount was being amortized over the term of the Term Loan A Commitment.

As a condition to the lenders’ funding the loans under the Credit Facility, concurrently with the funding under the initial Term Loan B Commitment on September 28, 2017 in the amount of $12.5 million, the Company issued to each of the two lenders a warrant to purchase 22,844 shares of Nuvectra common stock (a total of 45,688 shares) at an exercise price of $12.31 per share, which warrants are exercisable until September 28, 2027. In connection with the amendment dated February 14, 2017, the Company paid fees of $0.04 million. The fair value of the warrants on the date of grant totaled approximately $0.4 million and was recorded as additional paid-in capital in the consolidated balance sheet, as the warrants met the criteria under the relevant accounting standard for treatment as an equity instrument. The related debt discount was being amortized over the term of the Term Loan B Commitment.

- 15 -

NUVECTRA CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - Unaudited

As a condition to the lenders’ funding the new Term Loan A and Term Loan B under the February 2018 amendment to the Credit Facility, the Company issued to the each of the two lenders a warrant to purchase 30,245 shares of Nuvectra common stock (a total of 60,490 shares) at an exercise price of $9.30 per share, which warrants are exercisable until February 18, 2028. The fair value of the warrants on the date of grant totaled approximately $0.5 million and was recorded as additional paid-in capital in the consolidated balance sheet in the first quarter of 2018, as the warrants met the criteria under the relevant accounting standard for treatment as an equity instrument. The related debt discount is being amortized over the term of the Term Loan B Commitment.

Upon the funding of the Term Loan C Commitment, Oxford Finance LLC and SVB Financial Group will each be entitled to additional warrants for the purchase of Nuvectra common stock. The number of shares under each warrant will be equal to the amount of the term loan made by each lender multiplied by 4.50% and divided by the then current trading price of Nuvectra common shares. The exercise price of the warrants will be equal to the trading price of Nuvectra common shares on the date of funding. The fair value of these future warrants as of March 31, 2018 was approximately $0.1 million and was recorded in other long-term liabilities in the consolidated balance sheet. The warrants were classified as a derivative liability because the Company did not meet the criteria under the relevant accounting standard for treatment as equity instruments. As a result, the derivative liability warrants will be re-measured to its fair value at the end of each reporting period until it meets the requirements for equity treatment or is cancelled. See Note 10 “Fair Value Measurements” for additional information.

In connection with the February 2018 amendment to the Credit Facility, Term Loan A and Term Loan B Commitments were funded for aggregate gross proceeds of $40 million, of which $27.5 million was applied to repay the outstanding principal balance of the existing term loans. The Company determined that it met the criteria to be accounted for as a modification in which any unamortized debt discount is amortized over the remaining term of the exchanged or modified debt. The Company also paid a fee of approximately $0.8 million in connection with the second amendment which was recorded as a discount on long-term debt to be amortized over the term of the Term Loan B. The Term Loan C Commitment is subject to a non-use fee of 5% of the amount of such commitment if the commitment becomes available, but the Company declines to borrow the Term Loan thereunder. If any Term Loans are prepaid prior to their scheduled maturity, the Company must pay, in addition to the Final Payment, a prepayment fee equal to $1.3 million plus 3% of the prepaid principal if paid prior to February 2019, 2% of the prepaid principal if paid prior to February 2020, and 1% of the prepaid principal if paid thereafter.

The Loans are secured by a first priority lien on substantially all of the assets of the Company, including, without limitation, all cash, deposit accounts, accounts receivable, equipment, inventory, contract rights, and the Company’s real property located in Blaine, Minnesota, but excluding all intellectual property of the Company (other than accounts receivable and proceeds of intellectual property). The Company’s intellectual property is subject to a negative pledge. The Company must maintain its primary operating and investment accounts with SVB Financial Group, which accounts are subject to customary control agreements.

The Credit Facility contains customary representations and warranties, reporting and other covenants for credit facilities of this kind including prohibitions on the payment of cash dividends on the Company’s capital stock and restrictions on mergers, sales of assets, investments, incurrence of liens, incurrence of indebtedness and transactions with affiliates. The Company is subject to a quarterly financial covenant requiring the Company to achieve specified minimum consolidated product revenues. As of March 31, 2018, the Company was in compliance with the financial covenant. The events of default in the Credit Facility are customary for credit facilities of this kind, and include failure to pay interest or principal, breaches of affirmative and negative covenants, a material adverse change occurring, and cross defaults to other material agreements of the Company.

- 16 -

NUVECTRA CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - Unaudited

Deferred Financing Fees – The change in deferred financing fees is as follows (in thousands):

At December 31, 2017	$	962
Additions during the period		-
Amortization during the period		(69	)

At March 31, 2018	$	893

In accordance with Financial Accounting Standards Board (“FASB”) Accounting Standards Update (“ASU”) 2015-03, “Interest-Imputation of Interest (Subtopic 835-30): Simplifying the Presentation of Debt Issuance Costs,” the Company has presented debt issuance costs as a direct deduction from Long-Term Debt in the condensed consolidated balance sheet.

7. INCOME TAXES

The income tax provision for interim periods is determined using an estimate of the annual effective tax rate, adjusted for discrete items, if any, that are taken into account in the relevant period. Each quarter, the estimate of the annual effective tax rate is updated, and if the estimated effective tax rate changes, a cumulative adjustment is made. There is a potential for volatility of the effective tax rate due to several factors, including changes in the mix of the pre-tax income and the jurisdictions to which it relates, changes in tax laws, business reorganizations and settlements with taxing authorities.

The Company records a valuation allowance when it is “more likely than not” that all or a portion of a deferred tax asset will not be realized. Management reviews all available positive and negative evidence, including the Company’s current and past performance, the market environment in which the Company operates, the utilization of past tax credits, length of carry back and carry forward periods, existing contracts or sales backlog that will result in future profits, as well as other factors. The Company maintains a full valuation allowance on all of the net deferred tax assets for the periods presented. Until an appropriate level of profitability is sustained, the Company expects to continue to record a full valuation allowance on future tax benefits.

Pursuant to the terms of the tax matters agreement entered into with Integer at the time of the Spin-off, until March 14, 2018, the Company was prohibited from (i) causing or permitting to occur any transaction or series of transactions, subject to certain exceptions provided under the U.S. federal income tax rules, in connection with which one or more persons would (directly or indirectly) acquire an interest in its capital stock that, when combined with any other acquisition of an interest in its capital stock that occurs after the Spin-off, comprises 30% or more of the value or the total combined voting power of all interests that are treated as outstanding equity of Nuvectra for U.S. federal income tax purposes immediately after such transaction or, in the case of a series of related transactions, immediately after any transaction in such series; (ii) transferring, selling or otherwise disposing of 35% or more of its gross assets if such transfer, sale or other disposition would violate the rules and regulations of the Internal Revenue Service; (iii) liquidating its business or (iv) ceasing to maintain its active business.

