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

The matters addressed in this Item 2 that are not historical information constitute “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, including statements about any of the following: any projections of earnings, revenue, sales, profit margins, cash, effective tax rate, use of net operating losses, or any other financial items; the plans, strategies and objectives of management for future operations or prospects for achieving such plans, and any statements of assumptions underlying any of the foregoing. Any statements contained herein that are not statements of historical fact may be deemed to be forward-looking statements. Without limiting the foregoing, the words “believes,” “anticipates,” “plans,” “expects,” “seeks,” “estimates,” and similar expressions are intended to identify forward-looking statements. While the Company may elect to update forward-looking statements in the future, it specifically disclaims any obligation to do so, even if the Company’s estimates change and readers should not rely on those forward-looking statements as representing the Company’s views as of any date subsequent to the date of the filing of this Quarterly Report. Although we believe that the expectations reflected in these forward-looking statements are reasonable, such statements are inherently subject to risks and STAAR can give no assurances that its expectations will prove to be correct. Actual results could differ materially from those described in this report because of numerous factors, many of which are beyond the control of STAAR. A number of important factors could cause the results of the company to differ materially from those indicated by such forward-looking statements, including those detailed under the heading “Risk Factors” in Part I, Item 1A of the Company’s Form 10-K for the fiscal year ended January 2, 2015.

The following discussion should be read in conjunction with STAAR’s interim condensed consolidated financial statements and the related notes provided under “ Item 1- Financial Statements ” above.

Overview

STAAR Surgical Company (“we,” “us,” the “Company,” and “STAAR”) designs, develops, manufactures and sells implantable lenses and delivery systems for the eye. We are the world’s leading manufacturer of intraocular lenses used in “refractive” surgery, and we also make lenses for use in surgery to treat cataracts. All of the lenses we make are foldable, which allows the surgeon to insert them into the eye through a small incision during minimally invasive surgery. Refractive surgery is performed to treat the type of visual disorders that have traditionally been corrected using eyeglasses or contact lenses. We refer to our lenses used in refractive surgery as “implantable Collamer® lenses” or “ICLs” and market them under the Visian® brand name. The field of refractive surgery includes both lens-based procedures, using products like the Visian ICL®, and laser-based procedures like LASIK. Successful refractive surgery can correct common vision disorders such as myopia, hyperopia and astigmatism. Cataract surgery is a common outpatient procedure where the eye’s natural lens that has become cloudy with age is removed and replaced with an artificial lens called an intraocular lens (IOL) to restore the patient’s vision.

STAAR®, Visian®, Collamer®, STAARVISC®, Elastimide®, nanoFLEX®, nanoPOINT, CentraFLOW® AquaPORT®, Epiphany® and AquaFlow are trademarks or registered trademarks of STAAR in the U.S. and other countries.

Collamer® is the brand name for STAAR’s proprietary collagen copolymer lens material.

Products

A detailed description of STAAR’s business appears in our Annual Report on Form 10-K for the fiscal year ended January 2, 2015, along with a glossary explaining many of the specialized terms used in describing our products and our business. We recommend that readers unfamiliar with STAAR refer to that description.

ICLs - Implantable Collamer Lenses for Refractive Surgery. Sales of refractive lenses made up sixty-nine (69%) percent of our total sales in the third quarter of 2015. Made from our proprietary biocompatible Collamer material, highlights of STAAR’s family of Visian ICL products are as follows:

IOLs - Intraocular Lenses for Cataract Surgery. Our sales of IOLs made up 23% our total sales in the third quarter of 2015. Our range of foldable IOLs for patients undergoing cataract surgery includes the following:

Because most cataract patients are elderly, government agencies or government-sponsored entities generally pay all or part of the cost of IOLs in our major markets, including the U.S. As a result, cataract procedure volumes will likely remain relatively stable even under adverse conditions in the general economy. However, changes in reimbursement policy under these agencies and entities can reduce our selling prices or reduce the volume of cataract procedures.

Other Surgical Products. We also sell certain instruments, devices, and injector systems. Although we have been deemphasizing these products because of their lower overall gross profit margins, we expect that sales of injector systems will continue.

