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Executives

Richard Packer – Chairman, President and CEO

Ernie Whiton – VP of Administration and CFO

Analysts

Joshua Zable – Natixis Bleichroeder

Jonathan Block – SunTrust Robinson Humphrey

Greg Brash – Sidoti & Co.

ZOLL Medical Corporation (ZOLL) F4Q08 (Qtr End 09/28/08) Earnings Call Transcript November 13, 2008 10:30 AM ET

Operator

Thank you for holding for the ZOLL Medical Corporation 2008 fourth quarter and annual results. Today's call is being recorded at the request of ZOLL Medical Corporation. If anyone has any objections, you may disconnect now.

At this time I would like to introduce your host, Mr. Richard Packer, Chairman and Chief Executive Officer. Sir, you may begin.

Richard Packer

Great. Thank you for joining us this morning. I have with me Jon Rennert, our President, who joined us in July, should any of you have any questions for him on the impressions he has after four months, when we get to that. And of course, I have our CFO, Ernie Whiton, with me who will start with our Safe Harbor statement.

Ernie Whiton

All right. Thanks Rick. The matters we will be discussing today, which are not historical information, consist of forward-looking statements. Reliance should not be placed on forward-looking statements, because they involve risks and uncertainties, which may cause actual results, performance, and achievements of the company to differ materially from the anticipated future results, performance and achievements expressed or implied in such forward-looking statements.

Forward-looking statements may contain estimates and actual results may vary from estimates. Factors such as overall economic conditions, the demand for the company's products and services, availability of raw materials and manufacturing capacity, risk of non-payment of accounts receivable, risks associated with foreign operations, risks involved in litigation and other risks and uncertainties described from time-to-time in the company's filings with the SEC may cause actual results to differ materially from management's current estimates and expectations. The company disclaims any current intention to update forward-looking statements in the event of any changes in the facts, circumstances or expectations that underlie those statements. Rick?

Richard Packer

Great. Thanks Ernie. Both Ernie and I will speak this morning and then we will turn to your questions. I will cover a bit of history, but we will spend more time on the items such as the LifeVest that will carry us through 2009 and I believe have us positioned so well for the future. Ernie will carry the load on 2009 with the detail needed to explain how we will still be able to grow earnings in 2009 in spite of tough economic times and a significant foreign-exchange headwind. So let us get started.

2008 was obviously a terrific year, with our revenue growing just under 30%. This is by far the fastest revenue growth in our industry, and is being achieved because ZOLL has the most diversified portfolio of products, and we are selling to a wider market than anyone else. This breadth provides us a certain resiliency, which you saw in our results in Q4 and as we move through the back end of the year, when market conditions were clearly more challenging. And it is this breadth that will help us with 2009's challenges and really have us moving when the economy recovers.

At the bottom line, 2008 was also a great year, growing in excess of 40%. This is evidence of the leverage that exists within ZOLL as we gain scale; and we did this at the same time we were investing in the future growth drivers, such as the LifeVest and hypothermia.

Turning to the fourth quarter, in the North American hospital market, we showed no growth over fourth quarter of 2007. However, recall last year this area was up 46%. So it is a very tough quarterly comp. The core hospital fees excluding military and big government was flat, but I point out we achieved 24% for the year in hospitals, which is extremely good. So we looked at the flat against a tough comp has no problem. Overall, we believe the combination of R Series and M Series is allowing us to take market share, and we see this continuing. Also, AutoPulse gained a lot of momentum this year, with orders up over 30%.

On the pre-hospital side, Q4 was strong with 20% growth. EMS sales grew 10%, even in the face of pretty uncertain spending conditions. We did see some business move out of the quarter due to credit issues and budget pullbacks. However, we also saw one of the deals that pushed out of Q3 that I spoke about in the July call come through in Q4, as that customer worked through their funding issue. I think this is evidence that clinicians need our products, it is a necessity not a luxury; and that even if things are delayed somewhat, they still need to buy. The other elements of pre-hospital, public access AEDs, data management, and LifeVest were all on track, with the LifeVest continuing to accelerate.

International had another very strong quarter, and continues its recent trends. Here too, we're gaining traction with CPR and the AutoPulse. The R Series allowing us to gain market share in the hospitals. In EMS, we continued to do well, but with our competitor Physio-Control shipping their new LIFEPAK 15 to the international EMS customers, we will have to fight harder on that front.

So now let us look forward. As I said, Ernie will take us through the details of the 2009 plan, but generally, we see 2009 with all the questions we have about the economy, spending credit markets, foreign exchange, et cetera as a time to hunker down and just bull through, without damaging our longer-term prospects. In fact, if we are able to grow our profits, while taking a significant hit from foreign exchange and still investing in hypothermia, LifeVest, and absorbing well-challenged defib operations, it will be a real testament to the diversified business we are building here at ZOLL, and an accomplishment my team will be quite proud of.

So I will cover some of the items that will drive us forward, starting with the LifeVest product, about which we have spoken little. However, after two years of closely tracking progress, seeing what works and what does not, and how the LifeVest business builds over time, we believe we cannot talk with some assurance as to how the LifeVest business will evolve. Recall that LifeVest is a wearable defibrillator that serves primarily as a temporary safety net for someone who has been identified as having an elevated risk of a cardiac event. For example, somebody waiting for an ICD implant. The LifeVest is noninvasive, can be taken off when a patient no longer needs it, but operates just like an ICD in that it is monitoring the heart rhythm 100% of the time, it is fully automatic, and it saves the patient 99% of the time, just like an ICD.

