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Cutera, Inc. (NASDAQ:CUTR)

F3Q08 Earnings Call

November 03, 2008 at 5:00 pm ET

Executives

John Mills - Integrated Corporate Relation

Kevin Connors - President and Chief Executive Officer

Ronald Santilli - Chief Financial Officer; Vice President of Finance and Administration

Analysts

Thomas Gunderson - Piper Jaffray

Dalton Chandler - Needham & Company

Anthony Vendetti - Maxim Group, LLC

Operator

Welcome to the Cutera Incorporated third quarter 2008 earnings conference call. (Operator Instructions) I would now like to turn the conference over to John Mills of Integrated Corporate Relation. Please go ahead sir.

John Mills

By now everyone should have access to the third quarter 2008 earnings release, which went out today at approximately 4:00 pm eastern time. The release is available on the Investor Relations portion of Cutera’s website, at cutera.com and with its Form 8-K filed with the SEC and available on its website at sec.gov.

Before we begin, Cutera would like to remind everyone that these prepared remarks contain forward-looking statements, including statements concerning long-term domestic and international growth opportunities and strategies, future spending and execution on various aspects of our operations and business, expectations for increasing revenue, generating additional cash and returning to profitability and the development and the development and commercialization of existing and planned products.

Also, management may make additional forward-looking statements in response to your questions. Factors that could cause Cutera’s actual results to differ materially from these forward-looking statements include the global economic crisis which may reduce consumer demand for its products as potential customers to delay their purchase decisions and make it more difficult for some potential customers to obtain credit financing.

Cutera’s ability to increase revenue and manage expenses worldwide, the length of the sales cycle process, its ability to successfully develop and acquire new products and market them to both its installed base and new customers, unforeseen events and circumstances related to it’s operations, government regulatory actions, and those other factors described in the section entitled ‘Risk Factors’ in it’s most recent 10-Q filed November 3rd, 2008 with the SEC.

These forward-looking statements do not guarantee future performance and therefore you should not rely on them in making an investment decision without considering the risk associated with such statements. Cutera also cautions you to not place undue reliance on forward looking statements, which speak only as of the date they were made.

Cutera undertakes no obligation to update publicly any forward-looking statements to reflect new information, events or circumstances after the date they were made or to reflect the occurrence of unanticipated events.

With that I will turn the call over to the Company’s President and Chief Executive Officer, Mr. Kevin Connors.

Kevin Connors

Good afternoon everyone and thanks for joining us today to discuss Cutera’s results for the third quarter ended September 30, 2008. On today’s call I’ll provide an overview of our results, then Ronald Santilli, our CFO will provide additional details on our operating and financial results. Finally, I will provide some closing comments and open the call to your questions.

During the third quarter, we continue to be affected by challenging economic conditions. But, we were able to make significant progress towards our goal of bringing our operating expenses in line with our current revenue trend.

However, our third quarter revenue of $19.1 million which represents the contraction of 32%, compared to the same period last year was greater than expected and offset these operating improvements resulting in a net loss for the quarter of $0.22 a share. That net loss included $0.19 per share relay to an impairment charge for the write down of our investments and auction rate securities. We are pleased to have generated $2.9 million in operating cash flow during the quarter, which reflects the fundamental strength of our business model.

The U.S revenue in the third quarter of 2008 was $9.5 million or 46% lower than the amount reported for the third quarter of 2007. We are continuing to engage many new prospects. I believe this revenue decline was primarily driven by two factors.

First, we are experiencing a protracted sales like of results of this current economic crisis. We have been successful on expanding our business beyond dermatologists and plastic surgeons, physician specialties. However, we feel that the current market conditions may be causing some of non-core position prospects to defer a purchasing decision at the time even though, most of those decisions are not limited by credit barriers.

We further analyze our North American performance and we believe that a segment of our business. Those aesthetic practices that operate outside of establishment or co offices are being particularly affected by the economic environment. We believe that some of these prospects may be finding it more difficult to attain credit financing but that most in the specific category are delaying their purchasing decisions.

We target significant marketing resources toward that group as well as others. However, as I will be explaining further in a moment, you got some exciting initiatives towards targeting our pearl and just really Pearl fractional products to the Dermatology, and plastic surgeon offices.

