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NEUROMETRIX, INC. - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

July 24, 2014

You should read the following discussion of our financial condition and results of operations in conjunction with our financial statements and the accompanying notes to those financial statements included elsewhere in this Quarterly Report on Form 10-Q. This discussion contains forward-looking statements that involve risks and uncertainties. For a description of factors that may cause our actual results to differ materially from those anticipated in these forward-looking statements, please refer to the below section of this Quarterly Report on Form 10-Q titled "Cautionary Note Regarding Forward-Looking Statements." Unless the context otherwise requires, all references to "we", "us", the "Company", or "NeuroMetrix" in this Quarterly Report on Form 10-Q refer to NeuroMetrix, Inc.

Overview



NeuroMetrix is an innovative health-care company that develops wearable medical technology and point-of-care tests to help patients and physicians manage chronic pain, nerve disease, and sleep disorders. Our Company was founded in 1996 and has been publicly traded on NASDAQ since 2004. The Company's technology foundation was built at Harvard Medical School and the Massachusetts Institute of Technology. It is employed in numerous FDA-cleared products that have been used by physicians in more than 6 million diagnostic tests of nerve function. We have an intellectual property base that encompasses 64 issued and pending patents and extensive, difficult to replicate know-how in our practice area. We have an experienced management team and Board of Directors, and we are strategically located in the greater Boston area.

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One of our primary markets is the management and treatment of the neurological complications of diabetes. People with diabetes do not effectively regulate their blood glucose, or sugar, levels leading to chronically high levels of glucose in the blood, called hyperglycemia, and occasionally bouts of low glucose in the blood, called hypoglycemia. The primary reason that glucose levels are not effectively regulated in people with diabetes is that those with the disease do not produce insulin (Type I diabetes) or are resistant to the normal physiological action of insulin (Type II diabetes). Many Type II diabetics eventually require insulin because production of the hormone by their pancreas decreases with time. Type I diabetes usually affects children and teenagers whereas Type II diabetes has typically been a disease of adults over the age of 50. However, over the past decade, Type II diabetes is occurring in younger adults, which may be attributable to higher levels of obesity in this age group.

We believe that there are large and important unmet needs in the treatment of diabetic neuropathies and adjacent forms of chronic pain such as fibromyalgia, post herpetic neuropathy (shingles), and conditions with both chronic pain and disturbed sleep such as restless leg syndrome. As a medical device company with both unique and substantial experience in devices to measure and alter peripheral nerve function, we believe we are well positioned to address these unmet needs through the development of novel proprietary medical devices. Accordingly, we have a major focus on developing and marketing medical devices for diabetic neuropathies. We believe that we are the only medical device company with a strategic focus on the diabetic neuropathy market and our goal is to be the dominant player in this field.

During the past three years we have launched two products with the potential to change medical practice. SENSUS, our wearable transcutaneous electrical nerve stimulator indicated for management of chronic pain, and the only device cleared by the FDA for use during sleep, was launched in early 2013. Revenues from SENSUS were approximately $200,000 in 2013 and were $256,000 for the quarter ended June 30, 2014. We market SENSUS to physicians managing patients with painful diabetic neuropathy, or PDN, and other forms of chronic pain. The prevalence of PDN is 16% to 26% of people with diabetes representing a three to five million patient group. We are building demand by contracting with independent durable medical equipment, or DME, suppliers employing sales representatives who detail physicians. Physician prescriptions are fulfilled by the DME suppliers who maintain a stock of SENSUS devices and consumables

NC-stat DPNCheck, our point-of-care neuropathy test for accurate and cost-effective screening, diagnosing and monitoring of peripheral neuropathies such as diabetic peripheral neuropathy, was launched in late 2011. Revenues were approximately $1.3 million in 2013 and were $360,000 for the quarter ended June 30, 2014. Our sales efforts in the U.S. market are focused on Medicare Advantage providers who assume financial responsibility and the associated risks for the health care costs of their patients. For Medicare Advantage providers, we believe that NC-stat DPNCheck presents a compelling clinical case with early detection of neuropathy allowing for earlier clinical intervention to help mitigate the effects of neuropathy on both patient quality of life and cost of care. Also, the diagnosis and documentation of neuropathy provided by NC-stat DPNCheck helps clarify the patient health profile which, in turn, may have a direct, positive effect on the Medicare Advantage premium received by the provider. Outside of the U.S. we are working with Omron Healthcare. We received regulatory approval in Japan during the second quarter of 2014 and expect to launch NC-stat DPNCheck in that market during the third quarter of 2014. Other attractive international market opportunities include China where we are also working with Omron Healthcare and the Middle East and Mexico which we are addressing with local distributors.