Thus far, we have achieved over 20,000 patient months of use. And as we sit here today, over 1300 patients are currently wearing the device. The LifeVest is prescribed by a physician to be worn by a patient. It is a reimbursed device, fully covered by Medicare, and average reimbursement rates are around $2400 per month. A typical patient wears the device between two and three months, although some patients have chosen to wear the device much longer. Because this is a reimbursed device, this revenue stream is much less susceptible to economic conditions. It is driven by patients having events such as heart attacks and being diagnosed with heart failure. The LifeVest is rented to the patient and ZOLL, acting as a durable medical equipment supplier bills the insurance company. When the device is no longer needed by one patient, it is refurbished and ready for the next patient. As a result of this rental model, we are achieving about 75% gross margins in this business.

Looking at revenue growth for the LifeVest, we went into the year expecting 40% to 50% year-over-year growth, and we achieved somewhat more. In 2009, we expect growth to accelerate based on traction in existing territories and new sales territories that have been added and will be added. We expect growth to be over 60% in 2009. We currently have only 54 sales reps today and we estimate we need more than 100 to cover the market. So we have a long way to go. We will add another 15 or so this year. The LifeVest business was profitable in Q4, and we expect it to grow in profitability throughout 2009, while still adding sales reps.

So in the LifeVest, we have the makings of a large, very profitable business addressing an unmet clinical need and the business which is most likely recession-proof. As Ernie will cover, we expect more out of this business in 2009 than we did last July and it is one of the diversified businesses within ZOLL that will help us through 2009 and position us strongly in 2010 and beyond. There is much more to help on the LifeVest and I will be happy to answer any questions you have. But let me move on to other items that are key drivers for our future.

We notice in the release the launch of our R Series BLS device. We have also launched the WiFi capability for the R Series. The BLS version introduces very unique user interface technology that makes a sophisticated unit like an R Series seem like a dirt simple AED to a less-trained rescuer. The BLS version also allows us a lower priced R Series, so that we can accelerate the phase-out of the older M Series. Combined with WiFi, which gives this industry unique self test and BioMed features, we have significantly strengthened our hospital product offering.

In EMS, we have introduced to the international market new technology that allows our E Series defibrillator to be hooked up to the AutoPulse and for the first time ever, coordinate the chest compressions with defibrillation shocks. This will allow shocks during compressions, taking no blood flow time to near zero. This is a big deal. Recent clinical studies have shown that the length of CPR interruptions before and after defibrillation shocks are directly correlated with outcome. We are working with the FDA to get this feature approved here in the US. We see this capability as the first of many that will automatically coordinate resuscitation efforts. It is unique to ZOLL and it should help both defib and AutoPulse sales.

I would also like to mention a couple of additional items that will add strength to ZOLL as we move forward. The first is this morning's announcement that we will be adding Masimo’s carbon monoxide detection technology to our products. As you know, ZOLL was the first to adopt Masimo’s pulse ox technology and we benefited from its unique and superior performance. We see carbon monoxide detection the same way, and although you'll be sharing this market with others, for example, it will be on Physio’s LIFEPAK 15, we believe this capability will offer the market a compelling reason to buy new equipment.

Secondly, we will shortly announce that ZOLL has finally cracked the Health Trust Purchasing Group, also known as HPG. These are the folks who buy for all the Columbia HCA hospitals. We have been locked out of these hospitals up until now and had near zero market share in these hospitals, in spite of being the leader in the rest of the hospital market. This is a major breakthrough for ZOLL, one we have been working on for many years. So as we start to compete in these hospitals, we expect to see incremental business in the end of 2009 and then building in 2010.

Finally, let me touch on the Welch Allyn deal, which will add significant strength in 2010 and beyond. As previously disclosed, the deal has a number of elements. It arose of Welch Allyn’s desire to turn their defib business over to a reliable partner, so that Welch Allyn could concentrate on other areas. Basically, we are taking care of the operations part of new and existing Welch Allyn business. Welch Allyn will continue to sell AEDs, and we will take on Welch Allyn’s portable monitor and move this into the EMS market for them. We will do all of the defib service and warranty work and we will be paid for that effort. Eventually, we plan to absorb their Chicago-based defib R&D group, which will bring with it a new military defib as well as Welch Allyn’s monitoring technology, which we can use to route our product line to further strengthen its capabilities.

Basically, we ship Welch Allyn $6 million of cash to purchase tooling needed to build the products. To purchase inventory, we will eventually sell back to Welch Allyn its completed product and to purchase some software we can use in non-Welch Allyn related defibs. Depending on how quickly all of this comes together, we will spend $0.05 or so of EPS in 2009 supporting the transition, and get an incremental $12 million or so of revenues starting in 2010, I think a pretty compelling deal. So here again in the Welch Allyn arrangement, we have something that does not mean a lot in the short term, but can be quite profitable in the longer term.

If you put all the pieces together, we have compelling items such as LifeVest, R Series BLS that will help us in 2009, and a bunch of stuff coming online that will really make a difference in 2010 and beyond.

Now let me turn the call over to Ernie.

Ernie Whiton

Thanks, Rick. Let me start with our balance sheet. Our balance sheet remained solid. We finished Q4 with approximately $71 million in combined cash and investments. During the quarter, we generated approximately $15 million in positive cash from operations; during the year, we generated approximately $35 million in positive cash from operations. Our DSOs on accounts receivable were 72 versus 72 last quarter, and versus 76 last year end. Our inventory levels decreased approximately $3 million versus Q3 with inventory turnover improving from 2.9 times to 3.1 times. Raw material decreased by about $2.5 million, while combined with unfinished goods decreased about $0.5 million. Inventory turns at the end of last year were 2.9 for comparison purposes. We continue to have no debt on our balance sheet, so we have no funding issues.