Operations

STAAR is a global company. Activities outside the U.S. accounted for approximately 85% of our total sales during the first nine months of 2015, primarily due to the pacing of product approvals and commercialization that tend to occur first outside the U.S. STAAR sells its products in more than 60 countries, with direct distribution in the United States, Canada, Japan, Spain, and Germany, and independent distribution in the remainder of the world.

STAAR maintains operational and administrative facilities in the United States, Switzerland and Japan. In June 2014, STAAR completed a project to consolidate substantially all of its manufacturing in its Monrovia, California facility. Its current global operations are as follows:

The global nature of STAAR’s business operations subjects it to risks due to many factors some of which are beyond our control. As noted above, investors and prospective investors should consider carefully, in addition to other information contained in this report, the risks and uncertainties described in “Part I-Item 1A-Risk Factors” of the Company’s Form 10-K for the fiscal year ended January 2, 2015. Such risks and uncertainties could materially adversely affect our business, financial condition or operating results.

Recent Developments

We continue to devote significant effort towards improving our quality system and our remediation efforts. We believe we are on track for achieving our internal remediation metrics, and on budget. We increased prices on our products globally, on average by 5% to 7%, with most price increases taking effect on or about October 1, 2015. We expect to introduce in Europe the expanded optic version of the Visian ICL and TICL with CentraFLOW technology in the first quarter of 2016.

Status of Regulatory Submission

As previously disclosed, STAAR received an FDA Warning Letter, dated May 21, 2014, regarding compliance with current Good Manufacturing Practices at the Monrovia facility. Upon receipt of this letter, STAAR initiated development and subsequent implementation of corrective action plans related to this letter. Beginning on November 14, 2014 and continuing through February 4, 2015, the U.S. Food and Drug Administration (FDA) inspected the Company’s Monrovia facility as a follow-up to the 2014 Warning Letter and also as a post-approval inspection regarding the approved PMA supplement that added the Monrovia facility as an alternate manufacturing facility for the ICL. On February 4, 2015, at the conclusion of the inspections, the FDA issued a Form 483 with ten inspectional observations (2015 FDA-483). The observations focus primarily on the need for adherence to and improved procedures, processes and documentation relating to design change, design transfer into specifications and production, verification and validation associated with device design and production, improvement in Good Documentation Practices, and broader environmental monitoring.

STAAR responded to the 2015 FDA-483 and continues to develop and implement its corrective action plans relating to the 2014 Warning Letter and the 2015 FDA-483. STAAR takes the matters identified by the FDA seriously and will continue to work diligently to address the observations identified. STAAR has enhanced and continues to enhance its overall quality program as we focus on remediating all elements identified. We expect that it will take more than a year to fully complete all of the activities contained in our corrective action plans. We provide monthly updates to the FDA regarding our status on completing the deliverables contained in our corrective action plans.

There can be no assurance that the FDA will be satisfied with our response. Unless and until STAAR is able to correct outstanding issues to the FDA's satisfaction, the FDA may withhold approval of new products such as the Toric ICL (TICL) or take additional regulatory or legal action against us. Any such further action could have a material and negative impact on our ongoing business and operations.

Regarding our PMA Supplement submission to the FDA seeking approval of the TICL, on March 14, 2014 a FDA Ophthalmic Devices Panel of the Medical Devices Advisory Committee voted favorably in response to the three questions posed to it by the FDA’s Division of Ophthalmic, Neurological and Ear, Nose and Throat Devices (regarding the TICL’s safety and effectiveness as well as whether the TICL’s benefits outweigh its risks). Once again, STAAR cannot predict when, or if, the FDA will grant approval of the TICL for use in the United States. We do not expect a decision from the FDA regarding the TICL’s PMA Supplement until the FDA determines that we have resolved or made sufficient progress in addressing the issues raised in the 2014 Warning Letter and 2015 FDA-483.

Critical Accounting Policies

This Management's Discussion and Analysis of Financial Condition and Results of Operations discusses and analyzes data in our unaudited Condensed Consolidated Financial Statements, which we have prepared in accordance with U.S. generally accepted accounting principles. Preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. Management bases its estimates on historical experience and on various other assumptions that it believes to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Senior management has discussed the development, selection and disclosure of these estimates with the Audit Committee of our Board of Directors. Actual conditions may differ from our assumptions and actual results may differ from our estimates.

