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Conceptus, Inc. (NASDAQ:CPTS)

Q3 2008 Earnings Call Transcript

October 29, 2008 4:30 pm ET

Executives

Kim Golodetz – IR, Lippert/Heilshorn & Associates

Mark Sieczkarek – President and CEO

Greg Lichtwardt – CFO, EVP and Treasurer

Analysts

Shawn Fitz – Stephens

Jonathan Block – SunTrust Robinson Humphrey

Eric Snyder – UBS

Angela Woodall – Oppenheimer

John Putnam – Dawson James Securities

Jayson Bedford – Raymond James

Klaus Von Stutterheim – Deutsche Bank

Greg Simpson – Stifel Nicolaus

Vivian Wohl – Federated Kaufmann

Mark Regan – Watchfire Capital

Operator

Welcome to the Conceptus Incorporated third quarter 2008 financial results conference call. At this time, all participants are in a listen-only mode. Following management's prepared remarks, we will hold a Q&A session. (Operator instructions) As a reminder, this conference is being recorded today, October 29, 2008.

I would now like to turn the conference over to Ms. Kim Golodetz. Please go ahead, ma'am.

Kim Golodetz

Thank you. This is Kim Golodetz with Lippert/Heilshorn and Associates. Thank you all for participating in today's call. Joining me this afternoon from Conceptus are Mark Sieczkarek, President and Chief Executive Officer, and Greg Lichtwardt, Chief Financial Officer.

This call will follow the usual format, beginning with prepared remarks by management, and then we'll open the call up to your questions. In order to accommodate as many of you as possible, we ask that you limit your questions to one, plus one follow-up before rejoining the queue.

Earlier today, Conceptus issued financial results for the third quarter of 2008. If you have not received this news release or if you would like to be added to the Company's distribution list, please call Lippert/Heilshorn in New York at 212-838-3777 and speak with Cheryl Palazzo.

Before we begin, I would like to caution that comments made during this conference call by management will contain forward-looking statements regarding the operations and future results of Conceptus that involve risks and uncertainties. I encourage you to review the Company's filings with the Securities and Exchange Commission, including without limitation the Company's Form 10-K and Forms 10 Q, which identify specific factors that may cause actual results or events to differ materially from those described in the forward-looking statements.

These factors include strategic planning decisions by management, reallocation of internal resources, decisions by public and private sector payers, scientific advances by third parties, an introduction of competitive products, among others. Importantly, the content of this conference call contains time sensitive information that is accurate only as of the date of the live call, today, October 29, 2008. The Company undertakes no obligation to revise or update any statements to reflect events or circumstances after the date of this conference call.

With that said, I would like to turn the call over to Mark Sieczkarek. Mark?

Mark Sieczkarek

Thank you, Kim, and good afternoon everyone. Thanks for joining us. In our prepared remarks today, Greg and I will discuss the financial performance of Conceptus for the third quarter, guidance for the remainder of the year, and then I will update you on the progress we're making in our direct to consumer program and other goals for 2008. After that, of course, we'll take your questions.

We are speaking with you today from Las Vegas where the American Association of Gynecological Laparoscopy, one of our primary customer groups is holding their annual meeting. I should point out that there are 24 presentations on the Essure Procedure scheduled at this five-day conference, as our story continues to gain enthusiasm and acceptance as the ultimate gold standard for permanent birth control.

Let me start today's discussion with our third quarter financial results before I turn the call over to Greg. They certainly speak to a healthy and growing business. Third quarter net sales increased 62% year-over-year and exceeded our guidance.

Now while this result reflects the impact of our acquisition of Conceptus SAS, it also represents solid domestic sales growth of 38% and international unit growth of 48% on a comparable direct sales basis. Our international results have exceeded our expectations, and the domestic business continues to turn in a very strong physician metrics and reflects strong execution in driving the percentage of sales coming from the office channel, an important initiative for us. For the third quarter, 55% of our domestic sales came from the office channel, up from 51% in the previous quarter.