Now let me turn to our P&L. From an annual P&L perspective, 2008 was a very strong year. As indicated in our press release, worldwide revenue was just under $400 million, growing 29%, with North American hospital growing 37%, pre-hospital 23%, worldwide AEDs 31%, AutoPulse 21%, and International 34%. Our gross margin decreased by about 1.5 points. Below-margin California business in Q1 cost us approximately one percentage point for the full year. Operating expenses decreased from 47% of sales to 44% of sales, reflecting leverage in our growth and our operating return on sales improved from 7% to 9%. EPS of $1.10 exceeded our original outlook for 2008 of $1.

From a quarterly P&L perspective, we achieved our objective in Q4 with revenue growth of 14% and EPS of 41%. Our gross margin of 55% was consistent with Q4 of last year. Operating expenses dropped from 45% of sales to 42% of sales, reflecting leverage in our business. Operating return on sales improved from 11% to 13%. The other expense of negative $1 million roughly reflected a foreign exchange loss from marking our foreign denominated inter-company receivable balance at the end of the quarter rate. The impact was larger than normal due to the rapid strengthening of the US dollar during the latter part of Q4.

Our tax rate of 30% reflected the decision in the fourth quarter to permanently reinvest certain foreign earnings, which we plan to invest in building our LifeVest business internationally.

Now let me turn to forward guidance. Based upon noise in the press about the economy and the uncertainty that noise can bring to near-term spending by customers in our business, we provided you with a conservative view of our business for 2009 back in July. From an overall perspective, our view of our core business in total has not changed dramatically since July, although some pieces have been adjusted. Now obviously, a lot of things in the world have changed since July, which you are all aware of, I'm not going to review these.

I'm going to focus on what is relevant to ZOLL. From ZOLL’s perspective, within our core business, some markets look at little weaker and some markets look a little stronger.

Altogether, these things essentially net out to no significant change. There are however some effects outside our core business that have changed, so I would like to focus on these. So while I would normally start with the details of our core business, I am going to hold that for now and focus on those other things that are changing.

First, as Rick noted, our LifeVest business is running stronger. While we originally estimated this business would grow 40% to 50% in 2008, in fact, it grew faster than 50%. We now believe this business will grow at 60% or more in 2009. It is important to note that as a reimbursed product, this business is not dependent upon hospital capital equipment spending. Instead, it is more related to the incidence of heart disease and heart attacks. Given the under penetration of this market, the sales resources we added in 2008 and the momentum we have gained, we believe this will grow faster than we previously estimated.

On the other hand, the US dollar has strengthened suddenly and significantly over the past couple of months. This will create a significant headwind for us in 2009, as we translate the revenues of our foreign subsidiaries into US dollars, and impact only partially mitigated by the impact of translating for co-operating expenses of these subsidiaries into US dollars. If the foreign exchange rate remains unchanged from where they were a couple days ago, this currency impact on our 2009 earnings as compared to what we reported in 2008 could be in the mid $0.20 per share range. Historically, as the dollar deteriorated in a much slower fashion over the course of a number of years, the benefit we received in our P&L was much more modest, typically a couple of pennies or so in any given quarter. We anticipate the impact in 2009 to be much more significant because of the speed at which the US dollar has suddenly strengthened.

To put this in perspective, let me give you an example. Over the past three years, the UK pound went from $1.76 at the end of Q4 of ’05 up to $2.05 and back to $1.84 at the end of Q4 of ’08. Subsequent to the end of Q4 of ’08, it has dropped to around $1.50; this represents a decrease of almost 20% in a couple of months. The dollar has suddenly and shapely reversed course over the past couple of months, and as a result the impact of the strengthening will come through P&L over the course of a single year.

From a higher level perspective, you can think of it this way. Our international revenues constitute about a quarter of our revenues, approximately half of this comes from our direct subsidiaries. If you apply a 23% drop in the average foreign exchange rate, this drives a revenue impact of about $12 million. While some of this is offset by local operating expenses, which are also denominated in local currency the bottom line impact in this example, is about $0.26. This 23% that I mentioned reflects an approximation of the overall decrease in average rates for ZOLL’s businesses for 2008 versus where they were a couple days ago.

Another thing that has changed since our July call is our strategic alliance with Welch Allyn. As previously disclosed, we have entered into a number of arrangements with Welch Allyn. These include, ZOLL manufacturing of Welch Allyn AEDs, ZOLL servicing the Welch Allyn installed base of defibrillators, and the pending acquisition of Welch Allyn’s R&D facility in Wanborough at Illinois. In 2009, we anticipate the impact of this alliance to me be modestly dilutive, say, $0.05 per share over the course of the year.

Finally, in a proactive response to the overall economic environment, we have implemented cost reduction measures across the company, these include, freezing executive salaries, limiting hiring, and reducing other expenses. From an overall 2009 EPS perspective, we believe the higher performance in the LifeVest will offset the impact of the Welch Allyn initiatives. We believe our cost reduction initiatives will partially offset the impact of the foreign exchange hit. Taken all together, we now see EPS growth of about 10% over 2008, or roughly in line with revenue growth.

Now in order to assist you with your models, before I turn the call back to Rick, let me review the details of the ups and downs in our core business. Again, the effect of these does not net out to a significant impact and is included in our 2009 EPS outlook, which I just covered. So, getting to the details, in July provided a first cut deal of 2009. Our July view had mid to high single digit growth in the North American hospital business, excluding military. For military, we assume revenue would drop from $26 million to $8 million. We assume 20% pre-hospital growth, which was comprised of mid single digits EMS growth, 30% data management and AutoPulse growth, low teens pad growth, and 50% LifeVest growth. Our international growth assumption was mid teens.