An accounting policy is deemed critical if it requires an accounting estimate to be made based on assumptions about matters that are highly uncertain at the time the estimate is made, if different estimates reasonably could have been used, or if changes in the estimate that are reasonably likely to occur could materially impact the financial statements. Management believes that there have been no significant changes during the nine months ended October 2, 2015 to the items that we disclosed as our critical accounting policies and estimates in Management's Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the fiscal year ended January 2, 2015.

Net sales for the three months ended October 2, 2015 were $18.8 million, an increase of 3% compared to the $18.2 million reported during the three months ended October 3, 2014. Net sales for the nine months ended October 2, 2015 were $56.3 million, a decrease of 4% compared to the $58.4 million reported during the nine months ended October 3, 2014. The effect of changes in currency exchange rates had a negative impact on net sales of $1.8 million and $5.2 million, respectively, for the three and nine months ended October 2, 2015 when compared to their respective prior year periods.

Total ICL sales for the three months ended October 2, 2015 and October 3, 2014 were $12.9 million and $10.6 million, respectively or an increase of 21%. The sales increase was driven by higher ICL unit sales in each region, with EMEA, APAC and North America growing 37%, 13% and 10%, respectively. EMEA ICL sales were $4.8 million during the third quarter of 2015, a 25% increase over the prior year. Sales in Germany tripled over the prior year period due to the conversion of the market from the former distributor to direct selling which began July 1, 2015. APAC ICL sales were $6.4 million during the third quarter of 2015, an increase of 21% as compared to the prior year period. Korea sales continue to recover and China ICL sales increased 20% due to the adoption of the CentraFLOW® technology introduced in December 2014 and price increases in certain markets beginning in July 2015.

Total ICL sales for the nine months ended October 2, 2015 and October 3, 2014 were $37.4 million and $35.1 million, respectively an increase of 7%. The sales increase was driven by higher ICL unit sales in each region, with EMEA and North America growing 23% and 8%, respectively. These impacts were partially offset by foreign currency changes due to the strengthening U.S. dollar against the euro and yen.

Total IOL sales for the three months ended October 2, 2015 were $4.4 million, a decrease of 24% compared with $5.8 million for the three months ended October 3, 2014. Total IOL sales for the nine months ended October 2, 2015 were $15.0 million, a decrease of 20% compared with $18.8 million for the nine months ended October 3, 2014. The decrease in IOL sales for both periods is due to: 1) changes in currency exchange rates that had a negative impact on IOL sales of $0.5 million and $2.0 million, respectively, for the three and nine months ended October 2, 2015 as a result of a weakening yen effecting Japan sales, the weakening euro effecting France sales; 2) a planned phase-out of sales in China; 3) a planned hold on sales in Germany due to the distributor-to-direct conversion; and 4) a continued decline in the U.S. In Japan, where we have over half of our IOL business, unit sales increased 5% for the quarter.

Other product sales for the three and nine months ended October 2, 2015 were $1.5 million and $3.9 million, respectively, a decrease of 19% and 14%, respectively, compared with $1.8 million and $4.6 million for the three and nine months ended October 3, 2014, respectively. The decrease in both periods was primarily driven by currency impacts on injector part sales and lower sales of other products which the Company has been deemphasizing.

Gross profit for the third quarter of 2015 was $12.8 million, or 68.3% of net sales, compared with $11.9 million, or 65.3% of net sales, in the prior year period. During the first nine months of 2015, gross profit was $38.1 million, or 67.6% of net sales, compared with $39.4 million, or 67.5% of net sales, in the prior year period. The increase in gross profit for the third quarter of 2015 was primarily due to an increased mix of higher margin ICL units, higher average selling prices exclusive of currency impacts, and lower unit and other costs partially offset by the impact of the weaker euro on average selling prices. For the nine month period, the negative effect of the weaker euro on gross profit was offset by lower unit costs.

General and administrative expenses increased by 49% to $4.9 million in the third quarter of 2015 from the $3.3 million reported in the third quarter of 2014. General and administrative expenses for the nine months ended October 2, 2015 were $14.8 million, an increase of 5% when compared with $14.1 million reported last year. The increase in both periods primarily was the result of the reversal of a bonus accrual of $1.6 million in the prior year period.