8.	COMMITMENTS AND CONTINGENCIES

Litigation – Periodically the Company is a party to various legal actions, both threatened and filed, arising in the normal course of business. While the Company does not expect that the ultimate resolution of any ordinary course pending actions will have a material effect on its results of operations, financial position, or cash flows, litigation is subject to inherent uncertainties. As such, there can be no assurance that any pending or threatened ordinary course legal action, which the Company currently believes to be immaterial, does not become material in the future.

On September 19, 2017, Boston Scientific Corporation filed a lawsuit in district court in Suffolk County, Massachusetts, against the Company and three former Boston Scientific employees recently hired by the Company, alleging tortious interference of contract on the part of the Company and breaches of contract related to non-solicitation and confidentiality by Boston Scientific’s former employees. No demands for any monetary relief or specific performance have been made by Boston Scientific at this time. The Company intends to vigorously defend against the allegations.

Purchase Commitments – Contractual obligations for purchase of goods or services are defined as agreements that are enforceable and legally binding on the Company and that specify all significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum, or variable price provisions; and the approximate timing of the transaction. The Company’s purchase orders are normally based on its current manufacturing or other operational needs. Inventory to be purchased by Nuvectra in 2018 under its supply agreements is subject to certain minimum order quantity requirements. As of March 31, 2018, the Company had no material commitments to purchase capital assets; however, planned capital expenditures for 2018 are estimated at approximately $1.8 million and will primarily be financed by existing cash and cash equivalents, cash generated from sales, or the Credit Facility. The Company also enters into contracts for outsourced services; however, the contracts generally contain provisions allowing for cancellation without significant penalty.

- 17 -

NUVECTRA CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - Unaudited

Operating Leases – The Company is party to various operating lease agreements for office and laboratory facilities. In the first quarter of 2018, the Company amended one of its office leases previously scheduled to expire to extend the expiration date until March 2023.

Minimum future estimated annual operating lease payments as of March 31, 2018 were expected to be (in thousands):

2018 (remaining 9 months)	$	531
2019		720
2020		732
2021		745
2022		619
Thereafter		85
Total estimated operating lease payments	$	3,432

9.	EARNINGS (LOSS) PER SHARE (“EPS”)

Basic net loss per share is calculated by dividing net loss by the weighted average number of common shares outstanding during the period. Diluted net loss per share is equal to basic net loss per share as the Company had no potentially dilutive securities outstanding for any of the periods presented.

The following table illustrates the calculation of Basic and Diluted EPS (in thousands, except per share amounts):

	Three Months Ended
	March 31, 2018			March 31, 2017
Basic net loss per share:
Net loss	$	(10,533	)	$	(13,122	)
Weighted average common shares outstanding		12,509			10,335
Basic net loss per share	$	(0.84	)	$	(1.27	)
Diluted net loss per share:
Net loss	$	(10,533	)	$	(13,122	)
Weighted average common shares outstanding		12,509			10,335
Dilutive stock options, restricted stock and restricted stock units		-			-

Weighted average common shares outstanding – assuming dilution		12,509			10,335
Diluted net loss per share	$	(0.84	)	$	(1.27	)
Outstanding securities and warrants that were not included in the diluted calculation because their effect would be anti-dilutive
		1,377			1,581

10.	FAIR VALUE MEASUREMENTS

The carrying amounts of cash, accounts receivable, accounts payable, and accrued expenses approximate fair value because of the short-term nature of these items. As of March 31, 2018, the fair value of the Company’s variable rate long-term debt approximates its carrying value and is categorized in Level 2 of the fair value hierarchy.

- 18 -

NUVECTRA CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - Unaudited

Assets and Liabilities Measured at Fair Value on a Recurring Basis

Fair value measurement standards apply to certain financial assets and liabilities that are measured at fair value on a recurring basis (each reporting period).

The Company has categorized its warrants measured at fair value on a recurring basis in Level 3 of the fair value hierarchy. The fair value of the warrants classified as liability awards was determined by utilizing a Monte Carlo simulation model, which projects the value of Nuvectra stock versus its peer group under numerous scenarios, and determines the value of the award based upon the present value of these projected outcomes. The estimated fair value of the warrants is presented as a long-term asset and a liability in the condensed consolidated balance sheet. The estimated fair value of the warrant liability will be revalued on a periodic basis and any resulting increases or decreases in the estimated fair value will be recorded as an adjustment to earnings. The table below presents a summary of changes in the fair value of the Company’s Level 3 liability warrants during the first quarter of 2018 (in thousands):

Balance at December 31, 2017	$	400
Loss on fair value of warrant liability		55
Reclassification of warrant liability to equity upon issuance of warrants		(455	)
Fair value of warrant liability issued in 2018		109
Gain on fair value of warrant liability		(15	)

At March 31, 2018	$	94

As discussed in Note 6, “Debt,” in connection with the issuance of warrants upon the amendment to the Credit Facility in February 2018, the fair value of a warrant liability was reclassified to equity. Additionally, the Company recognized a warrant liability related to the Term Loan C Commitment of $0.1 million.

The Company’s investments in marketable securities primarily consist of investments in debt securities, which are classified as Cash and Cash Equivalents on the consolidated balance sheet because of their original maturities of three months or less. Unrealized gains or losses for the periods presented are included in other comprehensive loss.

The fair values of marketable securities were estimated using the market approach using prices and other relevant information generated by market transactions involving identical or comparable assets. The Company uses quoted market prices in active markets or quoted market prices in markets that are not active to measure fair value. When developing fair value estimates, the Company maximizes the use of observable inputs and minimizes the use of unobservable inputs. As of March 31, 2018, the fair market value of marketable securities was approximately $43.4 million, all of which had original maturities of three months or less.

Marketable securities, measured at fair value, by level within the fair value hierarchy were as follows (in thousands):

March 31, 2018

Fair Value Hierarchy

Cost

Unrealized Gain

Fair Value

Cash

Level 1

18,136

Government

Level 1

3,995

Financial

Level 2

10,337

Industrial

Level 2

10,888

Total

43,356

December 31, 2017

Fair Value Hierarchy

Cost

Unrealized Loss

Fair Value

Cash

Level 1

7,336

Government

Level 1

1,499

Financial

Level 2

3,799

)

3,798

Industrial

Level 2

8,649

Total

21,283

)

21,282

- 19 -

NUVECTRA CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - Unaudited

Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis

Fair value standards also apply to certain assets and liabilities that are measured at fair value on a nonrecurring basis. A summary of the valuation methodologies for assets and liabilities measured on a nonrecurring basis is as follows:

Long-lived Assets – The Company reviews the carrying amount of its long-lived assets to be held and used, other than goodwill, for potential impairment whenever certain indicators are present as described in Note 1 “Summary of Significant Accounting Policies.” During the first quarter of 2018 and 2017, no impairment charges were recorded related to the Company’s long-lived assets.

Goodwill – Goodwill recorded is not amortized but is periodically tested for impairment. The Company assesses goodwill for impairment on December 31, or more frequently if certain events occur as described in Note 1 “Summary of Significant Accounting Policies.” During the first quarter of 2018 and 2017, no impairment charges were recorded related to the Company’s goodwill.

