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STAAR SURGICAL CO - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

May 13, 2014

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, as amended, including statements about any of the following: any projections of earnings, revenue, sales, profit margins, cash, effective tax rate or any other financial items; the plans, strategies, and objectives of management for future operations or prospects for achieving such plans; metrics for 2014; statements regarding new products, including but not limited to, expectations for success of new products in the U.S. or international markets or government approval or commercialization of new products (including the Toric ICL in the U.S.); future economic conditions or size of market opportunities; expected IOL backorder position; expected costs of Monrovia facility expansion; expected costs and savings from business consolidation plans and the timetable for those plans; statements of belief, including as to achieving 2014 growth plans or metrics; expected regulatory activities and approvals, product launches, and any statements of assumptions underlying any of the foregoing. 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. These factors include, without limitation, those described in our Annual Report on Form 10-K for the fiscal year ended January 3, 2014. STAAR undertakes no obligation to update these forward-looking statements to reflect events or circumstances after the date of this report or to reflect actual outcomes.



The following discussion should be read in conjunction with STAAR's interim condensed 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 3, 2014, 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 make up over sixty (60%) percent of our total sales. Made from our proprietary biocompatible Collamer material, highlights of STAAR's family of Visian ICL products are as follows:



· The Visian ICL treats refractive disorders such as myopia (near-sightedness)

and hyperopia (far-sightedness). STAAR began selling the Visian ICL outside the

U.S. in 1996 and inside the U.S. in 2006.



· The Visian Toric ICL™, or TICL™, treats myopic and hyperopic patients with

astigmatism. Astigmatism is a condition that causes blurred vision when an

irregular shape of the cornea prevents light from focusing properly on the

retina. STAAR has been selling the Visian TICL outside the U.S. since 2002.

STAAR remains in dialogue with the FDA regarding its PMA Supplement submission

seeking approval to sell the TICL in the U.S. This matter is further discussed

below under, "Status of Regulatory Submission."



· STAAR currently sells several versions of the Visian ICL and Visian TICL

globally; the original V4, the V4b, which expands the population of eligible

patients to individuals in the lower diopter range (from -3.0 to +3.0), and the

V4c, which includes the proprietary CentraFLOW technology (a port in the center

of the myopic ICL and TICL) that eliminates the need for a peripheral

iridectomy or irodotomy procedure prior to implanting the ICL.

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· STAAR's goal is to position the Visian ICL and TICL products throughout the

world as primary choices for refractive surgery.



IOLs - Intraocular Lenses for Cataract Surgery. Our range of foldable IOLs for patients undergoing cataract surgery includes the following:

· Aspheric IOLs, available in single-piece and three-piece designs made from (i)

Collamer, STAAR's proprietary biocompatible collagen copolymer lens material,

and (ii) from silicone. Aspheric IOLs are designed to improve the patient's

quality of vision when compared to earlier spherical IOL designs. The three

piece aspheric silicone is sold preloaded in certain markets outside of the

U.S. The Collamer three piece lens is only marketed and sold in the U.S.



· The nanoFLEX IOL, a single-piece Collamer aspheric IOL that can be implanted

through a micro-incision with a single-use disposable nanoPOINT injector system, is available in the U.S and territories that accept the CE Mark.



· The Preloaded IOL line consists of a three-piece silicone and a three piece and

single piece acrylic IOL preloaded into a single-use disposable injector which

is currently available outside the U.S. The acrylic IOL Preloaded line utilizes

an acrylic lens sourced from another manufacturer. The KS-SP is the

single-piece preloaded acrylic IOL and the KS-X is the three piece preloaded

acrylic IOL. The KS IOL line is available in Japan and on a limited basis in

Europe.



· STAAR Toric IOL is a single piece silicone toric IOL, used in cataract surgery

to treat preexisting astigmatism and is currently only marketed in the U.S.

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 parts. Although we have been deemphasizing these products since 2009 because of their lower overall gross profit margins, we expect that sales of these products will continue to increase due to an increase in demand of injector parts. Operations



STAAR operates its global administrative headquarters and a manufacturing facility in Monrovia, California, and also maintains product manufacturing facilities in Nidau, Switzerland, and materials manufacturing in Aliso Viejo, California.

STAAR has implemented a project to consolidate its product manufacturing into a single site at its Monrovia, California location by the middle of 2014, which we expect to yield significant savings in cost of goods, lower our global administrative and regulatory costs and reduce income taxes. As of the end of the first quarter of 2014, all IOLs and approximately 41% of ICLs were manufactured in the U.S. This project, which is subject to significant risks, is further described under Note 12, "Manufacturing Consolidation Project and Tax Strategy."



Strategy and Key Operational Metrics

STAAR's strategy is to be valued as a leading global provider of innovative intraocular lens system technologies. STAAR employs a commercialization strategy that focuses on achieving sustainable profitable growth.