Second, we believe our revenue for the quarter was also impacted by the relative timing our product launches. We received FDA clearance for our new Pearl fractional product recently and started shipping only during the end of the quarter. In contrast, FDA clearance for Pearl product was received in early 2007, which allowed us to enjoy significantly higher upgrade revenue for the entire third quarter of 2007.

International revenue decreased 8% in the third quarter of 2008 compared to third quarter 2007, and accounted for half the quarter’s overall revenue. During the past quarter, we saw strength in many of our direct territories in Europe. Latin America also committed to perform well for us. When measured on a nine months year-to-date basis, our international revenue increased 18% compared to the same period last year.

We have made significant investments in developing our [6:32] launch infrastructure, and even with the current economic uncertainty affecting different world regions, we expect to continue our path of long term overall international growth.

We are taking decisive action in response to these challenging economic times, including efforts to bring our operating expenses in line with our current revenue trend. As indicated in our last call, we implemented some expense reduction measures during the third quarter and reduced our operating expenses by $2.9 million compared to the second quarter of 2008.

We are pleased with the flexibility in business model that enabled us to lower expenses quickly and respond to our lower current revenue level. We remain committed to increasing our revenue and profits in generating cash. Turning to research in development, we are continuing to develop innovative solutions and expand the clinical understanding and application to the current products.

We believe that strategic ongoing investments in product research and development are critical to our success. Even in these challenging economic times and in line with that principle, we continue to keep our investments high in this area. We are committed to introducing new products and applications to various segments of the aesthetic market and we are looking forward to a planned new product launch in the first half of 2009.

We will provide a more detailed update on our engineering efforts during the fourth quarter of 2008 conference call. Our new ProFractional product is designed to improve pronounced wrinkles by targeting the deep dermal layer enables us to compete in this expanding fractional market. The clinical results for this application are continuing to exceed our expectations. We do not begin shipping ProFractional until the end of the third quarter and it was not a meaningful contributor to revenue in that period.

However, we are optimistic about the long term contributions that we will make to our future revenue as we educate the market on its features and benefits. We believe that both ProFractional and our Pearl product launched last year are duly suited for the dermatology and plastic surgeon offices.

We have sharpened our sales in marketing focus on this market segment and expect many new opportunities with these products in the coming quarters. Now I would like to turn the call over to Ron to discuss our financials in more details; Ron.

Ronald Santilli

Thanks Kevin and thanks to all of you for joining us today on our third quarter 2008 conference call. Third quarter 2008 revenue was $19.1 million, a 32% decrease when compared to the third quarter of 2007. Our net loss for the third quarter was $2.8 million or $0.20 per diluted share. Included in these results are the $2.4 million or $0.19 per diluted share impairment charge related to the write down of our investment in auction rate security. Excluding the impairment charge net of tax, our loss was $0.03 per share.

Product revenue for the third quarter of 2008 decreased by 34% when compared to the third quarter of 2007. These results were primarily driven by an uncertain world wide economy.

Upgrade revenue for the third quarter of 2008 decreased 61% when compared to the third quarter of 2007. This decrease was primarily attributable to our large number of Pearl upgrade sales in the third quarter of 2007. We commenced shipments of that product earlier that year. In contrast, we just started shipping our new ProFractional in the end of third quarter of 2008 and have many initiatives in place to increase our upgrade revenue in the fourth quarter. We are pleased with the clinical results of ProFractional and we will be focusing our efforts with the core specialty in penetrating sales and building relationship with the opinion leaders.

Service revenue for the third quarter of 2008 increased 25% to $2.9 million when compared to the third quarter of 2007. Although we are pleased with our third quarter growth rate, our sequential service revenue growth rates are declining. As a result, a few customers are likely to purchase service contracts.

We believe this reduced customer demand for service contract is due to the challenging economic environment combined with the strong reliability of our products. Customers appear to be more willing now to accept the financial risk and paying on time in material basis rather than purchase a term service contract.

Titan refill revenue for the third quarter of 2008 increased by 14% to $1.3 million compared to the third quarter of 2007. Titan remains the popular application that is sold on a majority of our Xeo systems.

We are continuing to experience growth in our business from existing customers. During the third quarter of 2008, 32% of our revenue was derived from sales of service upgrades in Titan refill. We are committed to strong customer satisfaction and believe we will continue to realize greater accretive growth in our annuity revenue categories once the economy becomes more stable.