Warrants – In order to determine the fair value of the warrants classified as equity awards, the Company used a Monte Carlo simulation model. The risk-free interest rate represents the 10-Year U.S. Treasury rate as of the issuance date. The expected volatility assumption is based on historical volatilities for publicly traded stock of comparable companies. The following table summarizes the assumptions as of March 31, 2018 used for estimating the fair value of the warrants classified as liability awards:

Risk-free interest rate	2.87	%
Expected volatility	65	%
Contractual term (in years)	10
Dividend yield	-	%

11.	BUSINESS SEGMENT, GEOGRAPHIC AND CONCENTRATION RISK INFORMATION

The Company has two reportable segments and two reporting units, consisting of Nuvectra and NeuroNexus.

Nuvectra is a neurostimulation company committed to helping physicians improve the lives of people with chronic conditions. Algovita is the Company’s first commercial offering and is approved for the treatment of chronic pain of the trunk and/or limbs. Nuvectra’s innovative technology platform also has capabilities under development to support other neurological indications such as SNM for the treatment of overactive bladder and DBS for the treatment of Parkinson’s disease and Essential Tremor. Revenue includes development and engineering service fees and sales from the release of Algovita in the United States and Europe. Future revenues of Nuvectra are expected to come primarily from sales of Algovita, particularly after expansion of its launch commercially in the United States, and Virtis, the second application of the Company’s neurostimulation technology platform and its first product for the SNM market.

NeuroNexus designs, manufactures and markets neural-interface technologies for the neuroscience clinical research market. Revenues includes sales of neural interface technology, components and systems to the neuroscience and clinical markets.

An analysis and reconciliation of the Company’s product lines, business segments and geographic information to the respective information in the consolidated financial statements follows. Sales by geographic area are presented by allocating sales from external customers based on where the products are shipped or services are rendered (in thousands):

	Three Months Ended
	March 31, 2018		March 31, 2017
Product line sales:
Algovita	$	9,081	$	3,387
Neural interface components and systems		1,037		1,201
Development and engineering service		456		452

Total sales	$	10,574	$	5,040

- 20 -

NUVECTRA CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - Unaudited

	Three Months Ended
	March 31, 2018		March 31, 2017
Business segment sales:
Nuvectra	$	9,537	$	3,839
NeuroNexus		1,037		1,201

Total sales	$	10,574	$	5,040

	Three Months Ended
	March 31, 2018			March 31, 2017
Segment (loss) income from operations:
Nuvectra	$	(9,655	)	$	(12,605	)
NeuroNexus		8			56
Total segment loss from operations		(9,647	)		(12,549	)
Unallocated operating expenses		—			—
Operating loss		(9,647	)		(12,549	)
Unallocated other expense, net		(873	)		(573	)
Loss before provision for income taxes	$	(10,520	)	$	(13,122	)

All of the Company’s long-lived tangible assets are located in the United States.

12.	related party transactions

On March 14, 2016, Integer completed the Spin-off, at which time the Company became a separate public company. The Company entered into, or amended, various agreements with Integer to effect the Spin-off and to provide a framework for the Company’s relationship with Integer going forward after the Spin-off including a supply agreement, license agreements, a separation and distribution agreement, a tax matters agreement, a transition services agreement and an employee matters agreement, which provided for the allocation between Nuvectra and Integer of assets, employees, liabilities and obligations (including PP&E, employee benefits, and tax-related assets and liabilities) attributable to the Company’s business for the period prior to, at, and after the Spin-off.

Employee Benefit Plans – Certain of the Company’s employees historically participated in various Integer stock-based compensation plans. Compensation expense allocated to Nuvectra for these plans from Integer was based upon the costs directly attributable to Nuvectra employees. See Note 5 “Employee Benefit Plans” for additional information.

Supply Agreement – The Company has a supply agreement with Integer pursuant to which Integer manufactures Algovita and certain of its components. Total charges incurred under this supply agreement are included in cost of sales.

13. RECENTLY ISSUED ACCOUNTING STANDARDS

In the normal course of business, management evaluates all new accounting pronouncements issued by the FASB to determine the potential impact they may have on the Company’s condensed consolidated financial statements. Based upon this review, except as noted below, management does not expect any of the recently issued accounting pronouncements, which have not already been adopted, to have a material impact on the Company’s condensed consolidated financial statements.

Recently Adopted in 2018

In May 2017, the FASB issued ASU 2017-09, Compensation-Stock Compensation (Topic 718): Scope of Modification Accounting. ASU 2017-09 clarifies when changes to the terms or conditions of a share-based payment award must be accounted for as modifications. Under ASU 2017-09, an entity will not apply modification accounting to a share-based payment award if the award’s fair value, vesting conditions and classification as an equity or liability instrument are the same immediately before and after the change. ASU 2017-09 will be applied prospectively to awards modified on or after the adoption date. The adoption of ASU 2017-09 did not have a material impact on the Company’s condensed consolidated financial statements.

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NUVECTRA CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - Unaudited

In January 2017, the FASB issued ASU 2017-01, Business Combinations (Topic 805): Clarifying the Definition of a Business. ASU 2017-01 provides a screen to determine when an integrated set of assets and activities (collectively referred to as a “set”) does not constitute a business. The screen requires that when substantially all of the fair value of the gross assets acquired (or disposed of) is concentrated in a single identifiable asset or a group of similar identifiable assets, the set is not a business. This screen reduces the number of transactions that need to be further evaluated. If the screen is not met, the amendments in ASU 2017-01 (i) require that to be considered a business, a set must include, at a minimum, an input and a substantive process that together significantly contribute to the ability to create output and (ii) remove the evaluation of whether a market participant could replace missing elements. The adoption of ASU 2017-01 did not have a material impact on the Company’s condensed consolidated financial statements.

In August 2016, the FASB issued ASU 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments. This update provides clarification regarding how certain cash receipts and cash payments are presented and classified in the statement of cash flows. ASU 2016-15 addresses eight specific cash flow issues with the objective of reducing the existing diversity in practice. The adoption of ASU 2016-15 did not have a material impact on the Company’s condensed consolidated financial statements.

In January 2016, the FASB issued ASU 2016-01, Recognition and Measurement of Financial Assets and Financial Liabilities, which updates certain aspects of recognition, measurement, presentation and disclosure of financial instruments. The adoption of ASU 2016-01 did not have a material impact on the Company’s condensed consolidated financial statements.

In May 2014, the FASB issued ASC Update No. 2014-09, Revenue from Contracts with Customers (Topic 606), which has been subsequently updated. ASU 2014-09 provides enhancements to the quality and consistency of how revenue is reported while also improving comparability in the financial statements of companies using U.S. GAAP and International Financial Reporting Standards. ASC 606 outlines a single comprehensive model for companies to use in accounting for revenue arising from contracts with customers and supersedes most current revenue recognition guidance, including industry-specific guidance. The core principle requires entities to recognize revenue in a manner that depicts the transfer of goods or services to customers in amounts that reflect the consideration an entity expects to be entitled to in exchange for those goods or services. The new standard also includes criteria for the capitalization and amortization of certain contract acquisition and fulfillment costs. The Company adopted ASU 2014-09 and its related amendments effective January 1, 2018 under the modified retrospective method and will only apply this method to contracts that are not completed as of the date of adoption. The modified retrospective method results in a cumulative effect of initially applying the standard as an adjustment to the opening balance of retained earnings at the date of initial application for the impact to changes in the timing and amount of revenue recognition as well as the timing of capitalization and amortization of certain contract costs. With the exception of the increased disclosure requirements, the adoption of ASU 2014-09 did not have a material impact on the Company’s Consolidated Financial Statements as of the date of adoption, January 1, 2018 and as of and for the quarter ended March 31, 2018. Please see Note 2, “Revenue from Contracts with Customers,” for the Company's updated policies related to revenue recognition and accounting for costs to obtain and fulfill a customer contract.