Our current view has mid single digit growth for North American hospital, excluding military versus mid to high single digit growth in July, not a huge change. Our view of the military business in 2009 has now somewhat improved from the $8 million we assumed in July. We had previously expected military orders to drop significantly moving toward the election and general conditions. However, from an orders perspective, Q4 was solid and Q1 of ’09 is looking a lot like the quarterly average run rate of the past four years, excluding the California order. So, we now expect to do better here; let’s assume, $12 million, it could be better. In pre-hospital we see mid single digit EMS growth same as before as we were already are factoring in state deficits. We now see mid to high teen data management growth versus 30% previously. Recall, these products are sold in the EMS, recall also that these products help EMS become more efficient. We see pad growth of high single digit, low double digits versus low teens; however, we see faster LifeVest growth, say 60% or a little more versus previous 50%. So, within pre-hospital overall, we see no significant change from our 20% outlook in July.

With respect to international, excluding the impact of foreign exchange, we continue to see mid to high teen growth. We recognize this is significantly below our recent trends; however, as a result of the foreign exchange impact in described earlier, our reported international growth assuming foreign exchange rates don’t change or probably show closer to the mid single digits. On a consolidated basis, we believe we might pick up a point or so of improvement in operating return on sale. This could come from either modest improvement in gross margin percentage or OpEx, operating expense as a percentage of sales. Gross margin should improve without the California contract in 2009 and with an improved mix of data management and LifeVest business, this will be partially offset by the negative impact of foreign exchange rates. Operating expenses should grow slowly in our core business. As we indicated in our press release, we will be making investments in our growth areas including, LifeVest, AutoPulse, therapeutic hypothermia, and Welch Allyn defibrillator operations. Our tax rate for 2009 is expected to approximate 35%.

From a quarterly perspective, we expect an even steeper ramp than we’ve seen historically through the course of the year in revenue and EPS. The current uncertainty in the spending environment that originally help drive our conservative outlook for 2009 is likely to have a more pronounced effect in the first half of the year. We believe that as customers gain increased visibility into their spending capability, spending will improve during the latter part of 2009. While customers can delay purchases in the short term because our core defibrillator products are standard of care, they can’t choose to go without defibrillators. As defibrillators get older, maintenance gets more expensive and risks increase. As the spending environment improves in latter part of 2009, our performance should improve. In addition with the momentum we have gained with the AutoPulse, spending should improve here as well. Our performance should also ramp up as our LifeVest, which is not dependent upon capital expense spending continues to grow with increased penetration. With respect to quarterly revenue, recall that Q1 of 2008 included $8.5 million of very low margin California revenue. So, excluding California, one view of 2009 might have revenue increasing in the mid single digits in both Q1 and Q2 with 10% growth in Q3 as things being to improve and something close to 20% in Q4. Recognizing that any quarter can vary by a few cents either up or down, one possible EPS scenario might have Q1 and Q2 each flat with 2008. Q3 growing 10% and Q4 growing close to 20%.

So, in summary our outlook for our core businesses is not much different than in July, but we get there in a different manner. We do expect the first half of 2009 to be slow with EPS flat. We expect things to pick up in the second half as customers gain visibility into their spending capability, we believe, we will have good momentum going into 2010 with defibrillators improving, AutoPulse building off our current momentum, and LifeVest continuing to penetrate the market. As the comparative impact of foreign exchange fluctuations washes out, and economic uncertainty begins to lift, we will also have contributions from Welch Allyn to look forward to. We believe we are solidly positioned in our core business and have a number of opportunities to take advantage of the investments in emerging products we’ve been making over the past few years. With a solid balance sheet, we believe as Rick said in the press release, our long term prospects have never been this strong.

Richard Packer

Great, thank you Ernie. Jonathan, if you would please moderate question and answers.

Question-and-Answer Session

Operator

(Operator instructions) Our first question is from Joshua Zable from Natixis.

Joshua Zable – Natixis Bleichroeder

Hi, guys, congrats on a great quarter. Nice for taking my call here.

Richard Packer

Thank you.

Joshua Zable – Natixis Bleichroeder

First, Ernie, I am just trying to understand, I know you did a real good job of walking us through the P&L, but I guess, it seems like your top line obviously is pretty similar to where it was or exactly the same where it was, but your EPS came down. And I know you talked about foreign exchange. My understanding was it, A, you guys had a number of contracts in dollar denominated contracts. And B, I guess, assuming the sales are lost overseas for whatever reason and they are regained in other places, is the sort of non-drop to the bottom line really more a function of Welch Allyn deal, and other things – I am just trying to put the math together here and it’s not adding up for me.

Ernie Whiton

So, there is a hit to revenue that comes from foreign exchange because our products are produced in the US, there is – as we take a hit from foreign exchange to revenue there is nothing offsetting that hit in cost of goods sold. So, that hit drops straight to gross margin. There is a partial offset in the operating expenses. So, the top line revenue hit doesn’t drop straight to the bottom line, but it drops in a fairly significant way. Offsetting that drop in revenue are pickups we are getting from things like the LifeVest, the military, and potentially some international upside in the base apples to apples local market comparative business. So, for example when I described international growth expectations on a comparative local currency basis, we said mid to high teens. You know that’s substantially slower than we’ve been growing. So, there is some potential upside. When we put all of that together, we see revenues essentially unchanged. The reason the bottom line drops is because the marginal impact of the foreign exchange hit was no relief in cost of goods sold because the products are produced in the US is greater than the marginal benefit that we get from the other revenues that are going to be up, okay? Another way to think about it is if you start at $1.40, take $0.26 off for foreign exchange, take $0.05 off Welch Allyn, add $0.06 to the LifeVest, and add $0.06 for cost reductions that we have initiated that gets you back to $1.21, which is essentially 10% growth. Does that help?