As we discussed on the first and second quarter conference calls, it's our belief that domestic sales have thus far been relatively unaffected by the economy. Now, this is understandable because of several factors.

First, our product is not a classical elective procedure, but rather a non-urgent care procedure. The difference being that cue most adults view birth control as a necessity and most forms, temporary and permanent are covered by insurance and therefore do not represent a burdensome out of pocket expense.

Secondly, with a significant portion of our sales coming from the office channel, this means that for most patients, the Essure procedure will be their lowest cost birth control option, with just a $10 or $20 co-pay in many cases, certainly less than for tubal ligation and also an IUD implant or prescription for an oral contraceptive.

Now having said these things let me reiterate what I said in the press release. The impact of the significantly worsening economic downturn on near term Essure procedure is unknown because we are venturing into a situation where we have no prior experience. Now, although we are heartened that we have not seen an impact on our results to-date, if the economy continues to deteriorate, it is possible at some point Essure growth could be impacted. We believe that our guidance reflects the appropriate amount of conservatism.

Now in addition to the strong sales performance during the third quarter, Conceptus achieved the critically important milestone of positive net income, not to mention beating our net income guidance we provided you during last quarter's conference call. This resulted from strong top line sales growth and continuing improvement in operating leverage.

In addition, for the second quarter in a row, the Company generated nearly $4.5 million of positive operating cash flow. This has been without a doubt the most successful quarterly financial performance in our history and we are working hard to consistently deliver this type of incremental improvement or profitable revenue growth in the future.

Now I raise these points about the economic impact and our ability to achieve profitability and growth while investing in a direct to consumer program as several analysts have been rather pessimistic, speculating that the Essure procedure will be highly sensitive to the economy and that we cannot provide balance growth in both sales and profits with a direct to consumer awareness program.

Our results, especially in this year of challenging economic conditions, speak for themselves. And our commitment to make further progress and to continue to execute on our plan comes with a very credible track record of meeting our promises.

With that, I'm going to ask Greg to comment in more detail on the financial results for the third quarter. Greg.

Greg Lichtwardt

Thank you, Mark. Good afternoon, everyone. As I customarily do, I'm going to take a few minutes to provide some additional commentary to our financial results for the third quarter, and our financial guidance for the fourth quarter and full year as reported in today's press release.

First, I would like to direct your attention to the revised format of our press release, which we are debuting during our first quarter of profitability. We believe our revised format is more comparable to that of other medical device companies, and is more informative to investors.

Specifically we are disclosing a non-GAAP EPS number that excludes stock-based compensation expense, amortization of intangible assets and amortization of debt issuance costs. We believe this metric will highlight for investors the same metrics used by management in analyzing our results, and will facilitate comparisons of results for current periods with historical operating results, and assist in analyzing future trends.

Now turning to the financial results for quarter. With respect to third quarter net sales as Mark mentioned, we achieved strong growth in both our domestic and international sales channels over the prior year. With domestic sales increasing 38% and international unit sales increasing 48% on a comparable direct sales basis.

Overall, sales of $26.6 million for the quarter exceeded the upper end of our guidance range of $26 million that we gave last quarter, and were comprised of $21.2 million in domestic sales and $5.4 million of international sales. Total sales for the third quarter represented quarter to quarter net sales growth of approximately 4% overall. While domestic sales grew 7% sequentially, international declined only 6%, which was better than expected in a quarter noted for strong seasonality.

On a unit basis, we shipped approximately 22,900 units during the third quarter, of which the U.S. accounted for 70%, and international for 30%. International average selling prices remain around $800 and for Europe specifically, are $844, which is a slight decrease from the second quarter primarily due to the stronger U.S. dollar in translation of those sales. Domestic ASPs remain above $1,300.