STAAR's key operational metrics for 2014 are guided by two principal strategic goals: to achieve and maintain profitability and to lay the groundwork for further growth. In pursuit of these goals, STAAR has aligned its business initiatives during 2014 along five key annual metrics it will use to gauge its success for the year. Those metrics are as follows:



· Increase total revenue by 8% to 10% for the full year.

- As discussed below in "Results of Operations," our total revenue increased by 12% in the first quarter of 2014.

· Grow ICL sales by 20% for the full year.

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- As discussed below in "Results of Operations," ICL sales grew by 15% in the first quarter of 2014.

· Increase gross profit margins by 300 basis points to 72.7% for the full year.

- As discussed below in "Results of Operations," our gross profit declined by 150 basis points to 68.8% in the first quarter of 2014 compared to 70.3% in

the first quarter of 2014.



· Achieve profitability on a GAAP basis for the full year.

- As discussed below in "Results of Operations," we reported a net loss of $1.4 million in the first quarter of 2014.

· Complete our manufacturing consolidation project by the middle of 2014 with no

material disruption to customer supply requirements or quality.

- Our consolidation efforts are proceeding according to plans and we expect this to continue through completion in the middle of 2014.

Other Highlights In the first quarter of 2014, ICL revenue grew in the Europe, Middle East and Africa (EMEA) region by 27%, in the Asia Pacific (APAC) region by 17% and declined in North America by 14%. Sales were particularly strong in portions of the EMEA and APAC region where the ICL with CentraFLOW technology is available for sale. IOL revenue in the first quarter of 2014 increased four (4%) percent primarily due to increased sales of KS-IOL products in the European markets and increased sales of preloaded silicone IOLs in Japan. Our third party supplier of components for the KS-IOL product line increased the quantity of KS-IOL products delivered to us. We extended the term of our supply agreement with our supplier and we expect the supply of KS-IOL components from our supplier to continue

to increase throughout 2014. STAAR continued its manufacturing consolidation efforts in the first quarter of 2014 and we expect to complete transferring manufacturing activities from Nidau, Switzerland to Monrovia, California by the middle of 2014 (See "Operations," above). In the first quarter of 2014 we incurred $0.2 million in consolidation-related costs and we expect to spend an additional $0.1 million during the remainder of 2014 to complete the transfer from Switzerland. After we complete these manufacturing transfer activities, we target gross margins nearing eighty (80%) percent for our manufactured products and an effective tax rate of approximately ten percent. At the end of the first quarter, the Company had approximately 26,500 ICLs in finished goods inventory, compared to approximately 17,100 ICLs in inventory at the end of the fourth quarter. This inventory build is consistent with management's plan to assure adequate supply and quality of product throughout this consolidation project process and to prepare for the potential U.S. launch for the TICL.

In markets where both the ICL and TICL are approved for sale, approximately forty (40%) percent of units sold are TICLs. In the event the FDA approves the TICL, assuming the U.S. market follows the sales patterns of other markets, we expect that total U.S. ICL sales (meaning ICLs and TICLs) could double in the first full year after launch.

Our Preloaded ICL with enhanced optics remains in development and we expect CE Market approval by mid-2014. Also in development is an ICL with an enhanced optic to add near-vision enhancement of up to two diopters which could address early onset of presbyopia. We are targeting availability in the EU for this product in early 2015.



Status of Regulatory Submission

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'sDivision 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). STAAR cannot predict when, or if, the FDA will grant approval of the TICL for use in the United States. On October 9, 2012, STAAR submitted a clinical study protocol regarding the ICL with CentraFLOW technology. On December 12, 2013, we met with the FDA in Washington D.C. to discuss the protocol and we remain in dialogue with the FDA regarding a revised proposed protocol.



On March 3, 2014, the Japanese Ministry of Health, Labor and Welfare approved the Visian ICL with CentraFLOW technology for marketing and sale in Japan.

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. 13 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 three months ended April 4, 2014 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 3, 2014. Results of Operations

The following table shows the percentage of our total sales represented by the specific items listed in our statements of operations for the periods indicated, and the percentage by which these items increased or decreased over the prior period. Percentage Change for Percentage of Net Sales for Three Three Months Months April 4, March 29, 2014 2014 2013 vs. 2013 Net sales 100.0 % 100.0 % 12.1 % Cost of sales 31.2 29.7 17.7 Gross profit 68.8 70.3 9.7 General and administrative 26.7 22.0 36.3 Marketing and selling 30.4 29.4 16.1 Research and development 17.3 7.6 * Medical device tax 0.2 0.3 (32.2 )

Other general and administrative expenses 0.9

5.0 (81.4 ) 75.5 64.3 31.6 Operating income (loss) (6.7 ) 6.0 * Other income (expense), net 1.1 (1.7 ) *