Not Yet Adopted

In February 2016, the FASB issued ASU 2016-02, Leases, in order to increase transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet for those leases classified as operating leases under previous GAAP. ASU 2016-02 requires that a lessee should recognize a liability to make lease payments (the lease liability) and a right-of-use asset representing its right to use the underlying asset for the lease term on the balance sheet. ASU 2016-02 is effective for fiscal years beginning after December 15, 2018 (including interim periods within those periods), using a modified retrospective approach, and early adoption is permitted. The Company is currently in the process of evaluating the impact of adoption of the ASU on its condensed consolidated financial statements.

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Forward-Looking Statements

This report contains “forward-looking statements” within the meaning of the safe harbor provisions of the U.S. Private Securities Litigation Reform Act of 1995. Our actual results could differ materially from those discussed in the forward-looking statements. Forward-looking statements can be identified by the use of words such as, but not limited to: “anticipate,” “intend,” “plan,” “goal,” “seek,” “believe,” “project,” “target,” “estimate,” “expect,” “strategy,” “future,” “likely,” “may,” “can,” “continue,” “could,” “should,” “would,” “will,” and similar expressions or references to future periods. These statements are based on the beliefs and assumptions of our management based on information currently available to management. Such forward-looking statements are subject to risks, uncertainties and other important factors that could cause actual results and the timing of certain events to differ materially from future results expressed or implied by such forward-looking statements. Important factors that could cause our actual results to differ materially from those indicated in the forward-looking statements include: (i) our ability to successfully commercialize Algovita and to develop, complete and commercialize enhancements or improvements to Algovita; (ii) our ability to successfully compete with our current SCS competitors and the ability of our U.S. sales representatives to successfully establish market share and acceptance of Algovita; (iii) the uncertainty of obtaining regulatory approvals in the United States and Europe for our Virtis SNM system; (iv) our ability to successfully launch and commercialize the Virtis SNM system if it receives regulatory approval; (v) our ability to demonstrate the features, perceived benefits and capabilities of Algovita to physicians and patients in competition with similar products already well-established and sold in the SCS market; (vi) our ability to anticipate and satisfy customer needs and preferences and to develop, introduce and commercialize new products or advancements and improvements to Algovita in order to successfully meet our customers’ expectations; (vii) the outcome of our development plans for our neurostimulation technology platform, including our ability to identify additional indications or conditions for which we may develop neurostimulation medical devices or therapies and seek regulatory approval thereof; (viii) our ability to identify business development and growth opportunities and to successfully execute on our strategy, including our ability to seek and develop strategic partnerships with third parties to, among other things, fund clinical and development costs for new product offerings; (ix) the performance by our development partners, including Aleva Neurotherapeutics, S.A., of their obligations under their agreements with us; (x) the scope of protection for our intellectual property rights covering Algovita and other products using our neurostimulation technology platform, along with any product enhancements or improvements; (xi) our ability to successfully build, attract and maintain an effective commercial infrastructure and qualified sales force in the United States; (xii) our compliance with all regulatory and legal requirements regarding implantable medical devices and interactions with healthcare professionals; (xiii) any product recalls, or the receipt of any warning letters, mandatory corrections or fines from any governmental or regulatory agency; (xiv) our ability to satisfy the conditions and covenants, including trailing six month revenue milestones, of our Credit Facility; and (xv) our ability to raise capital through means other than or in addition to the Credit Facility should it become necessary to do so, through another public offering of our common stock, private equity or debt financings, strategic partnerships, or other sources. Factors that could cause or contribute to such differences include, but are not limited to, those included in the section entitled “Risk Factors” in Nuvectra’s Annual Report on Form 10-K for the fiscal year ended December 31, 2017. Furthermore, such forward-looking statements speak only as of the date of this report. We undertake no obligation to publicly update any forward-looking statement, whether written or oral, that may be made from time to time, whether as a result of new information, future developments, or otherwise.

Our Business

Nuvectra is a neurostimulation medical device company focused on the development and commercialization of our neurostimulation technology platform for the treatment of various disorders through stimulation of tissues associated with the nervous system. Our neurostimulation technology platform has the capability to provide treatment to patients in several established neurostimulation markets, including SCS, SNM, DBS, and other emerging neurostimulation markets.

Our Algovita™ SCS system, or Algovita, is the first application of our neurostimulation technology platform and is indicated for the treatment of chronic pain of the trunk and limbs. Algovita received premarket approval from the FDA in November 2015, and we commercially launched Algovita in the United States during the first half of 2016. Outside of the United States, Algovita obtained CE Mark approval in June 2014 and is indicated for the treatment of chronic intractable pain of the trunk or limbs. Algovita is reimbursable under existing SCS codes in the United States, the European Union (“EU”) and Australia, and has been commercially available to patients in Germany and several other European countries since November 2014.

We have also developed our existing platform for use in the SNM market and have filed regulatory submissions with the FDA and CE Mark authorities in January 2017 and December 2016, respectively, for Virtis, the Company’s SNM system for the treatment of chronic urinary retention and the symptoms of overactive bladder. In addition, in early 2016, we entered into a development agreement with Aleva. This agreement provided that we would leverage our neurostimulation technology platform to develop a DBS system for Aleva to treat Parkinson’s disease. This platform is still under development. During the third quarter of 2017, Aleva received additional financing, and we entered into an Amended and Restated Development Agreement.

Our results also include the operations of our subsidiary NeuroNexus. NeuroNexus works closely with researchers to develop and refine new tools that aid and advance neuroscience research. NeuroNexus designs, manufactures and sells neural interface systems including high quality, high density microelectrode arrays, custom designed probes, electrode instrumentation and accessories. In addition, the NeuroNexus team possesses years of neuroscience research experience to help facilitate successful research projects and provide insight to minimize known challenges.

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Our revenues include sales of Algovita, neural interface technology, components and systems to the neuroscience and clinical markets, and development and engineering service fees. We expect that our future revenues will come primarily from sales of neurostimulation medical device products, including Algovita, particularly as we continue our launch commercially in the United States, and from Virtis, the second application of our neurostimulation technology platform and our first product for the SNM market. From time to time, our future revenues may also include technology licensing fees, development and engineering service fees, and royalty fees.