I will now address our operating performance. Our gross margin in the third quarter of 2008 was 59%, compared to gross margin of 66% in the third quarter of 2007. The decrease in gross margin was primarily attributable to higher service and Titan refill revenue as a percentage of total revenue, which has a lower gross margin than our other revenue categories, increased level of international distributed business, which has slightly lower gross margins than our direct business, and lower than expected overall revenue which reduced the leverage of our manufacturing and service department expenses and was diluted to a gross margin percentage in the short term.

Sales and marketing expenses for the third quarter of 2008 were $8.1 million or 42% of revenue compared to $10.6 million or 38% of revenue for the third quarter of 2007.

The decrease in expenses in the third quarter of 2008 in absolute dollars was due primarily to our reduced marketing and sales cost in North America. As a reminder, we lowered our sales territories in North America to 46 in July. The increase sales and marketing expenses as a percentage of revenue was due primarily to lower than expected U.S. revenue.

Research and development expenses were $1.8 million in each of the third quarters of 2007 and 2008. Although the total spending is flat, as the percentage of revenue at an increased from 6% in the third quarter of 2007 to 10% in the third quarter of 2008 due to our decline in revenue. We intend to increase our dollar investment in this area and our continuing commitment to develop and commercialize innovative products and applications.

General and administrative expenses increased slightly from $3.1 million in the third quarter of 2007 to $2.6 million in the third quarter of 2008, although the total spending declined, as a percentage of revenue it increased from 11% to 14%, due to our lower level of revenue. Our effective income tax rate for the third quarter of 2008 was 3%. This rate has decreased from previously mentioned rates due primarily to our lower than expected profit levels and our tax exempt interest income becoming a larger percentage of the projective pretax income for fiscal 2008.

For Q4 2008 modeling purposes we suggest using effective tax rate of approximately 10% for the remainder of 2008. For modeling purposes in 2009 we recommend using a quota of 25% effective tax rate.

Turning to the balance sheet, our financial position remains strong. As of September 30th, 2008, we had a $109.4 million in cash marketable securities in long term investments, with no debt. This represents over $8.50 per outstanding share.

We are pleased with the $2.9 million of cash generated by operations during this challenging quarter and believe we can continue to generate operating cash flow even during in this uncertain economic time.

During the quarter, we have recorded a non cash impairment charge of $2.4 million or $0.19 per diluted share for the write down of our investment and auction rate security. Because this is an unrealized loss, there was no net tax impact for this impairment charge.

As a reminder, we have $13.4 million par value invested in various auction rate securities. These securities are guaranteed to maturity by either federal or municipal government. The securities has scheduled to mature 20 to 35 years from now.

Liquidity for these securities was previously provided by an auction process, which typically occurred every 30 days. However, due to the US financial crisis, this auction has been failing since February of 2008, thus eliminating the short term opportunity for liquidity.

Though we took this non-cash impairment charges in the third quarter, we have not sold any of these securities. If this market reestablishes itself, we will be able to recover some of this charge. However, if evaluation of these securities further deteriorates, we will be required to record additional impairment charges into each quarter.

Net accounts receivable at the end of the third quarter of 2008 was $6.5 million and the DSOs were 31 days. Our DSO continues to remain strong and was better than our targeted 35 to 45 days, due to a thorough credit approval process and strong collection effort.

We have not changed our credit standards during these temporary economic times and are pleased that our results remain among the best in the industry.

Inventories increased slightly from $8.6 million at June 30, 2008 to $8.8 million at September 31, 2008. This inventory level calculates to over four turns per year.

Now that I’ve concluded my overview of Cutera’s financial performance, I’ll turn the call back to Kevin.

Kevin Connors

In the coming quarters, we will be focusing our efforts on, one, continuing the development of the Pearl Fractional story with the heightened focus on dermatology and plastic surgeon offices. We are pleased with the clinical results of this product and are excited about the opportunities that presents within this segment of the market.

Two, we will also continue to closely monitor the evolving demands of our customers and consumers while aligning our sales and marketing in R&D resources quickly to address any market changes.

Three, as we showed last quarter, continue our efforts to decisively manage expenses since they remain within targeted bubble to achieve and maintain long term profitability.

And fourth, we recognize that we will experience a shift in our business, customers that once generated a significant part of our business appeared to be more impacted by a challenging economic environment. We have identified the need to focus ourselves in marketing efforts to better capture a healthier segment of the market.

We believe that we have the right product to date to form at a higher level in future as we are not satisfied with the current performance level.