Marketing and selling expenses decreased 11% to $6.3 million in the third quarter of 2015, compared with $7.0 million in the third quarter of 2014. Marketing and selling expenses for the nine months ended October 2, 2015 were $17.8 million, a decrease of 12% when compared with $20.2 million reported last year. The decrease is due to optimization of North American selling and promotional costs, a decrease in selling and promotional costs in Japan, partially offset by increased selling costs in Germany as a result of the conversion to a direct sales force in that market and moving to direct distribution in Spain during the first half of 2015.

Research and development expense increased in the third quarter of 2015, by 17% to $3.7 million, compared with $3.1 million in the third quarter of 2014. Research and development expense for the nine months ended October 2, 2015 was $10.8 million, an increase of 18%, when compared with $9.1 million reported last year. The increase is primarily the result of increased validation, remediation and other FDA expenses.

Other general and administrative expenses for the nine months ended October 3, 2014 related to the Company’s manufacturing consolidation project which was completed in June 2014.

* Denotes change is greater than + 100%

The year over year change in other income (expense), net for the three month period is primarily due to changes in foreign currency gains and losses and royalty income and for the nine month period primarily due to an increase in royalty income.

* Denotes change is greater than + 100%

The provision for income taxes is determined using an estimated annual effective tax rate. The income tax benefit for the three months ended October 2, 2015 was $11,000. The income tax provision for the nine months ended October 2, 2015 was $0.1 million, compared to a provision of $0.5 million and $1.1 million reported for the three and nine months ended October 3, 2014. The income tax provision primarily benefited from the mix of pretax earnings in lower- and zero- rate foreign jurisdictions and includes pre-tax losses generated in certain foreign jurisdictions which are consolidated for Swiss income tax purposes.  There are no unrecognized tax benefits as of any period presented. 

Based on current year projections, we currently expect the estimated annual effective tax rate to be 67%.

The provision for income taxes is determined using an estimated annual effective tax rate.  The effective tax rate may be subject to fluctuations during the year as new information is obtained, which may affect the assumptions used to estimate the annual effective tax rate, including factors such as the mix of pre-tax earnings in the various tax jurisdictions applicable to the Company, valuation allowances against deferred tax assets, the recognition or de-recognition of tax benefits related to uncertain tax positions, if any, and changes in or the interpretation of tax laws in jurisdictions where the Company conducts business.

Liquidity and Capital Resources

STAAR’s liquidity requirements arise from the funding of our working capital needs, primarily inventory and accounts receivable. Our primary sources for working capital and capital expenditures are cash flows from operating activities, proceeds from the exercise of stock options or warrants, and borrowings under our credit facilities. Our liquidity also depends, in part, on customers paying within credit terms, and any extended delays in payments or changes in credit terms given to major customers may have an impact on STAAR’s cash flow. In addition, any abnormal product returns or pricing adjustments may also affect our short-term funding. We may, in the future elect to supplement this with further debt or commercial borrowing.

STAAR believes its current cash balances, coupled with cash flow from operating activities will be sufficient to meet its working capital requirements for the foreseeable future, including the approximate $4 million cost in 2015 associated with our quality system remediation efforts of which $3.4 million was incurred during the first nine months of 2015. Although we anticipate these costs will continue into 2016, we cannot currently estimate the amount but will update as more information becomes available. If the need for financing arises, which we cannot rule out, STAAR cannot assure that it will be available on acceptable terms, or if at all. STAAR’s Japanese and Swiss subsidiaries have bank lines of credit in place for working capital purposes, but STAAR does not maintain such a credit line in the U.S. STAAR Japan’s line of credit is currently fully drawn (renewable annually) and the total amount available under the Swiss credit line is reduced by the guarantee issued by Bankinter Spain described below.

To the extent STAAR’s cash balances exceed levels needed for working capital, and as a cushion for unforeseen demands, STAAR intends to invest its cash in expanding and improving its business. It does not anticipate paying dividends from its earnings for the foreseeable future.

Overview of Changes in Cash and Cash Equivalents and Other Working Capital Accounts.