Our Customers

Algovita was designed to provide pain management solutions to patients who have evolving requirements and needs. We are still developing our customer base for Algovita, which includes distributors in Europe and hospitals, surgery centers and medical facilities in the U.S. served through a direct sales force and third-party distributors; therefore, the nature and extent of our selling relationships with each customer is different in terms of breadth of products purchased, purchased product volumes, length of contractual commitment, ordering patterns, inventory management, and selling prices. Our NeuroNexus customers include institutions, scientists or universities throughout the world who perform research for the neuroscience and clinical markets. Additionally, our customers include a company in the DBS market serviced through a strategic development agreement.

Strategic and Financial Overview

We are a neurostimulation medical device company formed in 2008 to design and develop a neurostimulation technology platform that could be utilized in multiple indications. Since our inception, the majority of our resources have been spent designing and developing Algovita. SCS was chosen as the first sector of the neurostimulation market to pursue, as we believe that it is a high growth and established market, there is an established regulatory and reimbursement pathway, and we believe that there are significant unmet needs in the SCS market. We currently have four significant competitors in the United States who may be better capitalized and who offer similar SCS devices that are already established and accepted in the market. While the competitive landscape for SCS remains challenging and we may face barriers to market acceptance of our product, we believe Algovita has certain differentiating features from other existing SCS systems that offer our patients and customers a broad set of capabilities and treatment options.

We have been leveraging our neurostimulation technology platform for other sectors of the neurostimulation market such as SNM and DBS, and are exploring other emerging indications. We submitted a premarket approval application for Virtis to TÜV SÜD America and the FDA in December 2016 and January 2017, respectively.

In early 2016, we entered into a development agreement with Aleva which was amended and restated on August 31, 2017. This agreement provided that we would leverage our neurostimulation technology platform to develop a DBS system for Aleva to treat Parkinson’s disease. Under its shareholders’ agreement with Aleva, certain privileges that Integer assigned to Nuvectra at the time of the Spin-off terminated because Integer did not fund a second tranche equity investment in Aleva as obligated under certain circumstances, including the right to receive a technology access success fee and an additional payment if Aleva were sold, sold its assets or were otherwise liquidated. However, Aleva has recently obtained additional financing from another source. If we complete development of a DBS system to treat Parkinson’s disease for Aleva, we expect that Aleva will continue to commercialize the DBS system. If it does so and is successful, we would receive royalties on the sale of these DBS systems and components.

We also intend to pursue other strategic partnerships to fund clinical and development costs of new products, expand our product distribution channels, supplement our product commercialization efforts, obtain assistance in designing and performing clinical studies and post market studies, add specialized clinical or regulatory expertise, or acquire or obtain access to complementary intellectual property.

We have a history of significant net losses, and we expect to continue to incur net losses for the foreseeable future. We expect that future revenue growth will come largely from sales of Algovita in the United States market.

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Our Financial Results

The discussion that follows should be read in conjunction with our condensed consolidated financial statements and related notes and with the Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in our Annual Report on Form 10-K for the fiscal year ended December 31, 2017. The following table presents certain selected financial information derived from our condensed consolidated financial statements for the periods presented (dollars in thousands, except per share data):

	Three Months Ended						Change
	March 31, 2018			March 31, 2017			$			%
Sales:
Algovita	$	9,081		$	3,387		$	5,694			168	%
Neural interface components and systems		1,037			1,201			(164	)		(14	%)
Development and engineering services		456			452			4			1	%
Total sales		10,574			5,040			5,534			110	%
Cost of sales		4,808			2,411			2,397			99	%

Gross profit		5,766			2,629			3,137			119	%
Gross profit as a % of sales		54.5	%		52.2	%
Selling, general and administrative expenses (SG&A)		12,133			10,805			1,328			12	%
SG&A as a % of total operating expenses		78.7	%		71.2	%
Research, development and engineering costs, net (RD&E)		3,280			4,373			(1,093	)		(25	%)
RD&E as a % of total operating expenses		21.3	%		28.8	%

Operating loss		(9,647	)		(12,549	)		2,902			23	%
Interest expense, net		850			370			480			130	%
Other expense, net		23			203			(180	)		(89	)%
Provision for income taxes		13			—			13			100	%
Effective tax rate		0.0	%		0.0	%
Net loss	$	(10,533	)	$	(13,122	)	$	2,589			20	%
Diluted earnings per share	$	(0.84	)	$	(1.27	)	$	0.43			34	%

Sales

Algovita. The primary factor behind the 168% increase in sales from the first quarter of 2017 to the first quarter of 2018 was due to continued growth in volume of sales from the Company’s commercial launch of Algovita in the United States during 2016. We expect to continue to develop our worldwide sales organization for Algovita, consisting of direct sales representatives and independent sales agents in the United States and a network of distributors and independent sales agents outside of the United States, to support future growth.

We expect our revenue to fluctuate from quarter to quarter due to a variety of factors, including seasonality, as we have historically experienced lower sales in the first quarter and third quarter of the year, which we believe is due to weather-related events, holidays, the buying patterns and implant volumes of our distributors, hospitals and clinics and reimbursement related issues such as patient deductibles. We anticipate that our total revenue will increase as we continue our commercialization in the United States.

Neural Interface Components and Systems. Neural interface components and systems are related to our NeuroNexus segment and consist of sales of neural interface technology, components, and systems to the neuroscience and clinical markets. The primary factor behind the 14% decrease in sales from the first quarter of 2017 to the first quarter of 2018 was due to decreased volume of component sales. Price fluctuations did not have a significant impact on sales for the periods presented.

Development and Engineering Service. We recognized $0.5 million of development and engineering services revenue during the first quarter of both 2018 and 2017 from our development agreement with Aleva. See the section entitled “Strategic and Financial Overview” above for more information related to our development agreement with Aleva.

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Cost of Sales

Cost of sales consists of the costs of components and materials, labor costs, amortization of technology intangibles, and plant and equipment depreciation and overhead. The primary driver behind the 99% increase in cost of sales from the first quarter of 2017 to the first quarter of 2018 was the increase in sales of our Algovita systems. We expect that our cost of sales will continue to increase as our sales of our Algovita products continue to grow.

From the first quarter of 2017 to the first quarter of 2018 our gross profit increased $3.1 million, or 119%, and our gross profit as a percentage of sales, or gross margin, increased from 52.2% to 54.5%. These increases were primarily due to an increase in the volume of Algovita sales in the United States.

Our gross margin has been and will continue to be affected by a variety of factors, including by our revenue mix as margins vary across each of our product lines, the costs to have our product manufactured for us, inventory-related charges and write-downs, the ratio of trial to permanent implants, and the average selling prices of our products. We expect our gross margin to be positively affected over time to the extent we are successful in reducing manufacturing costs and our revenue mix continues to shift towards Algovita and Virtis. However, our gross margin may continue to fluctuate from period to period.

Selling, General and Administrative Expenses

Selling, general and administrative (“SG&A”) expenses consist primarily of personnel costs, including salary and employee benefits for our sales and marketing personnel and for personnel that support our general operations, such as information technology, executive management, financial accounting, and human resources personnel. SG&A expenses increased $1.3 million, or 12%, from the first quarter of 2017 to the first quarter of 2018. This increase was primarily the result of an increase in personnel-related expenses as we have continued to build our Algovita worldwide sales organization and increased marketing expenses as the Company prepares for the commercial launch of Virtis.