While the near term prospects for industry are difficult to predict given the economic uncertainty, we believe that our diverse global infrastructure, solid cash position, strong portfolio products designed for various market segments and various development projects underway offer continuing long term opportunities for our Company.

Now, I would like to open up the call for your questions. Operator.

Question-and-Answer-Session

Operator

(Operator Instructions). Your first question comes from the line of Tom Gunderson – Piper Jaffray. Please go ahead.

Thomas Gunderson – Piper Jaffray

It is a tough economy out there. Everybody knows, and you have talked about it. Where, in what category are ASPs under the most pressure? How did they do during the quarter?

Kevin Connors

ASPs had slight pressure on them but nothing significant, Tom. The only caveat to that is that we did have a pretty significant part of our business through distributors, and so that transfer pricing is at a lower price, so we think that is a probably the lion’s share of the reason for that.

Thomas Gunderson – Piper Jaffray

What the distributors put the screws to you as well in these tough times?

Kevin Connors

No. We are not experiencing any of that, Tom.

Thomas Gunderson – Piper Jaffray

Okay. And then, I am assuming but tell me if I am wrong or right. I am assuming that upgrades from physicians, from offices that already have your products and are already generating income from those but upgrades might be a little more immune to tough economy. Has that been your experienced?

Kevin Connors

Well, I think the biggest cause for upgrade business to pop one way or the other is timing of new product launch. So, clearly we are focused on telling the Pearl Fractional story to our existing customers and so, going forward we expect to see more significant contributions from that and as we launch new products that tends to have a very positive impact on an upgrade business.

Thomas Gunderson – Piper Jaffray

All right, from those existing customers selling Pearl Fractional, are you get in the same level of push back that you get from new customers as well as being able to take on additional debt at this time?

Kevin Connors

I do not think it is so much a credit issue, Tom. We do expect to have a strong upgrade business going forward. Now, that we have more, we will be able to accumulate more experience with Pearl Fractional.

Thomas Gunderson – Piper Jaffray

Okay, and then last question. I think it was last week you traded for a few moments below cash level. One of the worries that Wall Street has out there is that you might make an acquisition that would be good for long term business strategy but maybe not so good for near term revenue or earnings growth. Can you tell us a little bit about what you are thinking about acquisitions right now?

Kevin Connors

Well, we have an open mind to look at new opportunities but we do not have anything in the pipeline that we are looking to acquire.

Thomas Gunderson – Piper Jaffray

Okay. Thanks.

Operator

Your next question comes from the line of Dalton Chandler – Needham & Company. Please go ahead.

Dalton Chandler – Needham & Company

The 2.9 million in cash reduction, you have mentioned, I assume you did not get the full benefit of that in the third quarter but you will in the fourth quarter. Could you comment on that?

Ronald Santilli

Hi, Dalton, it is Ron. Yes, we did get most of that in the third quarter but the adjustments would made very early in July. So most of the adjustments from what we had said at the beginning of last quarter have taken effect.

Dalton Chandler – Needham & Company

Okay and then just follow up on who is still buying. Do you find that practices with established aesthetics practices are continuing to expand the practice by your equipment or have a full back as well?

Ronald Santilli

Well, in the script we talked about the customers that seem to be doing relatively well in this current environment, the greatest success stories seem to be with existing aesthetic practices. They are continuing to buy equipment and they have successful practices where they have been able to successfully market these procedures and as new applications are launched they tend to continue to be interested to add those things to their practice. So long winded answer, but, yes, we are using that.

Dalton Chandler – Needham & Company

Okay, good, and the Titan refills were up year-over-year but they were down a bit sequentially. Do you think that is due to a decline in procedures or is that just the timing issue with the refill?

Ronald Santilli

Well, I think probably the right apples-to-apples comparison is the Q3 because typically at the summer time a lot of these procedures pull back a bit. But it has been pretty steady growth for many quarters affecting last quarter and then we grew up 26%. So, it does get a little lumpy and there is some seasonality to that.

Dalton Chandler – Needham & Company

Okay and then just last question here. You have mentioned the first half ’09 new product launch. Is that, would that be a product that is still pending approval or do you need approval or is it something that maybe you could launch without approval?

Kevin Connors

Yes, we are not going to comment on that Dalton. I do not want to tip our hands to the competition in terms of what we are working on but we feel that we will have a regulatory strategy in place to have something in the market the first half.

