Acquisition of DuraHeart II

9 Months Ended

Sep. 28, 2013

Acquisition of DuraHeart II

Acquisition of DuraHeart II

Note 2.  Acquisition of DuraHeart II

On June 30, 2013, we acquired certain assets and assumed certain liabilities from Terumo Corporation (“Terumo”) related to the DuraHeart II Left Ventricular Assist System product line (DuraHeart II) previously under development by Terumo.  Under the terms of the acquisition, we made an upfront cash payment to Terumo of $13.0 million, and will be obligated to make potential future milestone payments, based on regulatory approvals and product sales, of up to $43.5 million. Terumo also maintains the right to repurchase the Purchased Assets in the event that Thoratec does not fulfill certain conditions relating to the development of the DuraHeart II by August 2016. As part of the agreement, a team of Terumo employees transferred to Thoratec. Additionally, Thoratec and Terumo entered into a distribution partnership, in which Terumo will commercialize DuraHeart II in Japan and potentially other parts of Asia, if and when local regulatory approvals are obtained. DuraHeart II is an ultra-compact, full-support, centrifugal flow chronic ventricular assist system that uses a unique technology foundation known as “force balance” suspension. The device uses magnetic forces, balanced by hydrodynamic support, to achieve consistent gaps across the operating range of the pump, independent of pump speed. The primary reasons for the acquisition were to diversify the technology platforms within the Company’s research and development portfolio and to apply the Company’s resources and expertise in mechanical circulatory support to advance DuraHeart II through product development and clinical trials.

The DuraHeart II acquisition was accounted for as a business combination. In connection with the acquisition, we recorded $2.0 million of acquisition-related costs, which were recognized in our condensed consolidated statement of operations for the nine months ended September 28, 2013 within operating expenses. We also recorded $9.9 million of goodwill, equal to the amount by which the purchase consideration exceeded the fair value of the acquired assets. This goodwill was allocated to our sole operating segment (Cardiovascular) and is deductible for U.S. income tax purposes. The operating results of the DuraHeart II product line from the date of acquisition, including zero revenue and $1.5 million net loss, are included in our condensed consolidated statement of operations for the nine month period ended September 28, 2013.

We will be obligated to pay potential post-closing cash milestone payments of $5.5 million and $10.5 million upon Conformité Européene (“CE”) Mark approval in Europe and U.S. Food and Drug Administration (“FDA”) approvals, respectively, for the DuraHeart II device currently under development (collectively referred to as the “regulatory milestones”). Additional milestone payments totaling $27.5 million will become payable by us upon reaching various commercial sale milestones after the regulatory approvals are obtained (referred to as the “commercial sales milestones”). The fair value of the combined contingent consideration due upon achievement of the regulatory milestones and the commercial sales milestones was estimated to be $18.8 million at the acquisition closing date and has been recorded as a non-current liability, because such contingent consideration is expected to be settled no earlier than 2016.

Total purchase price consideration was as follows (in thousands):

Cash paid at the acquisition closing date (June 30, 2013)	$	13,000
Estimated fair value of contingent consideration	18,800
Total estimated purchase price	$	31,800

We determined the initial fair value of the contingent consideration in connection with the regulatory and commercial sales milestones using various estimates, including probabilities of success, discount rates and the estimated amount of time until the conditions of the milestone payments are met. This fair value measurement is based on significant inputs not observable in the market, representing a Level 3 measurement within the fair value hierarchy (see Note 3 for more information about fair value measurements). The key assumptions used to determine the fair value of the contingent consideration in connection with the regulatory milestones include a 5.3% discount rate and probability adjusted milestone payment date ranges from July 2016 to January 2020. The key assumptions used to determine the fair value of contingent consideration in connection with the commercial sales milestones include a 20.0% discount rate and probability-weighted expected milestone payment date ranges from July 2019 to January 2029, based on the aggregate number of commercial units sold (starting at the 500th unit sold to the 10,000th unit sold). As of September 28, 2013, there were no significant changes in the range of outcomes for the contingent consideration recognized as a result of the acquisition, although the fair value of the contingent consideration for regulatory and commercial sales milestone payments increased by $0.1 million and $0.2 million, respectively, as a result of the passage of time as development work progressed towards the achievement of the milestones, which were recorded within operating expense.

Preliminary Purchase Price Allocation as of the acquisition date is summarized as follows (in thousands):

Property, plant and equipment	$	8,900
Identifiable intangible assets:
Favorable lease contract	600
In-process research and development	12,400
Goodwill	9,900
Total estimated purchase price consideration	31,800
Less: Contingent consideration	18,800
Cash paid at the acquisition closing	$	13,000

We recorded an In-Process Research & Development (IPR&D) asset in the amount of $12.4 million, which represents an estimate of the fair value of in-process technology related to the DuraHeart II device. The estimated fair value was determined using the multi-period excess earnings method, a variation of the income approach. The multi-period excess earnings method estimates the value of an intangible asset equal to the present value of the incremental after-tax cash flows attributable to that intangible asset. The fair value using the multi-period excess earnings method was dependent on an estimated weighted average cost of capital of 22.5%, which represents a rate of return that a market participant would expect for these assets.

Pursuant to accounting standards for business combination, intangible assets related to IPR&D assets are considered to be indefinite-lived until the completion or abandonment of the associated research and development efforts. Accordingly, amortization of the IPR&D will not occur until it reaches market feasibility. During the period the assets are considered indefinite-lived, they will be tested for impairment on an annual basis, as well as between annual tests if we become aware of any events occurring or changes in circumstances that would indicate that the fair values of the IPR&D projects are less than their respective carrying amounts. If and when development is complete, which generally occurs when regulatory approval to market a product is obtained, the associated assets would be deemed definite-lived and would then be amortized based on their estimated useful lives at that point in time. Costs incurred in connection with this project subsequent to the date of acquisition will be expensed as incurred. If the related project is terminated or abandoned, we may have an impairment related to the IPR&D, calculated as the excess of the asset’s carrying value over its fair value.

Pro forma financial information (unaudited)

The following unaudited pro forma information presents the combined results of operations for the nine months ended September 28, 2013 and September 29, 2012 as if the DuraHeart II acquisition had been completed as of the beginning of 2012. Actual 2013 acquisition-related transaction costs of $2.0 million were excluded from the 2013 pro forma results below and included in the 2012 pro forma results as if these costs were incurred during the 2012 period. All other adjustments to the pro forma results in 2013 and 2012 were not significant.

	Nine Months Ended September 28, 2013		Nine Months Ended September 29, 2012
	(in thousands)
Product sales	$	374,648	$	363,196
Income before taxes	65,922		77,691
Net income	49,242		53,764

The pro forma results do not reflect operating efficiencies or potential cost savings which may result from the consolidation of operations.