Our SG&A expenses may fluctuate from period to period due to the seasonality of our revenue and the timing and extent of our SG&A expense. Going forward, we expect SG&A expenses to continue to increase as we build our Virtis worldwide sales organization consisting of direct sales representatives and independent sales agents in the United States and a network of distributors and independent sales agents outside of the United States. We expect that this will require recruiting appropriate and qualified direct sales representatives and independent sales agents, expanding our commercial infrastructure in the United States and training our direct sales representatives and independent sales agents. Thereafter, we expect that our sales representatives and independent sales agents will require lead time in the field to access and grow their network of accounts and produce sales results. We believe that successfully recruiting, training and retaining a sufficient number of productive sales representatives and independent sales agents is important in achieving our future growth objective.

Research, Development and Engineering Costs, Net

Research, development and engineering (“RD&E”) costs primarily include salary and employee benefits for our specialists in software engineering, mechanical engineering, electrical engineering, and graphical user interface design. Many of these specialists have considerable experience in neurostimulation-related products. Additionally, RD&E costs include design verification testing expenses, which include salary and employee benefits for our engineers who test the design and materials used in our medical devices. RD&E costs also include salary, benefits and other personnel-related expenses for our regulatory, quality and clinical affairs employees.

RD&E costs decreased $1.1 million, or 25%, from the first quarter of 2017 to the first quarter of 2018. The decrease was primarily the result of timing of research projects and a decrease in the use of consultants.

As we must continually strive to anticipate and meet our customers’ and patients’ evolving needs and preferences, we expect to continue to invest in product development, product enhancements and improvements and future clinical studies to further develop and update our existing technologies and to expand the features offered in Algovita. We also intend to continue to pursue strategic partnerships to fund clinical and development costs, in part or in full, of new products, expand our product distribution channels, improve our access to physicians and opinion leaders, supplement our product commercialization efforts, obtain assistance in performing clinical studies, add specialized clinical or regulatory expertise, or acquire or obtain access to complementary intellectual property.

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Interest Expense, Net

Interest expense, net for the first quarter of 2018 and the first quarter of 2017 was $0.9 million and $0.4 million, respectively. Interest expense, including amortization of deferred financing fees and discounts on debt, related to our Credit Facility was $1.0 million and $0.5 million for the first quarter of 2018 and the first quarter of 2017, respectively. The increase was primarily a result of an increase in our outstanding borrowings under our Credit Facility in the first quarter of 2018 as compared to the first quarter of 2017. Interest income from investments was $0.1 million for both the first quarter of fiscal year 2018 and the first quarter of 2017, respectively. For additional information, see Note 6 “Debt” of the notes to our Condensed Consolidated Financial Statements.

Other Expense, Net

Other expense, net for the first quarter of 2018 and 2017 related primarily to the revaluation of our warrant liability due to the change in the estimated fair value.

Provision for Income Taxes

During the first quarters of 2018 and 2017, we recorded a valuation allowance for the amount of the deferred tax asset that was generated from our net losses and federal research and development tax credit earned and Section 754 election to the extent they exceeded any deferred tax liability, as it was more likely than not that the deferred tax asset generated from those activities will not be realized. See Note 7 “Income Taxes” of the notes to our Condensed Consolidated Financial Statements for disclosures related to our income taxes.

Liquidity and Capital Resources

Background

We have incurred significant net losses and negative cash flows from operations since our inception and we expect to continue to incur additional net losses for the foreseeable future.

Immediately prior to the completion of the Spin-off, Integer made a cash capital contribution of $75.0 million to us, which we have been using for the continued development and commercialization of Algovita, development of Virtis, and general corporate purposes. This cash capital contribution, together with our cash on hand, inclusive of the proceeds from the Company’s follow-on common stock offering completed in the first quarter of 2018, prior Credit Facility draw-downs (and additional funds available under our Credit Facility in the future, subject to the satisfaction of certain conditions), as well as cash generated from sales, is in an amount that we estimate will, based on our current plans and expectations, meet our cash needs for at least the next twelve months. Based on our sequential quarterly revenue growth since the commercial release of our Algovita system into the United States market, and on our expectations of future and continued revenue growth, we believe that the Company should be able to achieve these trailing six month revenue milestones during the relevant periods, although there can be no assurances that we will be able to do so due to unforeseen obstacles that may negatively affect our business. We periodically evaluate our liquidity requirements, alternative uses of capital, capital needs and available resources. As a result of this process, we have in the past sought, and may in the future seek, to explore strategic alternatives to finance our business plan, including but not limited to, a public offering of our common stock, private equity or debt financings, sale of non-strategic assets, or other sources, such as strategic partnerships. We have elected and may continue to elect to make near-term decisions, including engaging in various capital generating initiatives, to provide additional liquidity. Furthermore, as of March 14, 2018, we are no longer be prohibited under the terms of the tax matters agreement with Integer from raising additional funds. However, if we are unable to raise additional funds when needed, we may be required to delay, reduce, or terminate some or all of our development plans. We are also focusing on increasing the sales of our products to generate cash flow to fund our operations. However, there can be no assurance that we will be successful in our plans described above or in attracting alternative debt or equity financing.

Currently, we expect our research and development expenditures for 2018 to be between approximately $15 million and $20 million. These expenditures are primarily to continue our research and development program to enhance and improve Algovita and Virtis and to continue to develop our neurostimulation technology platform for uses in indications outside of SCS and SNM. Costs are primarily related to development engineering, regulatory, quality and clinical affairs. We expect to finance these expenditures using cash on-hand, net proceeds from our follow-on common stock offering completed in February 2018, and from internally generated funds. We may increase, decrease or re-allocate these anticipated expenditures during any period based on industry conditions, the availability of capital, or other factors. We believe that nearly all of our anticipated research and development expenditures are discretionary.

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Consolidated Cash Flows

Net cash used in operating activities was $9.8 million compared to a net loss of $10.5 million for the first quarter of 2018. Net cash used in operating activities was $15.1 million compared to a net loss of $13.1 million for the first quarter of 2017. The primary components driving the decrease in cash used in operating activities from the first quarter in 2017 to the first quarter in 2018 was the $2.6 million decrease in our net loss (adjusted to exclude non-cash charges) and changes in working capital accounts, specifically, the significant payments in the first quarter of 2017 ($3.2 million) related to large accounts payable and other current liabilities balance at the end of 2016 for inventory purchases from Integer in accordance with certain minimum order quantity requirements under our supply agreement. Additionally, there was an increase in accounts receivable of $1.3 million in the first quarter of 2017 as compared to a decrease in accounts receivable in $1.8 million in the first quarter of 2018.

Net cash used in investing activities was $0.1 million for the first quarter of 2018 compared to $5.3 million for the first quarter of 2017. Cash used in investing activities related to the purchases of property, plant and equipment. As of March 31, 2018, we had no material commitments to purchase capital assets; however, planned capital expenditures for the remainder of 2018 are estimated at approximately $1.8 million.