Dalton Chandler – Needham & Company

Okay. Thanks a lot.

Operator

(Operator Instructions). Your next question comes from the line of Anthony Vendetti – Maxim Group. Please go ahead.

Anthony Vendetti – Maxim Group, LLC

The percent financing for your products, we have heard that that number for some companies has gone down due to the availability creditor or lack thereof. Can you talk about what percent in the third quarter of your sales were financed?

Ronald Santilli

Most of our sales are financed. One way or the other meaning through third quarter leasing source or they have their own local bank where they obtain a loan and get their funding that way. Most of who we sell to our physicians who are still very credit worthy. We are finding more of the issues as being primarily here in the US where they are deferring the decision to purchase and are not as much related to lack of credit.

Anthony Vendetti – Maxim Group, LLC

So would you say, Ron, when you say most of the sales have some sort of financing whether to third party or to local bank. Is most 60%, 70%, or are you talking 80%, 90%?

Ronald Santilli

Yes, it is probably up there into the 80% range that they are typically not writing a check, $150,000 check. They are getting financing somewhere to finance the capital purchase.

Anthony Vendetti – Maxim Group, LLC

Right, right, and you guys do not do any of, you do not self finance any of these at this point, do you?

Ronald Santilli

That is correct. We do not. We work with third party finance leasing companies.

Anthony Vendetti – Maxim Group, LLC

And the tax rate that you have said for fourth quarter, you expect to be, what was that?

Ronald Santilli

At about 10%.

Anthony Vendetti – Maxim Group, LLC

Just 10%, and then ’09 you said to use 25 or 35?

Ronald Santilli

A 25% will probably good.

Anthony Vendetti – Maxim Group, LLC

Twenty five percent and that’s because of the increase in international revenues?

Ronald Santilli

Yes, part of it is the international. Part of it is also related to tax exempt interest income, which is becoming a bigger piece of our profit which of course is exempt from income tax.

Anthony Vendetti – Maxim Group, LLC

Okay and any affects losses this quarter?

Ronald Santilli

Nothing appreciable, I think there were maybe 60,000 to 70,000 in there but nothing large.

Anthony Vendetti – Maxim Group, LLC

And on the Pearl Fractional, that debt product the list price for that and the gross margin on that, is that higher than your current gross margin, your average gross margin for the products that you have now?

Ronald Santilli

Pearl and Pro Fractional are slightly more expensive products, since they are laser based. So they are a little bit lower but not significantly. Obviously, our gross margins have declined and I think a lot of that is related to the service and Titan refill business which has become a bigger piece of the revenue and that is at lower margins.

Anthony Vendetti – Maxim Group, LLC

Okay, and the list on the Pearl Fractional, do you have that, the actual list price.

Ronald Santilli

Well, it is showed at on, typically on Xeos.

Kevin Connors

And that is just over $100,000.

Ronald Santilli

Yes.

Kevin Connors

For a single application version of that on Xeo.

Anthony Vendetti – Maxim Group, LLC

Okay, and Kevin just a follow up regarding the new product, is this a new product platform or is this an upgrade to something that you currently have and that supposed to be out by 2009?

Kevin Connors

We are not going to comment exactly when we will have it released, but our plan is to have it the first half of the year and we want to be able to talk about it more on the next conference call.

Anthony Vendetti – Maxim Group, LLC

Okay. Anything else in the pipeline that might be different in, not necessarily new platform for you, but maybe something that the industry has not yet though of that you have in the pipeline for 2009 or 2010.

Kevin Connors

Well we are working on some exciting things beyond what we are talking about in the first half, and I think that it is all aesthetic application but do not always were light based. So I think there are some pretty exciting things.

Anthony Vendetti – Maxim Group, LLC

And lastly on the international, you said Latin America was strong, any other international companies or countries that were strong and helped this quarter?

Ronald Santilli

We are pleased with our directs in Europe as well.

Kevin Connors

Japan is moving along as well.

Operator

Thank you and at this time I am showing no further questions in the cue. I would like to turn the call back over to Mr. Mill.

Kevin Connors

Thank you for participating on our call today. We look forward to seeing you at various investor events during the quarter; including the Piper Jaffray Healthcare Conference and updating you on our fourth quarter conference call in February. Good Afternoon and thanks for your interest in Cutera.

Operator

Ladies and gentlemen, that does conclude our conference for today. We thank you for your participation and you may now disconnect.

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