With respect to domestic physician metrics during the quarter, as mentioned in our press release, we once again performed above our expectations with 528 physicians performing their first preceptored case, 491 physicians becoming certified and 499 physicians transitioning to the office.

At the end of the quarter, we have 3,317 physicians in preceptorship, of which about 20% are completing preceptorship in the office. Certified physicians performing in the hospital number 2,165 and certified physicians performing in the office total 2,861.

At the end of the third quarter, a total of 8,343 U.S. physicians had performed at least one Essure procedure. Overall, utilization rates were consistent with the second quarter of 2008, and we continue to believe the ongoing movement of physicians to the certified and in-office categories will provide growth in this metric in the near future.

Gross profit margin reached 81% for the quarter as compared with 74% in the previous year period and 80% in the immediately preceding quarter. The current gross profit margin fully reflects the benefits from the higher average selling prices associated with our acquisition of Conceptus SAS, production cost reductions related to the third generation device and volume increases. Future fluctuations in gross profit are likely due to channel mix and exchange rates, although we expect the range of movement to be very narrow.

Total operating expenses of $18 million for the third quarter were in line with our guidance, and up from $15.4 million in the previous year's third quarter, yet are down by $3.8 million from the previous quarter. The quarter to quarter decline is primarily related to decreases in DTC expenditures, which we informed you would decline in the latter half of 2008 as the bulk of our planned advertising for 2008 has been completed. Mark will provide more on this in his remaining comments.

The year-over-year increase of $2.6 million in operating expenses is mainly comprised of $1.6 million in added Conceptus SAS expenses resulting from our acquisition and $1.1 million in U.S. selling, general and administrative payroll related costs, associated with the expansion of our sales force, and other incentive payment. This year-over-year increase of only 16% in operating expenses, which includes very little DTC expenditures in each period, compared to a revenue growth of 62%, demonstrates the type of ongoing operating leverage from our business that we believe will contribute to our ability to drive profitable sales growth.

Other income and expense for the third quarter of 2008 netted to a $500,000 expense, down from other income of $700,000 in the third quarter of 2007 and other expense of $200,000 in the second quarter of 2008. The interest earned on invested capital stabilized in the third quarter to an overall yield of 2% and we recorded additional foreign exchange losses on the strengthening of the U.S. dollar throughout the quarter.

Other income and expense for the quarter can be summarized as follows

$400,000 in interest income, $600,000 in interest expense and debt issuance amortization, and a $200,000 currency loss primarily from the transaction effects of our intercompany accounts.

Our GAAP net income for the third quarter of 2008 was $3 million or $0.10 per fully diluted share, compared with a GAAP net loss of $2.6 million for the prior year third quarter or a loss of $0.09 per share. Net income of $3 million exceeded our guidance range of $2 million to $2.5 million, primarily due to greater than expected revenues on forecasted operating expenses.

As I mentioned in our previous call, the third quarter earnings per share includes the effect of all diluted employee stock awards. This amounted to an additional 866,000 shares for the third quarter of 2008. This amount was lower than we guided you to, primarily, due to our average stock price being less than forecasted in the quarter, leading to many shares not – being considered non-dilutive.

As mentioned in my opening remarks, we are also providing a non-GAAP earnings per share number. Our calculation of non-GAAP EPS excludes share-based compensation expense, amortization of intangibles and amortization of debt issuance cost. Non-GAAP net income for the third quarter of 2008 was $4.7 million or $0.15 per fully diluted share and that compares with a non-GAAP net loss of $700,000 or a loss of $0.02 per share in the third quarter of 2007.

The third quarter of 2008 non-GAAP metric excludes $1.4 million of stock-based compensation, $200,000 in intangible amortization and $200,000 in debt issuance costs. The amounts for the comparable period of 2007 would be $1.7 million for stock-based compensation, $100,000 for intangibles amortization and $200,000 for debt issuance costs.