Net cash provided by financing activities was $35.6 million for first quarter of 2018 compared to less than $0.01 million for the first quarter of 2017. Cash provided by financing activities in the first quarter of 2018 was composed of $23.8 million from the sale of common stock and net borrowings under our amended Credit Facility of $12.5 million. Cash provided by financing activities in the first quarter 2017 was immaterial.

Credit Facility

As of February 2018, the Credit Facility consists of (a) term loan facilities in an aggregate maximum principal amount of $45 million comprised of (i) a $27.5 million Term Loan A Commitment, which was funded in full in February 2018, (ii) a $12.5 million Term Loan B Commitment, which also was funded in full at the closing of the amendment in February 2018 to repay the previously existing term loan, and (iii) a $5 million Term Loan C Commitment, which is available commencing on the date of achieving consolidated trailing six month product revenues of at least $25 million (the “Third Tranche Milestone”) and ending on the earlier of March 31, 2019 or sixty days following the Third Tranche Milestone.

Based on our sequential quarterly revenue growth since the commercial release of our Algovita system into the United States market, and on our expectations of future and continued revenue growth, we believe that the Company should be able to achieve the Third Tranche Milestone, although there can be no assurances that we will be able to do so due to unforeseen obstacles that may negatively affect our business. The term loan bears interest at the Wall Street Journal prime rate plus 4.15%, subject to an interest rate floor of 8.65%. At March 31, 2018 the interest rate on borrowings under the term loan was 8.65%. The Credit Facility provides for interest-only payments on outstanding term loan borrowings for 24 months after the first borrowing in February 2018 followed by 30 months of principal payments in equal amounts on outstanding term loan borrowings plus accrued interest payments.

On March 18, 2016, in connection with arranging the Credit Facility, we paid Piper Jaffray an arrangement fee of $1,125,000, which equaled 2.50% of the aggregate principal amount of the then-existing Credit Facility. On March 18, 2016, under the terms of the Credit Facility, we paid a commitment fee in an amount equal to 0.50% of the aggregate principal amount of the then-existing $40 million term loan and $5 million revolving line of credit. We also paid a fee of $25,000 plus the expenses of the lenders when we amended the Credit Facility in February 2017 and a second amendment fee of approximately $0.8 million when we amended the Credit Facility in February 2018.

In addition, we will pay a final payment fee in an amount equal to 7.75% of the funded amount of the term loan, which final payment fee is due at the time of the final principal payment for the Credit Facility or upon early termination of the Credit Facility. If we satisfy the conditions and covenants to allow for drawing on the Term Loan C Commitment, but do not draw upon such commitment prior to the availability expiration date, we will pay a non-use fee of 5.00% of the unfunded amount of such commitment.

If available and we draw on the Term Loan C Commitment, we will issue warrants to the lenders to purchase a number of shares of our common stock with a notional value equal to 4.5% of the funded amount of such commitment, with all warrants issued at such time having an exercise price equal to the lower of the average closing price of our common stock for the ten previous days of trading or the closing price of our common stock on the day prior to such commitment funding. Each warrant is expected to be exercisable for ten years from the date of issuance.

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The Credit Facility includes affirmative and negative covenants, including an affirmative covenant regarding minimum revenue requirements, prohibitions on the payment of cash dividends on our capital stock, and restrictions on mergers, sales of assets, investments, incurrence of liens, incurrence of indebtedness and transactions with affiliates. The Credit Facility includes a prepayment fee for the prepayment of the outstanding term loan balance prior to the maturity date in an amount equal to $1.3 million plus 3.00% of the prepaid term loan balance for a prepayment made prior to February 2019, 2.00% of the prepaid term loan balance for a prepayment made prior to February 2020 and 1.00% of the prepaid term loan balance for a prepayment made thereafter. Our obligations under the Credit Facility are secured by substantially all of our assets, except for our intellectual property, which is subject to a negative pledge covenant.

For additional information regarding the Credit Facility, see Note 6, “Debt” of the notes to our condensed consolidated financial statements.

Contractual Obligations and Commitments

The following table summarizes our contractual obligations at March 31, 2018, and the effect such obligations are expected to have on our liquidity and cash flow in future periods:

	Payments Due by Period
	Total		Less Than 1 Year		1 – 3 Years		3 – 5 Years		More than 5 Years
(in thousands)
Term loans	$	54,667	$	3,508	$	22,387	$	28,772	$
Operating lease commitments ⁽¹⁾		3,432		710		1,458		1,264		-
Purchasing commitments ⁽²⁾		30,389		20,389		10,000		-		-
Total	$	88,488	$	24,607	$	33,845	$	30,036	$	-

⁽¹⁾

We lease office and laboratory facilities located in Texas, Colorado and Michigan. The lease, as amended, for our Plano, Texas headquarters, which is with Integer, expires in March 2023. The leases, as amended, for our Broomfield, Colorado and Ann Arbor, Michigan facilities expire in September 2022 and June 2022, respectively.

⁽²⁾

Purchasing commitments represent contractual non-cancelable obligations to purchase goods and services to be used in our operations.

Off-Balance Sheet Arrangements

We have no off-balance sheet arrangements within the meaning of Item 303(a)(4) of Regulation S-K.

Recently Issued Accounting Standards

In the normal course of business, we evaluate all new accounting pronouncements issued by the FASB to determine the potential impact they may have on our Condensed Consolidated Financial Statements. See Note 13 “Recently Issued Accounting Standards” of the notes to the Condensed Consolidated Financial Statements contained in Item 1 of this report for additional information about these recently issued accounting standards and their potential impact on our financial condition or results of operations.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Interest Rate Risk – There have been no material changes from the Company’s interest rate risk as previously disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017.

ITEM 4. CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures

Our management, with the participation of our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)). Disclosure controls and procedures are designed to ensure that material information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and to ensure that such material information is accumulated and communicated to our management, including our CEO and CFO, as appropriate to allow timely decisions regarding required disclosure. Based on this evaluation, our CEO and CFO concluded that as of the end of the period covered by this quarterly report, our disclosure controls and procedures were effective.

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Changes in Internal Control Over Financial Reporting

We maintain a system of internal controls that are designed to provide reasonable assurance that our books and records accurately reflect, in all material respects, the transactions of the Company and that we meet and achieve our control objectives. From time to time, we may experience changes to our internal controls due to, for example, employee turnover, re-balancing of workloads, extended absences, and promotions of employees.

Beginning January 1, 2018, we implemented ASC 606, Revenue from Contracts with Customers. Although the new revenue standard did not have a material impact on our net loss, we did implement changes to our processes related to revenue recognition and the control activities within them. These included the development of new policies based on the five-step model provided in the new revenue standard, new training, ongoing contract review requirements, and gathering of information provided for disclosures.

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PART II—OTHER INFORMATION

ITEM 1.

LEGAL PROCEEDINGS

Periodically we are a party to various legal actions, both threatened and filed, arising in the normal course of business. While we do not expect that the ultimate resolution of any ordinary course pending actions will have a material effect on our results of operations, financial position, or cash flows, litigation is subject to inherent uncertainties. As such, there can be no assurance that any pending or threatened ordinary course legal action, which we currently believe to be immaterial, does not become material in the future.