Joshua Zable – Natixis Bleichroeder

That does help very much. And just on the AutoPulse which will dovetail nicely into my next one. The $0.06 is just from higher revenue or are you guys going to sort of get some more profitability out of AutoPulse going forward?

Richard Packer

It’s – the LifeVest is what you are referring to Josh?

Joshua Zable – Natixis Bleichroeder

I am sorry, on the LifeVest, yes.

Richard Packer

I do that all the time, too. No problem. It's a combination of higher growth and pairing back some expenses, so the profitability is better in the LifeVest to the tune of about $0.06 roughly.

Joshua Zable – Natixis Bleichroeder

Great. And Rick, I know you said, you would be happy to answer questions about the LifeVest, so I am going to ask a few. Can you give us an update on number of sales people and also maybe the margin and I guess any more details there?

Richard Packer

So, the number of sales people ended at about 54. We will add 15 or so during 2009. That 54 was up from I think 26 that we ended at the end of 2007. So, fairly good addition to that sales force. The gross margin we’re operating at about 75%.

Joshua Zable – Natixis Bleichroeder

Great. And then two quick ones here; the health trust, congratulations on getting that, I am just not sure if I heard correctly, you said that would help in 2010. Is there any reason to believe it would help in 2009?

Richard Packer

Well, it may. But typically it take a little while to start showing off and getting into deals, you know bit hospital deals typically have sales cycles nine to 12 months. We may get some bluebirds if there is a customer out there that’s a disgruntled Physio customer and we show up and they’ve been trying to figure out where to place their purchase order, we may be able to steel some business. I think the safer assumption is that it’s going to take us six to nine months to get into these deals, get into these accounts, move things forward. We will get perhaps a little bit at the very end of ’09, but we should start getting some significant market share in those hospitals in ’10.

Joshua Zable – Natixis Bleichroeder

Great. And then one more quick one; I know you made a comment about Physio’s LIFEPAK 12 hitting you guys internationally. Can you just talk a little bit about that?

Richard Packer

So, they’ve introduced the LIFEPAK 15, which looks a lot like a LIFEPAK 12. It's a beefier device, so in some ways it’s like the E Series. They’ve really tried to make something that’s very rugged for the environment. Has a color screen and a few things. But it’s the basic functionality of a LIFEPAK 12. They have introduced that into the international market. They don’t have 510k as we understand for that product yet in the United States. We don’t know if that will be held up by their consent decree or not. But certainly it's available in the international market. So, we'll have to use things like the AutoPulse shock sync, in the future of where resuscitation is going and work a little bit harder in order to continue our momentum in the EMS market in international in face of a new product from a creditable competitor.

Joshua Zable – Natixis Bleichroeder

Great. Well, thanks for answering my questions, guys. I will get back in queue.

Operator

Thank you. Our next question comes from Jonathan Block from SunTrust Robinson Humphrey.

Jonathan Block – SunTrust Robinson Humphrey

Thank you. Maybe just first question, Rick for you on EMS growth, I think you pointed to mid single digit. What does that reflect in terms of the state budget, in other words, clearly these are getting worse, not better. That’s not likely to turn around soon. So, does it reflect a worsening environment there? And then as a part of that question there has been a lot talk in the upcoming lame duck session, if you would, that maybe there is some state relief, and I think certainly your experience goes back to ’03, the last time the federal government stepped in and provided state relief. Did you see any material impact to your business?

Richard Packer

Well, I think in ’03 and ’04 there was certainly a lag effect with our business. It took a while for it to really start affecting our business. But we see in ’04, a slowdown in our EMS business due to state deficits and just not as much money going out to the cities and towns in terms of revenue sharing. I don’t remember a massive amount of money flowing from the Fed to help that situation out. I may just not be recalling it or perhaps it wasn’t of the magnitude that they are talking about now. The way we are thinking about it is in July we were thinking pretty dismally about it, I would say, and you know I think we were already experiencing in July some push outs as a result of a number of different things. So, we were being pretty cautious. I don’t know that it’s gotten a whole lot worse I think there is less of a difference when something goes from bad to worse and when something goes from good to bad. So, I think we’ve already made that adjustment in our thinking. There are funny things going on in some ways the AutoPulse is a compelling story, and if a fire chief is trying to protect this flow of revenue into his department, you know we’ve heard chiefs that want to go with an AutoPulse, which is something new, different that don't have, capability that they don't have, and pitch that, rather than replacing defibrillators, which they already have on their trucks. So, there is a lot of dynamics swirling. I think we can eke out some single digit growth in that market.

Jonathan Block – SunTrust Robinson Humphrey

Okay, perfect, fair enough. And then maybe moving on over to the AutoPulse integration. I missed your commentary on when that may occur and then may be if you could speak to what you believe this would translate to in terms of market share gains. In other words, what percent of your AutoPulses are going out the door today to customers that are not ZOLL defib users?

Richard Packer

More than half of the AutoPulse go to non-ZOLL people at this point, it’s roughly in that range, hasn’t changed a whole lot. So, there is a reasonable amount of people that have AutoPulse that might now be interested in getting a ZOLL defibs so that they can do more with that AutoPulse. In terms of the timing it’s available in the international markets, we’re probably going to have to collect some clinical data to prove it to the agency that as we shock during compressions there were no untoward events. We know that that’s the case, because people have been manually trying to do what we are doing in an automated manner for a while, but we’re going to have to collect some data. I don’t really have a projection as to when we are going to get that through the agency.