Income (loss) before provision for income taxes (5.6 )

4.3 * Provision for income taxes 1.1 1.7 (30.3 ) Net income (loss) (6.7 )% 2.6 % * * Denotes change is greater than +100%. Net Sales Percentage Change for Three Three Months Ended Months 2014 April 4, 2014 March 29, 2013 vs. 2013 Net sales $ 20,178$ 18,001 12 % ICL 12,241 10,631 15 IOL 6,613 6,347 4 Other 1,324 1,023 29 Net sales for the three months ended April 4, 2014 were $20.2 million, an increase of 12% compared with $18.0 million reported during the same period of 2013. Changes in currency had a $0.6 million unfavorable impact on net sales for the first quarter of 2014. Total ICL sales for the three months ended April 4, 2014 were $12.2 million, an increase of 15% compared with $10.6 million reported during the same period of 2013. The increase in ICL sales is due to increased sales in Europe, Middle East, Africa and Latin America (EMEA) +27%, and Asia Pacific (APAC) +17%, partially offset by a 14% decline in North America sales. Sales growth in EMEA was led by Spain +26%, Latin America + 58%, and Germany +34%. Sales growth in APAC was led by Korea +29% and China +25%. ICL volume increased by 14% and average selling prices (ASPs) increased 1%. ICL sales represented 60.7% and 59.1% of consolidated net sales, respectively, for the three months ended April 4, 2014 and March 29, 2013. 14

Total IOL sales for the three months ended April 4, 2014 were $6.6 million, an increase of 4% compared with $6.3 million reported during the same period of 2013. IOL sales were negatively impacted due to approximately $500,000 in backorders from the Company's acrylic IOL supplier and the negative effect of foreign currency exchange which totaled $482,000. IOL unit volume increased 16% driven by a 22% increase in silicone preloaded IOL sales in Japan and a 59% increase in acrylic preloaded IOL sales in EMEA as a result of increased supply. IOL sales represented 32.8% and 35.3% of consolidated net sales respectively, for the three months ended April 4, 2014 and March 29, 2013. Other product sales for the three months ended April 4, 2014 were $1.3 million, an increase of 29% compared with the $1.0 million reported during the same period of 2013. This increase was due to increased sales of acrylic preloaded injector parts to the Company's acrylic lens supplier to support the buildup of acrylic preloaded product supply for their markets. Gross Profit Percentage Change for Three Three Months Ended Months 2014 April 4, 2014 March 29, 2013 vs. 2013 Gross Profit $ 13,884$ 12,654 10 % Gross Profit Margin 68.8 % 70.3 %

Gross profit for the first quarter was $13.9 million, or 68.8% of revenue, compared with $12.7 million, or 70.3% of revenue, in the prior year period. Gross margin expansion was limited by three primary factors: 1) manufacturing inefficiencies in the U.S. and overhead absorption issues in Switzerland resulting in higher costs as the company transfers ICL production from Switzerland to the U.S.; 2) increased low margin IOL injector part sales; and 3) a decrease in overall IOL average selling prices based on geographic mix. The negative factors were partially offset by increased average selling prices

of ICLs. General and Administrative Percentage Change for Three Three Months Ended Months 2014 April 4, 2014 March 29, 2013 vs. 2013 General and Administrative $ 5,396 $ 3,958 36 % Percentage of Sales 26.7 % 22.0 %



General and administrative expenses for the quarter were $5.4 million, an increase of 36% when compared with $4.0 million reported last year. The increase is due primarily to increased compensation and recruiting costs.

Marketing and Selling Percentage Change for Three Three Months Ended Months 2014 April 4, 2014 March 29, 2013 vs. 2013 Marketing and Selling $ 6,138 $ 5,286 16 % Percentage of Sales 30.4 % 29.4 % Marketing and selling expenses for the quarter were $6.1 million, an increase of 16% when compared with $5.3 million reported last year. The increase is due primarily to increased promotional spending and costs associated with expansion of the U.S. sales team in anticipation of FDA approval to commercialize the

TICL in the U.S. 15 Research and Development Percentage Change for Three Three Months Ended Months 2014 April, 2014 March 29, 2013 vs. 2013

Research and Development $ 3,484 $ 1,366 - * Percentage of Sales 17.3 % 7.6 % * Denotes change is greater than +100%. Research and development expenses for the quarter were $3.5 million, an increase of 155% when compared with $1.4 million reported last year. The increase is driven by the cost of preparing for and attending the March 4, 2014FDA advisory panel meeting (previously scheduled for February 14, 2014, then postponed due to a snowstorm), which totaled $1.4 million during the quarter and new product development associated with V5 ICL.