With respect to the balance sheet, we ended the third quarter with cash of $23.8 million, representing an increase of $2.6 million from cash of $21.2 million at the end of the second quarter. We generated $4.5 million in cash flow from operations, which includes a cash outflow for the interest payment on our convertible debt of close to $1 million.

Worldwide accounts receivable days outstanding up 39, is down from 46 at the end of the second quarter. This represents an all-time low DSO, which is primarily related to our growth of office accounts using a credit card payment system. Inventory of $4.7 million is down slightly from the second quarter and remains at planned levels.

Okay, moving on to financial guidance. As reported in our press release, we are narrowing our full year sales guidance to a range of $103 million to $104 million. This compares with a range of $102 million to $105 million previously. We now expect full year net income to be between break even and $1.5 million or zero to $0.05 per diluted share on weighted average shares outstanding of 31.3 million. Our previous full year net income guidance was $500,000 to $2 million.

In detail, for the fourth quarter, we are guiding to a net sales of $29.5 million to $30.5 million, representing a quarter-to-quarter increase of 11% to 14%, and a year-over-year increase of between 59% and 64%.

Gross margin expectations for the fourth quarter continue to be 80% to 81%. Operating expenses are expected to be in the range of $17.8 million to $18.3 million for the fourth quarter. And that will put us at roughly $80 million in operating expenses for the full year. This operating expense guidance is consistent with the amounts we provided for the full year during our second quarter conference call.

The fourth quarter net income is expected to be between $5 million and $6.5 million or $0.16 to $0.21 per diluted share on weighted average shares outstanding of 31.4 million.

One final remark before I turn the call back over to Mark. With regards to our position in auction rate securities, we are continuing to hold $48.5 million of student loan backed securities for which there have been no auctions for the better part of 2008. We updated our evaluation of these securities in the third quarter and have provided an additional reserve of approximately $200,000 on these investments due to the lack of liquidity.

The cumulative reserve now stands at approximately $2.8 million or 5.9% of the total. This reserve is considered temporary and therefore does not impact our income statement in settlement of outstanding litigation and various government inquiries.

UBS, which holds 100% of our auction rate securities, recently designed a solution that will give us the opportunity to sell all auction rate securities back to UBS at par value by June 2010 unless they are redeemed by the issuer sooner. We received confirmation from UBS in October that all of our currently held auction rate securities are eligible to participate in this process and be redeemed at par.

Although we recorded an additional temporary charge in the third quarter, this is more due to the time value of money and not the risk of receiving less than full par value for our securities. We also expect written confirmation from UBS in the next couple of weeks that they are making available to us a no-cost lending facility that will allow us to gain access to these funds in the interim until the redemption date or the date at which we sell them back to UBS.

Okay, that concludes my remarks. I'll turn the call back over to Mark.

Mark Sieczkarek

Okay. Thanks, Greg. I'd like to use the next few minutes to discuss our main thrust for strategically growing our business, namely, the consumer awareness campaign and physicians transitioning to in-office procedures. I will also give you an update on some of the other important projects that we are working on this year.

First, the direct to consumer campaign. Let me first remind you that we ran this program because consumer awareness of Essure is minimal, and we know that consumers will choose Essure if they are aware of its availability. And our physicians have not demonstrated the ability to proactively consult with patients about Essure.

Now we structured the campaign in such a way that we could test our ability to develop a scalable media program for the future in order to fuel continued sales growth in permanent birth control market share. Now this program enables us to compete for a larger share of the 7.5 million families who have stated that their families are complete, but still remain on temporary forms of birth control.

The campaign was designed to reach our primary end customer with multiple touch points. Among these were TV, radio, magazine ads, newspaper inserts, the web, our call center and direct mail. We advertise in eight cities that have been selected based on a hurdle rate penetration of in-office physicians, adequate reimbursement and sales support, and the ability to extrapolate appropriately to predict national results related to various submarket attributes.

The eight cities represent about 5% of the American population. The initial bolus of ads ran February to June time frame with follow-up ads running in September to November of this year, and cycling for up to two years in many of these markets.