As of October 2, 2015 and January 2, 2015, respectively, STAAR had $16.1 million and $13.0 million, of cash and cash equivalents.

Net cash used in operating activities for the nine months ended October 2, 2015 and October 3, 2014, respectively, was $0.3 million and $4.4 million. Net cash used by operating activities for the nine months ended October 2, 2015 consisted of net loss of $5.7 million and a decrease in net working capital of $0.6 million and $4.8 million in non-cash items.

Net cash used in investing activities for the nine months ended October 2, 2015 and October 3, 2014, respectively, was $1.3 million and $2.4 million, primarily due to acquisition of property, plant and equipment.

Net cash provided by financing activities was $4.6 million and $2.4 million for the nine months ended October 2, 2015 and October 3, 2014, respectively. Net cash provided by financing activities for the nine months ended October 2, 2015 consisted of $2.8 million in proceeds from the exercise of warrants, $2.1 million in proceeds from the exercise of stock options, partially offset by $0.3 million in capital lease repayments.

Credit Facilities, Contractual Obligations and Commitments

Lines of Credit and Guarantee

The Company’s wholly-owned Japanese subsidiary, STAAR Japan, entered into an agreement on December 28, 2012, as amended, with Mizuho Bank, which provides for borrowings of up to 500,000,000 Yen (approximately $4.2 million based on the rate of exchange on October 2, 2015), at an interest rate equal to the Tokyo short-term prime interest rate (approximately 1.475% as of October 2, 2015). The line of credit expires September 30, 2016 and is renewable annually. The Company had 500,000,000 Yen outstanding on the line of credit as of October 2, 2015 and January 2, 2015 (approximately $4.2 million based on the foreign currency exchange rates on October 2, 2015 and January 2, 2015, respectively). As of October 2, 2015 there were no available borrowings under the line.

In August 2010, the Company’s wholly-owned Swiss subsidiary, STAAR Surgical AG, entered into a credit agreement with Credit Suisse (“Credit Suisse”). The credit agreement provides for borrowings of up to 1,000,000 Swiss Francs (approximately $1.0 million at the rate of exchange on October 2, 2015), to be used for working capital purposes. Borrowings, if any, on the credit line are due in one year from the borrowing date. The credit agreement is renewable every three years with a current expiration date of September 1, 2016. There were no borrowings outstanding as of October 2, 2015 and January 2, 2015, and the full amount of the line, reduced by any guarantees made to Bankinter Spain (“Bankinter”) (described below), was available for borrowing.

On May 1, 2015, STAAR Surgical AG entered into a guarantee agreement with Bankinter. The agreement, as amended, provides Bankinter with a guarantee of up to EUR 400,000 (approximately $436,000 at the rate of exchange on October 2, 2015) for trade receivables from the Company’s Spanish customers. The total guarantee amount is offset against the credit agreement in place with Credit Suisse and therefore reduces the credit line available to STAAR Surgical AG for working capital requirements to up to 564,000 Swiss francs (approximately up to $578,000 at the rate of exchange on October 2, 2015). Unless terminated sooner by Bankinter, the guarantee agreement expires on May 1, 2017.

Covenant Compliance

The Company is in compliance with the covenants of its credit facilities as of the date of this report.

Employment Agreements

The Company’s Chief Executive Officer and certain officers have as provisions of their agreements certain rights, including continuance of cash compensation and benefits, upon a “change in control,” which may include an acquisition of substantially all of its assets, or termination “without cause or for good reason” as defined in the employment agreements.

Supply Agreement

On April 11, 2014, the Company entered into an Amendment Agreement with Nidek Co., Ltd., which extended the term to December 31, 2016 during which STAAR would supply injectors to Nidek and Nidek would supply acrylic lenses to STAAR.

Decommissioning Fund

The Company is required by the California Department of Public Health (“CDPH”) to set aside funds for future estimated decommissioning expenses related to certain equipment used in its manufacturing process. The Company has set aside approximately $120,000, as determined and mandated by CDPH, for such costs included in other assets as of October 2, 2015 and October 3, 2014, respectively.

Off-Balance Sheet Arrangements

We do not have any off-balance sheet arrangements, as that term is defined in the rules of the SEC, that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that are material to investors.