Other General and Administrative Expenses

Percentage Change for Three Three Months Ended Months 2014 April 4, 2014 March 29, 2013 vs. 2013

Other General and Administrative Expenses $ 168 $

901 (81 )% Percentage of Sales 0.9 % 5.0 % Other general and administrative expenses for the quarter were $0.1 million, compared with $0.9 million reported last year. The decrease is due to lower expenses associated with the Company's manufacturing consolidation project which the Company anticipates will largely be completed by the end of the second quarter of 2014.



Other Income (Expense), Net

Percentage Change for Three Three Months Ended Months 2014 April 4, 2014 March 29, 2013 vs. 2013

Other Income (Expense), Net $ 202 $ (299 ) - * * Denotes change is greater than +100%.

Other income for the quarter was $0.2 million compared to other expense of $0.3 million in the first quarter of 2013. The increase in other income is due to foreign currency transaction gains recorded in the first quarter of 2014, compared to foreign currency transaction losses recorded during the first quarter of 2013 and an increase in royalty income. Income taxes Percentage Change for Three Three Months Ended Months 2014 April 4, 2014 March 29, 2013 vs. 2013 Provision for income taxes $ 219 $ 314 (30 )% The provision for income taxes is determined using an estimated annual effective tax rate. Income tax provision for the quarter was $0.2 million, compared to $0.3 million reported last year, partially benefiting in the current quarter from the mix of pre-tax earnings in the Company's lower-rate foreign jurisdictions. There are no unrecognized tax benefits as of any period presented. Based on current year projections, the Company expects the estimated annual effective tax rate to be 30%. 16



We do not expect to fully realize the tax benefits associated with our manufacturing consolidation project until after this project has been fully implemented, which is scheduled for completion in the middle of 2014.

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, 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. 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. If the need for financing arises, 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 purpose, but STAAR does not maintain such a credit line in the U.S. STAAR Japan line of credit is currently fully drawn. 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 April 4, 2014, January 3, 2014, and March 29, 2013, respectively, STAAR had $21.0 million, $22.9 million, and $19.2 million of cash and cash equivalents.

Net cash used in operating activities was $2.6 million for the three months ended April 4, 2014 and $0.4 million for the three months ended March 29, 2013 and consisted of net loss of $1.4 million, plus $2.1 million in non-cash items, offset by a $3.3 million increase in net working capital for the three months ended April 4, 2014.



Net cash used in investing activities was $1.4 million for the three months ended April 4, 2014, compared to $1.2 million in net cash used in investing activities for the three months ended March 29, 2013. Net cash used in investing activities was due to the acquisition of property, plant and equipment.

Net cash provided by financing activities was $2.1 million for the three months ended April 4, 2014, compared with $0.2 million in net cash used in financing activities for the three months ended March 29, 2013. The increase in cash provided by financing activities was due to increase in proceeds from exercise of stock options.



Credit Facilities, Contractual Obligations and Commitments

Accrued Termination Benefits for Manufacturing Consolidations Project

The Company has accrued $0.8 million as of April 4, 2014 in termination benefit costs in connection with its manufacturing consolidation project. The accrual represents STAAR's current best estimate of the termination benefits that will be paid to the eligible employees. Lines of Credit The Company's wholly owned Japanese subsidiary, STAAR Japan, has an agreement, as amended on December 28, 2012, with Mizuho Bank, which provides for borrowings of up to 500,000,000 Yen (approximately $4.8 million based on the rate of exchange on April 4, 2014), at an interest rate equal to the Tokyo short-term prime interest rate (approximately 1.475% as of April 4, 2014). The line of credit expires July 4, 2014, but the Company expects the bank will renew. The Company had 500,000,000 Yen outstanding on the line of credit as of April 4, 2014and January 3, 2014 (approximately $4.8 million and $4.8 million based on the foreign currencyexchange rates on April 4, 2014 and January 3, 2014). As of April 4, 2014 there were no available borrowings under the line. 17

In August 2010, the Company's wholly-owned Swiss subsidiary, STAAR Surgical AG, entered into a credit agreement with Credit Suisse (the "Bank"). The credit agreement provides for borrowings of up to 1,000,000 Swiss Francs (approximately $1.1 million at the rate of exchange on April 4, 2014), to be used for working capital purposes. There were no borrowings outstanding as of April 4, 2014 and the full amount of the line was available for borrowing. Covenant Compliance



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

Capital Lease Obligations



STAAR leases certain property, plant, and equipment under non-cancelable capital lease agreements. These leases vary in amount, duration, and rates.

Estimated future minimum payments under capital lease obligations were as follows (in thousands): April 4, January 3, Fiscal Year 2014 2014 2014 $ 215$ 303 2015 160 142 2016 23 6 2017 3 - Thereafter - - Total minimum lease payments $ 401$ 451 Less: interest (17 ) (22 ) Total lease obligation $ 384$ 429 Current $ 265$ 288 Long-term $ 119$ 141



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.


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