As I discuss what we've learned from this campaign, I want to extend the same caution as last time we discussed the program. It's still too early to predict sales results from our DTC program, especially when one considers the length of time most women require to make a decision about permanent birth control. Our modeling expectations with that in 18 month to 24 month incremental net income payback was an appropriate target for the expenditure, and we are obviously still many months away from being able to measure against that specific target.

However, to-date there is much evidence to support optimism as the leading indicators of awareness and interest are tracking well, making us optimistic that such a program can be a growth driver for us now and in the future, and may be a key contributor to our ability to draw from the 7.5 million families in the U.S. that still depend on temporary birth control methods for their long-term contraceptive needs.

As we reported to you last quarter, there have been several strongly positive diagnostic indicators from this program, including Essure.com, daily web visits, calls to our call center, and direct referrals to physicians, as well as increased awareness of the Essure brand among consumers in the tested markets.

Furthermore, the ads have definitely generated increasing levels of physician interest in Essure. We have taken numerous calls from physicians in these markets who either perform Essure procedures in the hospital and want to transition to the office or from physicians who do not perform Essure and now want to be trained. Now both categories of physicians report they are receiving calls from women who have seen our ads, visited our Web site and want to learn more about Essure from their doctor.

Another positive note, we have also heard reports from physicians in these test cities that a significant number of procedures they are performing are for women who are not their patients, demonstrating that self-referrals and referrals from other physicians can and do take place. As a result, we are seeing physicians in growing numbers in these cities, reaching out to family and general practitioners to educate them about Essure's patient benefits and to seek their referrals.

With regard to the impact on net sales from this program, we are tracking our performance in each city against an internal return requirement. Net sales that resulted so far are certainly within our range of expectations, and we are optimistic about the continued impact over the next 12 months to 18 months.

It remains our firm belief that woman educated about the benefits of Essure is not likely to forget, and that the viral marketing impact of Essure treated women telling others about her experience is powerful and will enable us to continue the growth in these markets for months and years to come.

In the coming months, we will be further assessing these results and completing our annual operating plan, and we'll be in a position to communicate to you our specific DTC intentions for 2009. But given the results to-date, we expect to expand our program in 2009, and continue to drive profitable and accelerated sales growth as a result.

Now, with respect to the transition to office procedures, we continue to hit home runs with 500 new doctors this quarter making the transition to the office, while maintaining utilization rates within that category. Our sales force and associated support people in programs continue to provide a compelling environment for physicians who now see in-office hysteroscopy built around the Essure procedure as a significant improvement in care for their patients.

As Greg reported, with over 2,800 office physicians certified, and another 600 in preceptorship, and 55% of our total sales being performed in the office, we are confident that with our pioneering efforts, we are setting the expectation among patients, physicians and payers that permanent birth control belongs in the office, not in the operating room.

As we have said, the transition to the office is very labor-intensive, as we help doctors establish all the elements that go into a successful experience for the patient, including office staff training, equipment selection, and other procedure room infrastructure, physician counseling skills, reimbursement and referral network building.

It's no surprise that the office is the highest utilization site for us, as it remains the most comfortable and satisfying for the patient. It's where the physician is economically and procedurally the most efficient, and it represents the lowest cost site of service for the payer.

The office will also prove to be a major advantage for the Essure procedure as competition enters this market. We designed Essure to be the optimal permanent birth control product for office use. Our purely mechanical mechanism of action does not rely on thermal injury with its attendant patient discomfort, pain management requirements and safety concerns, all of which are troublesome to manage in the office.

And, of course, we can't predict that Essure will always have at least six more years of clinically and commercially demonstrated effect and is compared with any potential competitor. We now have some of our women who participated in the clinical trials in their 10th year of depending on Essure without any pregnancies.

Moving on, let me update you on several projects we have under way that we believe will further solidify our business in many areas. First, operationally we have now completed the outsourcing of our distribution function here in the U.S. to FedEx.