We manage our historical neurodiagnostics business, centered on the ADVANCE System, for cash flow and not growth. This business generated $3.8 million in revenue during 2013 and $728,000 for the quarter ended June 30, 2014 and has few direct cash operating expenses. We expect this line of our business will continue to decline in the future.

Recent Developments



On June 24, 2014, the Company entered into a Securities Purchase Agreement with a single institutional investor providing for the issuance of common stock, convertible preferred stock and warrants to purchase common stock, which is referred to as the 2014 Offering. The Company received net proceeds of $7.9 million from the 2014 Offering. See Note 9, Stockholders' Equity, of our Notes to Unaudited Financial Statements contained elsewhere in this Quarterly Report on Form 10-Q for further information regarding this transaction.

Results of Operations



Comparison of Quarters Ended June 30, 2014 and 2013

Revenues



The following table summarizes our revenues:

Quarters Ended June 30, 2014 2013 Change % Change (in thousands) Revenues $ 1,343.8$ 1,160.5$ 183.3 15.8 %



Revenues include sales from SENSUS, our therapeutic device for relief of chronic pain; NC-stat DPNCheck, our diagnostic test for DPN; and our legacy ADVANCE neurodiagnostics business. During the second quarter of 2014, we shipped approximately 1,700 SENSUS devices plus consumable electrodes and recorded revenue of approximately $256,000 compared to 208 devices and $32,000 in revenue recorded in the second quarter of 2013. In the second quarter of 2014 we recorded revenue of $360,000 from sales of NC-stat DPNCheck devices and consumable biosensors compared to $129,000 in revenue recorded in the second quarter of 2013. Revenues also include sales from our ADVANCE neurodiagnostic products totaling $728,000 in the second quarter of 2014, compared to $1.0 million in the second quarter of 2013.

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Cost of Revenues and Gross Profit

The following table summarizes our cost of revenues and gross profit:

Quarters Ended June 30, 2014 2013 Change % Change (in thousands) Cost of revenues $ 655.3$ 501.1$ 154.2 30.8 % Gross profit $ 688.4$ 659.3$ 29.2 4.4 %



Our cost of revenues increased to $655,300 in the second quarter of 2014, compared to $501,100 in the second quarter of 2013. Gross margin decreased to 51.2% in the second quarter of 2014 from 56.8% in the second quarter of 2013. The decline in gross margin was due to a shift in product mix to lower margin SENSUS devices and to increased manufacturing costs associated with higher production.

Operating Expenses



The following table presents a breakdown of our operating expenses:

Quarters Ended June 30, 2014 2013 Change % Change (in thousands) Operating expenses: Research and development $ 1,464.8$ 913.8$ 551.0 60.3 % Sales and marketing 694.7 880.2 (185.5 ) (21.1 ) General and administrative 1,148.3 992.2 156.1 15.7 Total operating expenses $ 3,307.8$ 2,786.2$ 521.6 18.7 % Research and Development



Research and development expenses for the quarters ended June 30, 2014 and 2013 were $1.5 million and $913,800, respectively. The increase of $551,000 included outside engineering costs of $337,000 associated with development of an over-the-counter wearable device for chronic pain. Personnel costs, including severance costs, were higher in the second quarter of 2014 by $178,000.

Sales and Marketing



Sales and marketing expenses decreased to $694,700 for the quarter ended June 30, 2014 from $880,200 for the quarter ended June 30, 2013. The reduction of $185,500 included the effects of lower headcount and personnel-related costs totaling $375,700 partially offset by increased recruiting spending of $139,700.

General and Administrative



General and administrative expenses increased by $156,100 to $1.1 million for the quarter ended June 30, 2014 compared to the quarter ended June 30, 2013. This increase was primarily attributable to increased personnel costs totaling $98,400 and consulting and professional fees of $101,400, partially offset by a decrease in bad debt expense of $32,900.

Interest Income



Interest income was approximately $1,000 and $1,400 for the quarters ended June 30, 2014 and 2013, respectively. Interest income was earned from investments in cash equivalents.