Jonathan Block – SunTrust Robinson Humphrey

Okay, then Ernie I think you are going to get some questions on this one. I mean when you teed up ’09 in terms of on a quarterly breakup of the top line, I think you alluded mid single digit revenue growth in the first half, maybe 10% in 3Q, and 20% in 4Q. And it seems like pretty dramatic improvement. I just want to make sure I am thinking about this correctly. I mean you are not making the call of when we leave the recession behind us if you would, a function of that is the comps that you are up against, I mean you are up against 40% comps in the first half, and also I guess the way that FX would stake up as well, is that fair with maybe some improving trends going on in the core business?

Ernie Whiton

The quick answer is pretty much yes to all of your observations; I think you got it pretty well.

Jonathan Block – SunTrust Robinson Humphrey

Okay, and last one and then I will jump back in the queue. Just on – well again, when we think about 2009, where are you sort of ringing the expenses out of the business? I mean is there any compromise going on in terms of sales force or where are you finding the cost savings? Thanks guys.

Richard Packer

So, the question Jonathan has is you know the money that we’ve saved, where is it come from? Well, some of it’s come from high-paid people aren’t getting salary increases and can certainly deal with that. We’d like the bad alternative rather than getting ourselves in a fix and having to shed jobs, somewhere down the line. Some of it does come from initiatives that we would prefer to be initiating, but we’ve sliced back a little bit. For example, if business were stronger, I’d like to add another 10 sales people to the LifeVest sales force on top of the 15 we are going to add already. Anybody we add in the short term is pure carry because they don’t sell very much. It takes them about nine months to get up and running. So, we’ve made some compromises in terms of how quickly we are going to grow that business in order to make sure that we remain healthy and growing at the bottom line. There is a handful of marketing initiatives that we would like to move a little bit faster on that we’ll move a little bit slower on. But we certainly haven’t thrown out any of our major initiatives. We will make progress on the hypothermia product. We will make progress on our clinical efforts with the LifeVest and with the AutoPulse. We will make progress with LifeVest sales force. We will continue to spend money to push the AutoPulse more towards a standard of care. So, I think we got the right balance, but hasn’t been easy.

Jonathan Block – SunTrust Robinson Humphrey

Perfect. Thanks, guys.

Operator

Thank you. (Operator instructions) Our next question comes from Greg Brash of Sidoti & Co.

Greg Brash – Sidoti & Co.

Thanks for taking my call. I just wanted to get a better understanding of the FX hit here on EPS. So, you are saying that it is going to show obviously on the revenue side, but gross margin will likely be down in ’09 or are we also going to see it on the other income line?

Ernie Whiton

So, what I anticipate is that we get a hit in gross margin of somewhere around 1 point, right? Now that will be offset by the pickup we get from California and some mix pickup – California hit in ’08 was about 1 point. So, those two could pretty much offset each other. We then get a potential pickup coming from a higher mix of LifeVest and data management business. So, that’s how we get the opportunity to pick up a little bit of gross margin, despite the FX hit. The other income hit, this kind of gets into the mechanics of how foreign exchange works, but basically what happens is we’ve estimated the impact of foreign exchange by comparing the average rates over the course of ’08 to where we are roughly right now in terms of the foreign exchange environment, assuming that the foreign exchange environment stays exactly where it is, right? It doesn’t reverse course again, doesn’t get worse, you know, because essentially we are looking at – at the end of the year we will be looking at the average of the ’08 rates versus the average of the ’09 rates applied to what we do for business activity in ’09. That is the basis for our estimate of mid-20 hit. The impact hits other income is merely the impact of taking the receivables that have been generated at an average rate during the quarter, and marking them down to the end of quarter rate. So, essentially we have taken the overall impact of this into account by estimating average ’08 rates and then using where we are now as a proxy for average ’09 rates.

Richard Packer

So, some of it will come through other income and some of it will show up as pricing essentially and hit gross margin.

Greg Brash – Sidoti & Co.

All right. I'm just trying to get a sense I know you guys always talked in the past about enough leverage in the model to grow the operating margin by around 200 basis points a year. Obviously the Welch Allyn $0.05 is going to hit that and – decrease in the gross margin. But you are still looking for – I guess what are you looking for as far as operating margin improvement?

Ernie Whiton

We think we can grow by roughly a point.

Greg Brash – Sidoti & Co.

Okay.

Richard Packer

In ’09 and then –

Ernie Whiton

And then continue to grow. We’ve said historically, we would like to grow at a point or two a year, right? So, in ’08, we grew at 2 points based upon what we see at the moment, we think ’09 grows at about 1 point, and then going forward, we think we can pick up a point or two getting into the mid teens.

Greg Brash – Sidoti & Co.

Okay. And are these cost reductions, I mean do you already start that here in Q4, the G&A declined pretty significantly sequentially and so did the R&D.

Ernie Whiton

Yes. We’ve put in a – we have taken action effective October 01, reducing or holding the line on salaries. We are also restricting hiring in the core business to only that which is essential. And we are looking for other areas to operate more efficiently as well. But this stuff has been put in place.

Richard Packer

But in terms of the effect on Q4, the things that we are talking about really are not Q4 effects. In the Q4 numbers you are just seeing the normal ups and downs as things roll through. There’s nothing unusual in there, and there certainly wasn’t an effort in Q4 to try and mitigate a ton of spending.

Greg Brash – Sidoti & Co.