Secondly, we continue to make progress in validating a second manufacturing outsource company. The current timeline calls for validation to be completed late in this quarter and both of these projects will diversify risk; add to our capacity and lower costs for years to come.

On the product development side, we continue to work on the fourth and fifth generation of the Essure device, which we believe will represent exciting steps forward for the procedure. Our product development programs have yielded a generational improvement in Essure every two years since FDA approval, and in each case we have made the Essure procedure easier and faster to perform, more office compatible and have also improved our manufacturability and margins.

Now we're not going to share much of our thinking about these next-generation products for obvious competitive reasons, but let me say that the fourth generation product will deliver further ease of use improvements for the physician. And we believe the fifth generation as currently conceived, can allow us to leverage the expensive physician training, consumer and professional brand creation that we have accomplished, while staying in front of any potential competitor and be as game changing as our introduction was in 2002 of the first non-incisional permanent female birth control procedure. We anticipate that both projects will require clinicals and FDA submission, so we'll not be talking about timelines for some time to come.

Now lastly, an important project has been in the regulatory area where we've been pursuing marketing claims for Essure compatibility with the primary technologies used to perform global endometrial ablation.

We notified you last quarter that we had obtained approval from the FDA to modify our label claim on compatibility with thermal ablation, which includes both J&J's Thermachoice and Boston Scientific's HDA products. We are in the process of obtaining final labeling language from the FDA as it relates to the Essure compatibility with NovaSure. But we have already secured that compatibility claim for use in Europe and Canada.

Importantly, there is a large and growing body of anecdotal as well as clinical study evidence of successful use of Essure to manage the risk of ectopic pregnancy after global endometrial ablation procedure.

So for those of you attending AGL this week, not to mention the corresponding ESGE meeting in Europe, three weeks ago, we are seeing an increasing number of papers from physicians who are having great results with Essure and endometrial ablation.

So in summary, the highlights for the just completed quarter are, first, strong year-over-year domestic and foreign sales growth. Secondly, continued and consistently powerful physician metrics, 81% gross profit margins, good, if not great preliminary DTC results, positive net income for the first time totaling $3 million and positive cash flow from operations of $4.5 million.

Now, by the end of the year, we expect to have performed 90,000 procedures in 2008 and about 260,000 procedures since approval, with most of the recent procedures coming from the office environment. By year-end, with close to 9,000 physicians using Essure, we will have reached nearly one-third of all practicing OB/GYNs in this country.

With the DTC investment in building patient awareness showing positive signs that educated patients will choose a less costly, non-invasive Essure procedure method in a way that will allow us to generate profitable net sales growth, we are extremely excited about the future of our Company.

With that commentary, I would like to open up the call to your questions. Operator?

Question-and-Answer Session

Operator

(Operator instructions) Our first question will come from the line of Shawn Fitz with Stephens.

Shawn Fitz – Stephens

On the quarter and especially on the profitability, just a question relating to some of your physician training trends. I guess we were surprised by how robust the certification number was. Can you just talk a little bit about the dynamic that's driving that? And then as a follow-up, maybe just discuss two things. Number one, the utilization you're seeing for your certified docs that have been certified for more than a year, and then also it sounds like this emerging dynamic of physicians doing the preceptorship in office and what that can mean in terms of accelerating utilization coming out of the gate?

Greg Lichtwardt

Shawn, this is Greg. We have maintained a large pipeline for certifications for quite some time. And that pipeline includes trainers, sales people, nurses and doctors that are on a per diem basis. So fundamentally, it is the doctor though that controls how rapidly they move through preceptorship and not our capacity. The increase in certified doctors therefore is really attributable to more doctors calling us with cases, which I think is certainly a good thing.

With respect to transfers to the office, this is an area where we've been very focused for some time, and we've made headcount additions in the field to help with the infrastructure that's necessary to get the physician operating out of his office successfully.