13 Warrants offering costs



Warrants offering costs of $27,600 and $376,300 consists of offering costs allocated to warrants in the 2014 offering and 2013 offering, respectively.

Change in fair value of warrant liability

The change in fair value of warrant liability of approximately $475,261 relates to the revaluation of warrants issued in the 2014 Offering between the closing date of the 2014 Offering and the reporting date of June 30, 2014, plus the revaluation of warrants issued in the 2013 Offering between March 31, 2014 and June 30, 2014.

Comparison of Six Months Ended June 30, 2014 and 2013

Revenues



The following table summarizes our revenues:

Six Months Ended June 30, 2014 2013 Change % Change (in thousands) Revenues $ 2,675.3$ 2,561.9$ 113.4 4.4 %



Revenues include sales from SENSUS, our therapeutic device for relief of chronic, intractable pain; NC-stat DPNCheck, our diagnostic test for DPN; and our legacy ADVANCE neurodiagnostics business. Through the second quarter of 2014, we shipped approximately 3,200 SENSUS devices plus consumable electrodes and recorded revenue of approximately $451,000 compared to 353 devices and $65,000 in revenue recorded through the second quarter of 2013. Through the second quarter of 2014 we recorded revenue of $638,000 from sales of NC-stat DPNCheck devices and consumable biosensors. This was in comparison with $444,000 in revenue recorded through the second quarter of 2013. Revenues also include sales from our ADVANCE neurodiagnostic products totaling $1.6 million through the second quarter of 2014, compared to $2.1 million through the second quarter of 2013.

Cost of Revenues and Gross Profit

The following table summarizes our cost of revenues and gross profit:

Six Months Ended June 30, 2014 2013 Change % Change (in thousands) Cost of revenues $ 1,270.4$ 1,070.9$ 199.5 18.6 % Gross profit $ 1,404.9$ 1,491.0$ (86.1 ) (5.7 )%



Our cost of revenues increased to $1.3 million through the second quarter of 2014, compared to $1.1 million through the second quarter of 2013. Gross margin decreased to 52.5% in the second quarter of 2014 from 58.2% in the second quarter of 2013. The decline in gross margin was due to a shift in product mix to lower margin SENSUS devices and to increased manufacturing costs associated with higher production.

14 Operating Expenses



The following table presents a breakdown of our operating expenses:

Six Months Ended June 30, 2014 2013 Change % Change (in thousands) Operating expenses: Research and development $ 2,328.5$ 1,987.3$ 341.2 17.2 % Sales and marketing 1,140.9 1,660.1 (519.2 ) (31.3 ) General and administrative 2,295.0 2,225.8 69.2 3.1 Total operating expenses $ 5,764.4$ 5,873.2$ (108.8 ) (1.9 )% Research and Development



Research and development expenses for the six months ended June 30, 2014 and 2013 were $2.3 million and $2.0 million, respectively. The increase of $341,200 was primarily related to outside engineering costs of $348,000 associated with development of an over-the-counter wearable device for chronic pain and increased net personnel costs of $108,000. This was partially offset by a decrease in clinical costs of $174,000

Sales and Marketing



Sales and marketing expenses decreased to $1.1 million for the six months ended June 30, 2014 from $1.7 million for the six months ended June 30, 2013. The reduction of $519,200 included the effects of lower headcount and associated personnel costs of $600,000 partially offset by increased consulting costs of $93,100.

General and Administrative



General and administrative expenses were approximately level during the six months ended June 30, 2014 compared to the six months ended June 30, 2013.

Interest Income



Interest income was approximately $2,000 and $3,200 for the six months ended June 30, 2014 and 2013, respectively. Interest income was earned from investments in cash equivalents.

Warrants offering costs



Warrants offering costs of $27,600 and $376,300 consists of offering costs allocated to warrants in the 2014 offering and 2013 offering, respectively.

Change in fair value of warrant liability

The change in fair value of warrant liability of approximately $990,000 relates to the revaluation of 2014 warrants between the closing date of the 2014 Offering to the reporting date of June 30, 2014, plus the revaluation of the 2013 warrants from December 31, 2013 to June 30, 2014.