Yes. Okay. And then just curious, you did mentioned in the press release that the backlog was down, I guess, 10%, 12% sequentially, you know when it normally grows in the fourth quarter, just curious, historically what is it tended to grow in the fourth quarter?

Ernie Whiton

So, historically, it’s tended to grow significantly. If you look at last year, we are down – I think we are down few hundred thousand versus Q3. And Q3 I think was about where it was last year. Q4 of last year grew significantly. Now a big chunk of that was California, I think it ended up around $24 million. Now when you normalize, $8.5 million of that was 13% gross margin California business. So, when you normalize that probably went up, say, $10 million versus not going up this year. And I think the way I look at that is that reflected the order environment in Q4, which reflected the weakness that we were anticipating when we gave our first cut of guidance in July. So, while the backlog would normally have gone up in Q4, I think that’s indicative of the environment, and it’s reflected in our much more conservative outlook in ’09 relative to ’08.

Greg Brash – Sidoti & Co.

Are you guys seeing some of the other device companies sell capital equipments have mentioned temporary spending freezes at the hospitals ranging from 30 days to 60 days? Are you seeing similar activity?

Richard Packer

We’ve seen some of that. I wouldn’t say that we’ve seen a whole lot of that in the hospital market. There was a time in the fourth quarter before California signed their budget that there was a bunch of hospitals just holding until the budget was signed. When the budget was signed before the end of the quarter, at least for our part, the business, we expected all tumble through. But I think we are seeing more of that in the EMS market than we are in the hospital market.

Greg Brash – Sidoti & Co.

Okay. Great, thanks a lot guys.

Ernie Whiton

There is one bit of additional flavor I would like to add, and this goes back to a question that John asked, and that is when we look at our business as group waits to the professional customers, we don’t think we are so much dependent upon in economic recovery as customers getting more visibility into what their actual spending capabilities are, because again, our product is – our core products are standard of care and customers can’t choose to go without them. Where we get most affected is when customers have significant uncertainty in terms of what their spending capability is going to be. As that uncertainty lifts, even if the environment isn’t great we expect to see delayed purchases start to come through which is why we backed – why we’ve got the kind of ramp up in our outlook that I described.

Operator

Thank you. Our next question is a follow up question from Jonathan Block from SunTrust Robinson Humphrey.

Jonathan Block – SunTrust Robinson Humphrey

Thanks guys. And maybe just two or three quick follow ups; Ernie, just to circle back and reiterate on the EPS, again you got about roughly $0.25 from FX, you take a $0.05 hit on the Welch deal, and then you are making up about $0.10, but somewhat evenly between better performance in LifeVest and some in savings. I missed, I am sorry, what was Welch going to add to fiscal year 2010; I believe you gave a revenue or an EPS number.

Richard Packer

About $12 million of revenue.

Jonathan Block – SunTrust Robinson Humphrey

$12 million of revenue specific to 2010.

Richard Packer

Yes.

Jonathan Block – SunTrust Robinson Humphrey

Okay, great. And then, all this guidance; I mean, I assume hypothermia would be modest, but do you still plan to introduce that product in fiscal year 2009?

Richard Packer

We will probably not be generating revenue in 2009. We will have the catheter that we have redesigned for costs done and we will have alpha customers using it. That is our goal for 2009.

Jonathan Block – SunTrust Robinson Humphrey

Okay, great. And last one, Rick. I believe this is for you. On the LifeVest side, you mentioned very favorable reimbursement of roughly $2400. Does it vary a lot by region, I mean are you seeing it solid across the US, or is it poor in some areas and you will wait to build out until that improves?

Richard Packer

I think the general rates are pretty consistent, it obviously varies by Medicare, which hit the lowest rates and private insurance pays a little bit more. So, if that makes is dramatically different in some locale, it may be a little bit different. But I think that there is plenty of geography where we are not covered, we are not doing very much, maybe we have to give more free devices to get people comfortable with the device. But once the territory is up and running, it is generally the same across the environment.

Jonathan Block – SunTrust Robinson Humphrey

Great. And any possible data that we can see on that product in terms of saves or anything like that?

Richard Packer

There is data that is coming out. There were a couple of things that we are at – American Heart this week and as we move forward, there will be more data in the springtime. The big clinical trial, Randomized Prospective, the best trial, has been rather slow to get started and we don't expect to see any data out of that trial for a couple of years yet.

Jonathan Block – SunTrust Robinson Humphrey

Okay, and the last one, I promise. Just on the CERT trial, you think that is probably data-wise a fiscal year 2010 event?

Richard Packer

I think so. We have about 675 or so patients in that trial. There is a scheduled look at the data not by us but by the data people in the springtime. And depending on what the effect of the device is will determine when data is available. If we got wicked lucky and there was an enormous effect, we might see something in the fall of 2009, but I think 2010 is much more likely.

Jonathan Block – SunTrust Robinson Humphrey

Thanks, guys. I appreciate the time.

Operator

Thank you. Our next question is a follow-up question from Joshua Zable from Natixis.

Joshua Zable – Natixis Bleichroeder

Hey, guys, thanks for the follow-up. Just a quick one here. Just Ernie, on the $0.25 foreign exchange, can you just walk me through again what the revenue guidance growth is for International and sort of with it FX, just kind of walk me through the details of that again. I know you did, I'm just trying to read my notes here properly.

Ernie Whiton

Without FX, our anticipation is mid-to-high teens growth. We expect roughly a $12 million lack coming from foreign exchange, which would bring us back to mid-single digits growth. We think that there is – it is a little bit ambiguous because we think there is the potential for some real volume upside there that may offset part of it. So the best we can do at this point is the range.