Now you ask an interesting question about utilization rates. You have to bear in mind that for each one of these categories, physicians in preceptorship, physicians certified and practicing out of the hospital, and certified and practicing in the office, we have a large number of doctors. Some have just joined in the recent month or two, and others that have been in that category for quite a while, maybe in excess of a year. And certainly the utilization rate averages, while being stable, means that the newer doctors are at lower utilization rates, and the doctors that have been around in that category for a longer time have much higher utilization rates. So it is a bell curve, if you will, and we can definitely see that the factors that have been present in our business for the last several years continues, where the doctor that is certified and practicing in the hospital is doing roughly 3 times to 4 times as many procedures as the doctor that's in preceptorship and the doctor that's in the office is doing roughly twice as many procedures as the doctor that's in the hospital. And then we can even break down the doctors that are in the office to the ones that use more of our infrastructure, and we find that these are doctors that can be doing 4, 5, 10, 15 procedures a month. So we get into – with a smaller group of doctors, very, very high rates of utilization.

I think with respect to the last part of your question, maybe it's a little too early to say what specifically will come of this trend of physicians that are gaining preceptorship in the office. But it certainly a very positive sign for us that they are able to make the commitment financially to the hysteroscope. They see the value. They want to specialize in that and they want to do Essure procedures. Hopefully, that will mean an increase in utilization rates for those doctors that are in preceptorship in the office, but as I said, it's really a little too early at the moment to identify that.

Shawn Fitz – Stephens

Okay. Thank you, Greg. Mark, just last question here on the consumer awareness campaign. You indicated that you obviously are seeing very positive results, and that an 18-month payback period looks achievable. Could you quantify that in terms of what an 18-month payback would mean in terms of an ROI or maybe an internal rate of return for Conceptus? And then secondly as a follow-up, as we think about 2009, and how many cities do you think would be targets for a consumer awareness campaign above and beyond the eight you've identified this year?

Mark Sieczkarek

Yes, well, relative to your first question, I think for a variety of reasons, be it competitive or otherwise is the – to give you a specific answer that would be too granular. And I know in terms of the – looking forward to the cities in '09 as well, you might be (inaudible) of hearing this, but it's really too soon to be very specific. Our planning right now though has us looking at up to 15 cities beyond the eight we started this year. Now that being said, the media costs for that program are expected to be pretty much in proportion to what we spent in '08. So, a growth in advertising expenditures that we believe is going to be offset by even a larger growth in sales, so that we drive increased profitability. So once again, Shawn, I think we're saying here in summary is, good balanced effort in terms of the advertising, driving sales as well as continuing to drive the bottom-line as well. And I think for the skeptics out there, we finally proven that this business does have an awful lot of leverage as seen in our third quarter results and actually in terms of cash flow in the last two quarters.

Shawn Fitz – Stephens

Mark, Greg, thanks.

Mark Sieczkarek

Thank you, Shawn.

Operator

Our next question will come from the line of Jonathan Block with SunTrust Robinson Humphrey.

Jonathan Block – SunTrust Robinson Humphrey

First one, just maybe if you can point to any trends either here or abroad that you saw, clearly with the economy, I know you guys posted great results, but did you see anything by market which would tell you that some areas were weaker than others throughout the quarter and actually even into October?

Mark Sieczkarek

No, actually, in terms of regional type of differences, we never really seen any of that in our business, Jonathan. It's pretty much across the board type of impacts that we've seen on our business. You bring up even internationally, I think if you look back at the third quarter, quite frankly, international did extremely well in what has always been a very strong seasonality quarter in Europe. I was there about three weeks ago for the ESGE Conference and we also met with all of our distributors out there as well as our direct people, and they're very enthusiastic about the business going forward, and really don't see the impact relative to the economy.