On September 19, 2017, Boston Scientific Corporation filed a lawsuit in district court in Suffolk County, Massachusetts, against the Company and three former Boston Scientific employees recently hired by the Company, alleging tortious interference of contract on the part of the Company and breaches of contract related to non-solicitation and confidentiality by Boston Scientific’s former employees. No demands for any monetary relief or specific performance have been made by Boston Scientific at this time. The Company intends to vigorously defend against the allegations.

ITEM 1A.

RISK FACTORS

There have been no material changes from the Company’s risk factors as previously disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017.

ITEM 2.

UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

None.

ITEM 3.

DEFAULTS UPON SENIOR SECURITIES

None.

ITEM 4.

MINE SAFETY DISCLOSURES

Not applicable.

ITEM 5.

OTHER INFORMATION

None.

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ITEM 6.

EXHIBITS

Exhibit No.	Description
3.1		Certificate of Incorporation (filed as Exhibit 3.1 to our Current Report on Form 8-K on March 18, 2016, and incorporated herein by reference)

3.2		Bylaws of Nuvectra Corporation (filed as Exhibit 3.2 to our Current Report on Form 8-K on March 18, 2016, and incorporated herein by reference)

4.1		Warrant to Purchase Common Stock, dated March 18, 2016, issued to Oxford Finance LLC (filed as Exhibit 4.1 to our current report on Form 8-K on March 18, 2016, and incorporated herein by reference)

4.2		Warrant to Purchase Common Stock, dated March 18, 2016, issued to Silicon Valley Bank (filed as Exhibit 4.2 to our current report on Form 8-K on March 18, 2016, and incorporated herein by reference)

4.2.2		First Amendment to Warrant to Purchase Common Stock, dated March 23, 2018, issued to SVB Financial Group (successor by assignment from Silicon Valley Bank)*

4.3		Warrant to Purchase Common Stock, dated September 28, 2017, issued to Oxford Finance LLC (filed as Exhibit 4.1 to our current report on Form 8-K on October 3, 2017, and incorporated herein by reference)

4.4		Warrant to Purchase Common Stock, dated February 16, 2018, issued to Oxford Finance LLC (filed as Exhibit 4.1 to our current report on Form 8-K on February 21, 2018, and incorporated herein by reference)

10.1		Sublease Modification & Extension Agreement, dated February 1, 2018, between Nuvectra Corporation and Greatbatch Ltd (filed as Exhibit 10.1 to our current report on Form 8-K on February 6, 2018, and incorporated herein by reference)

10.2		Second Amendment to Loan and Security Agreement, dated February 16, 2018, among Nuvectra Corporation, Algostim LLC, Pelvistim LLC, NeuroNexus Technologies, Inc. and Oxford Finance LLC and Silicon Valley Bank (filed as Exhibit 10.1 to our current report on Form 8-K on February 21, 2018, and incorporated herein by reference)

10.3		Amendment No. 2 to the Transition Services Agreement, dated March 13, 2018, between Nuvectra Corporation and Integer Holdings Corporation (filed as Exhibit 10.1 to our current report on Form 8-K on March 19, 2018, and incorporated herein by reference)

31.1		Certification of Chief Executive Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended*

31.2		Certification of Chief Financial Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended *

32.1		Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002**

100.INS		XBRL Instance Document*

100.SCH		XBRL Extension Schema Document*

100.CAL		XBRL Extension Calculation Linkbase Document*

100.LAB		XBRL Extension Label Linkbase Document*

100.PRE		XBRL Extension Presentation Linkbase Document*

100.DEF		XBRL Extension Definition Linkbase Document*

* Filed herewith.

** Furnished herewith.

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

	NUVECTRA CORPORATION

Date: May 2, 2018	/s/ Scott F. Drees
	Scott F. Drees
	Chief Executive Officer
	(Principal Executive Officer)

Date: May 2, 2018	/s/ Walter Z. Berger
	Walter Z. Berger
	Chief Operating Officer and Chief Financial Officer
	(Principal Financial and Accounting Officer)

- 33 -

EXHIBIT INDEX

Exhibit No.	Description

3.1	Certificate of Incorporation (filed as Exhibit 3.1 to our Current Report on Form 8-K on March 18, 2016, and incorporated herein by reference)

3.2	Bylaws of Nuvectra Corporation (filed as Exhibit 3.2 to our Current Report on Form 8-K on March 18, 2016, and incorporated herein by reference)

4.1	Warrant to Purchase Common Stock, dated March 18, 2016, issued to Oxford Finance LLC (filed as Exhibit 4.1 to our current report on Form 8-K on March 18, 2016, and incorporated herein by reference)

4.2	Warrant to Purchase Common Stock, dated March 18, 2016, issued to Silicon Valley Bank (filed as Exhibit 4.2 to our current report on Form 8-K on March 18, 2016, and incorporated herein by reference)

4.2.2	First Amendment to Warrant to Purchase Common Stock, dated March 23, 2018, issued to SVB Financial Group (successor by assignment from Silicon Valley Bank)*

4.3	Warrant to Purchase Common Stock, dated September 28, 2017, issued to Oxford Finance LLC (filed as Exhibit 4.1 to our current report on Form 8-K on October 3, 2017, and incorporated herein by reference)

4.4	Warrant to Purchase Common Stock, dated February 16, 2018, issued to Oxford Finance LLC (filed as Exhibit 4.1 to our current report on Form 8-K on February 21, 2018, and incorporated herein by reference)

10.1	Sublease Modification & Extension Agreement, dated February 1, 2018, between Nuvectra Corporation and Greatbatch Ltd (filed as Exhibit 10.1 to our current report on Form 8-K on February 6, 2018, and incorporated herein by reference)

10.2	Second Amendment to Loan and Security Agreement, dated February 16, 2018, among Nuvectra Corporation, Algostim LLC, Pelvistim LLC, NeuroNexus Technologies, Inc. and Oxford Finance LLC and Silicon Valley Bank (filed as Exhibit 10.1 to our current report on Form 8-K on February 21, 2018, and incorporated herein by reference)

10.3	Amendment No. 2 to the Transition Services Agreement, dated March 13, 2018, between Nuvectra Corporation and Integer Holdings Corporation (filed as Exhibit 10.1 to our current report on Form 8-K on March 19, 2018, and incorporated herein by reference)

31.1	Certification of Chief Executive Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended *

31.2	Certification of Chief Financial Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended *

32.1	Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002**

100.INS	XBRL Instance Document*

100.SCH	XBRL Extension Schema Document*

100.CAL	XBRL Extension Calculation Linkbase Document*

100.LAB	XBRL Extension Label Linkbase Document*

100.PRE	XBRL Extension Presentation Linkbase Document*

100.DEF	XBRL Extension Definition Linkbase Document*

* Filed herewith.

** Furnished herewith.

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Nuvectra Corp - FORM 10-Q - May 2, 2018

Attached files

Nuvectra Corp Reports