Joshua Zable – Natixis Bleichroeder

And the mid-to-high teens growth, where were you guys before?

Ernie Whiton

Mid-to-high teens.

Joshua Zable – Natixis Bleichroeder

So on a volume basis, basically it's the same internationally?

Ernie Whiton

Right. Ex-FX.

Joshua Zable – Natixis Bleichroeder

Ex-FX it is the same from a volume perspective.

Ernie Whiton

Excluding FX, our outlook hasn't really changed.

Joshua Zable – Natixis Bleichroeder

Can you talk a little bit about that, because that is what I thought I had, but you had Physio out there obviously pushing a new product, which as always makes them a tougher competitor. And you mentioned that you could be sort of – volumes could be higher. Is there anything going on specifically, a new channel or something like that that gives you that confidence?

Ernie Whiton

Well, I think we have been gaining momentum over the past few years internationally with our strengthened management team, our strengthened distribution, and the strengthened product offerings that we have been bringing out. I think – we look at it as – we grew mid-30s this year in international, and we think that – taking it down to the mid-to-high teens growth is fairly conservative. We have been – we are giving you a number that is substantially below what we have been doing, which is why we continue to think there could be some upside there to help offset some of the FX impact.

Joshua Zable – Natixis Bleichroeder

Okay. And then just in general, I know you guys tend to be conservative and I'm also very candid and I know we all appreciate both those facts, but as I look out, obviously if I look at this quarter – your hospital market obviously struggling. You guys are seeing some stuff out there, which you talked about previously. But you still have a pretty nice 10% growth overall for the whole business here, but still growing in North America hospitals and EMS despite these challenges. Can you kind of talk about what gives you confidence there, again, you guys have established you're sort of anniversarying new products. It is a tough environment. Just kind of explain, what gives you the confidence that you can grow at all in this kind of environment?

Richard Packer

Well, a lot of it depends on what you define as this kind of environment, Josh. Let us take the hospital. We are only seeing a little bit in the hospital. Could it get a lot worse? Sure. Could this be the worst that it is for ZOLL? Yes. Usually hospital effects for us lags. So, we are taking a view where last year, for the year, we did 24% growth in the hospital; right? That is the core hospital market. And now we are down to the mid-single digits; right? That is a pretty steep decline that we are projecting. And we are projecting that, not because our competitors are stronger, certainly not because our product line is weaker, we have just introduced the BLS thing; we have just introduced WiFi; the AutoPulse gained a lot of traction; so clearly, we as a company a stronger in the hospital market. The reason it is moderating from mid-20s to mid-single is because the environment is going to be a little bit tougher, right? I think that that is a very reasonable expectation. Now if you think that hospitals aren't going to spend any money at all, well then, it is going to be tough for anybody to get any growth, but that isn't my perception.

In the EMS market, not quite as dramatic a swing, but we just did kind of a low-to-mid teens and now we are down in the mid-single digits again. Even though there isn't anything new being introduced in that marketplace. And Physio is continuing to struggle. So I think we have baked in a reasonable amount of conservatism in all of these things. My view is that you could get upside in a number of areas, military upside, internationally you could get upside, LifeVest could be much stronger than the 60%, I mean, there is a lot of things that could be positive, at the same time, other things might be more negative. But we are pretty comfortable that we can get a 10% revenue growth here, which is significantly slower than what we have done in the last three years.

Joshua Zable – Natixis Bleichroeder

That is fair. And then just on the – I know you had mentioned earlier you guys had an order pushed out in 3Q to 4Q. That was on the hospital side or the EMS side?

Richard Packer

That was North American EMS.

Joshua Zable – Natixis Bleichroeder

EMS. Okay, great, Rick. Thanks for the commentary and special thank you for giving us the color on LifeVest.

Richard Packer

Yes, well, it is time because of the significant business and obviously I think that we have a lot of knowledge of it and we can be pretty confident in the success that they're going to have but that. We talked an awful lot about foreign exchange and I would encourage you all to do the calculations to look at the foreign exchange charge to work through with Ernie. It really is a very large impact here and as we have gone through our budgeting process at the end of September and the early part of October, each time we made adjustments and the rates changed further, we were like little mice on a treadmill trying to keep up with the thing. We have given back in exchange in two months the euro against the dollar, what it took almost two and a half years to gain. That is how dramatic these swings have been. And you are seeing it all throughout the press as companies give their forward-looking guidance and certainly, we have never talked about foreign exchange, we have been over-achieving our projections for the last three years, foreign exchange has been a small piece that is never accounted for us, hitting our numbers. It has helped us over-achieve to a little extent. So it is kind of odd for us to be talking about something of this magnitude. But it is real, it is there. We don't have any control over it. We have done our best to mitigate it, but I would make sure that you all understand it, and if you are all skeptical, have us take us through the math, because it is a straight calculation.

Having said that, we believe that 2009 is going to be a year of growth for ZOLL and that our results are going to be a heck of a lot stronger than most people's. I mean, we think we are that strong. We also believe that we are properly balancing the near term with the long-term and positioning ourselves for continued success. And I encourage everybody to look through the chop of today’s noise and focus on the fact that we have an industry-leading position and that we have compelling products and new initiatives such as the LifeVest that really begin to change the game for ZOLL as the volumes get much bigger.

Thanks for all your time and we look forward to talking to you again in January.

Operator

Thank you, ladies and gentlemen, for your participation in today's conference. This does conclude the program. You may now disconnect.

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Source: ZOLL Medical Corporation F4Q08 (Qtr End 09/28/08) Earnings Call Transcript
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