Liquidity and Capital Resources

Our principal source of liquidity is our cash and cash equivalents. As of June 30, 2014, cash and cash equivalents totaled $13.7 million. On June 24, 2014, we entered into a securities purchase agreement providing for the issuance of (i) 664,600 shares of common stock at a price of $2.04 per share, (ii) 2,621.859 shares of Series A-3 Preferred Stock at a price of $1,000 per share, (iii) 4,022.357 shares of Series A-4 Preferred Stock at a price of $1,000 per share, and (iv) five year warrants to purchase up to 3,921,569 shares of common stock with an exercise price of $2.04 per share. We received net proceeds of approximately $7.9 million from the 2014 Offering. See Note 9, Stockholders' Equity, of our Notes to Unaudited Financial Statements contained elsewhere in this Quarterly Report on Form 10-Q for further information regarding this transaction. Our ability to generate revenue to fund our operations will largely depend on the success of our diabetes products and management of our legacy neurodiagnostic business to optimize cash flow. A low level of market interest in NC-stat DPNCheck or SENSUS, an accelerated decline in our neurodiagnostics consumables sales, or unanticipated increases in our operating costs would have an adverse effect on our liquidity and cash generated from operations. The following table sets forth information relating to our cash and cash equivalents:

June 30, December 31, 2014 2013 Change % Change ($ in thousands) Cash and cash equivalents $ 13,693.8$ 9,195.8$ 4,498.0 48.9 %



In order to supplement our access to capital, we are party to an amended Loan and Security Agreement, with a bank which provides us with a credit facility in the amount of $2.5 million, or the Credit Facility. The amended Credit Facility expires on January 30, 2015. Amounts borrowed under the Credit Facility will bear interest equal to the prime rate plus 0.5%. Any borrowings under the Credit Facility will be collateralized by our cash, accounts receivable, inventory, and equipment. The Credit Facility includes traditional lending and reporting covenants. These include certain financial covenants applicable to liquidity that are to be maintained by the Company. As of June 30, 2014, we were in compliance with these covenants and had not borrowed any funds under the Credit Facility. Of the Credit Facility limit, $225,000 is restricted to support a letter of credit issued in favor of our landlord in connection with the lease of our facilities in Waltham, Massachusetts. Consequently, the amount available for borrowing under the Credit Facility as of June 30, 2014 was $2,275,000.

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To date our cash and cash equivalents have increased by $4.5 million this year reflecting proceeds of $8 million from the 2014 Offering offset by our loss from operations.

In managing our working capital, we monitor days sales outstanding, or DSO, and inventory turnover rate, which are presented in the table below:

Quarters Ended Year Ended June 30, December 31, 2014 2013 2013 Days sales outstanding (days) 36 42 32 Inventory turnover rate (times per year) 4.1 2.6 3.9 The following table sets forth information relating to the sources and uses of our cash: Six Months Ended June 30, 2014 2013 (in thousands) Net cash used in operating activities $ (3,444.9 )$ (3,663.2 ) Net cash used in investing activities (17.4 ) (16.0 )



Net cash (used in) provided by financing activities 7,960.3 4,566.1

Our operating activities used $3.4 million in the six months ended June 30, 2014. The primary driver for the use of cash in our operating activities during the first six months of 2014 was our net loss of $3.4 million, which included non-cash charges of $170,000, for stock-based compensation and for depreciation and amortization, and non-cash credits of approximately $990,000 for revaluing outstanding warrants at fair value.

We believe that our cash and cash equivalents at June 30, 2014 and the cash to be generated from expected product sales will be sufficient to meet our projected operating requirements for at least the next twelve months. We continue to face significant challenges and uncertainties and, as a result, our available capital resources may be consumed more rapidly than currently expected due to (a) unanticipated decreases in sales of our products and the uncertainty of future revenues from new products; (b) changes we may make to the business that affect ongoing operating expenses; (c) changes we may make in our business strategy; (d) regulatory developments affecting our existing products and delays in the FDA approval process for products under development; (e) changes we may make in our research and development spending plans; and (f) other items affecting our forecasted level of expenditures and use of cash resources. Accordingly, we will need to raise additional funds to support our future operating and capital needs beyond the next twelve months. We may attempt to obtain additional funding through public or private financing, collaborative arrangements with strategic partners, or through additional credit lines or other debt financing sources to increase the funds available to fund operations. However, we may not be able to secure such financing in a timely manner or on favorable terms, if at all. We have filed a shelf registration statement on Form S-3 with the SEC to register shares of our common stock and other securities for sale, giving us the opportunity to raise funding when considered appropriate at prices and on terms to be determined at the time of any such offerings. Pursuant to the instructions to Form S-3, we currently have the ability to sell shares under the shelf registration statement, during any 12-month period, in an amount less than or equal to one-third of the aggregate market value of our common stock held by non-affiliates. As a result of the June 2014 Offering, we will be limited in the use of the shelf registration statement until June 2015. We have also filed a registration statement for an equity offering on Form S-1, which has not yet been declared effective. If we raise additional funds by issuing equity or debt securities, our existing stockholders may experience dilution, and the new equity or debt securities may have rights, preferences and privileges senior to those of our existing stockholders. If we raise additional funds through collaboration, licensing or other similar arrangements, it may be necessary to relinquish valuable rights to our potential products or proprietary technologies, or grant licenses on terms that are not favorable to us. Without additional funds, we may be forced to delay, scale back or eliminate some of our sales and marketing efforts, research and development activities, or other operations and potentially delay product development in an effort to provide sufficient funds to continue our operations. If any of these events occurs, our ability to achieve our development and commercialization goals would be adversely affected.

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Off-Balance Sheet Arrangements, Contractual Obligation and Contingent Liabilities and Commitments

As of June 30, 2014, we did not have any off-balance sheet financing arrangements.

See Note 6, Commitments and Contingencies, of our Notes to Unaudited Financial Statements for information regarding commitments and contingencies.

Recent Accounting Pronouncements

In May 2014, the FASB and the International Accounting Standards Board ("IASB") jointly issued Accounting Standards Update ("ASU") No. 2014-09, Revenue from Contracts with Customers ("ASU 2014-09"), a comprehensive new revenue recognition standard that will supersede nearly all existing revenue recognition guidance. The objective of ASU 2014-09 is that a company will recognize revenue when it transfers promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. ASU 2014-09 will be effective for the first quarter of 2017. An entity can elect to adopt ASU 2014-09 using one of two methods, either full retrospective adoption to each prior reporting period, or recognizing the cumulative effect of adoption at the date of initial application. The Company is in the process of evaluating the new standard and does not know the effect, if any, ASU 2014-09 will have on the Consolidated Financial Statements or which adoption method will be used.

Cautionary Note Regarding Forward-Looking Statements

The statements contained in this Quarterly Report on Form 10-Q, including under the section titled "Management's Discussion and Analysis of Financial Condition and Results of Operations" and other sections of this Quarterly Report, include 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, or the Exchange Act, including, without limitation, statements regarding our or our management's expectations, hopes, beliefs, intentions or strategies regarding the future, such as our estimates regarding anticipated operating losses, future revenues and projected expenses; our liquidity and our expectations regarding our needs for and ability to raise additional capital; our ability to manage our expenses effectively and raise the funds needed to continue our business; our belief that there are unmet needs in the treatment of diabetic neuropathies and adjacent forms of chronic pain and our expectations surrounding our NC-stat DPNCheck and SENSUS devices; our plans to develop and commercialize our products; the success and timing of our studies and/or clinical trials; our ability to obtain and maintain regulatory approval of our existing products and any future products we may develop; regulatory and legislative developments in the United States and foreign countries; the performance of our third-party manufacturers; our ability to obtain and maintain intellectual property protection for our products; the successful development of our sales and marketing capabilities; the size and growth of the potential markets for our products and our ability to serve those markets; the rate and degree of market acceptance of any future products; our reliance on key scientific management or personnel; the payment and reimbursement methods used by private or governmental third-party payers; and other factors discussed elsewhere in this Quarterly Report on Form 10-Q or any document incorporated by reference herein or therein. The words "believe," "may," "will," "estimate," "continue," "anticipate," "intend," "expect," "plan" and similar expressions may identify forward-looking statements, but the absence of these words does not mean that a statement is not forward-looking. The forward-looking statements contained in this quarterly report are based on our current expectations and beliefs concerning future developments and their potential effects on us. There can be no assurance that future developments affecting us will be those that we have anticipated. These forward-looking statements involve a number of risks, uncertainties (some of which are beyond our control) or other assumptions that may cause actual results or performance to be materially different from those expressed or implied by these forward-looking statements. These risks and uncertainties include, but are not limited to, those factors described in the section titled "Risk Factors" below and in our 2013 Form 10-K. Should one or more of these risks or uncertainties materialize, or should any of our assumptions prove incorrect, actual results may vary from those projected in these forward-looking statements. We undertake no obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise, except as may be required under applicable securities laws.

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