I think we kind of covered this in our remarks, but there is different ways of looking at it. And we say although this is elective, it's really a non-urgent care procedure. Adults view birth control as a necessity, and I think we've put ourselves in a great position in the office because with a co-pay situation in the office, and now 55% of our procedures are done there, from an economic standpoint, the $10 or $20 that it's going to cost you to get an Essure procedure is even favorable as compared to paying for a prescription for the pill, and/or an IUD insertion, which is pretty large – can be a pretty large upfront cost. So I think economics, when you think about it in the big picture, we're in a very good position to hopefully obviate that. But again, as we've also said too, we've never been in this situation before, so it's difficult to prognosticate in terms of what to expect.

Jonathan Block – SunTrust Robinson Humphrey

Okay, perfect. And then actually the 55% in office brings me to my next question, which would be, are you hearing anything that has changed in terms of where your competition, I guess pending competition stands. And then maybe if you can speak a little, because I don't know how well understood it is, about how your product stacks up versus the pending competition in terms of in-office, i.e., what a doc might have to put out there in regards to capital.

Mark Sieczkarek

Yes, sure. Again, we haven't heard very much publicly on that for quite some time. It's quiet down – quite a bit. I mentioned I was at the ESGE Conference in Amsterdam, and let's say the competition was there as well. I would say they had a weak presence and had only one presentation that was on the slate versus 15 presentations for Essure. So there wasn't anything new said there. There didn't seem to be certainly any excitement around it. And I think going to your question about the setup in the office, first of all, the doctor is going to have to get a capital piece of equipment in place. And then arguably too, because there is also going to be some flow requirements, fluid requirements as well and many of those offices are not equipped with those types of monitors. So I think there is definitely capital outlay. And then beyond that though as ours – as we stated in our comments, ours is set up perfectly for the office, where I think when you're talking about RF energy, there is different pain thresholds and I'm not sure that they're well suited for an office type environment.

Jonathan Block – SunTrust Robinson Humphrey

Okay, great. And maybe just one last one that I could throw in there. In regards to the direct to consumer, I think in the eight markets you might have had a different mix that was going on. Is there anything that you can speak to where one mix worked better than another, and did you find possibly a low cost mix where when we look to '09, maybe you can strip some cost out of the direct to consumer? Thanks.

Mark Sieczkarek

Yes, that's a great question and I wish I had a specific answer. Lot of that, we're receiving back both on our spending and media mix, it's still too early to come up with anything definitive. Obviously, I think what we're trying to do is figure out the – both the spend and media mix that's going to be the most efficient and economical. And the answers are not clearly in there. We're getting a little bit of direction. But, again not definitely clear direction now as we head into '09. I think the next three months will give us something a little bit more clear that will define our specific direction in '09. But I should also caution you that in advertising like this, and especially this is very different, it's a one-time use product, we're going to continue to test and refine and make our programs even more efficient. But, that being said, I think you can certainly take out of this phone call that we are very bullish about where we've gone so far on advertising and the results we've seen, and you should probably certainly expect it to become part of our fabric as we move forward.

Jonathan Block – SunTrust Robinson Humphrey

Okay, great. Thanks, guys.

Mark Sieczkarek

Thank you.

Operator

Our next question will come from the line of Eric Snyder with UBS.

Eric Snyder – UBS

Good afternoon. Congratulations on the profitable quarter.

Mark Sieczkarek

Thanks, Eric.

Eric Snyder – UBS

I think you described some potential fear around economic impact. I was wondering if you could walk through how that could occur. Because you described the – for insured patients in the office, that it's at the low-end of costs. So what proportion of your patients are private insured versus Medicare, Medicaid type insurance, first off?

Mark Sieczkarek

Okay. Well, the vast majority of our patients really now are still private pay insurance. If you go back to tubal statistics, they would roughly say that 70% of your population is private pay and 30% is Medicaid. But we see a much higher proportion yet for a variety of reasons including reimbursements that are private pay. So I think the hedge in our statement comes from the fact that the awareness issue and the awareness of the fact that they only have to pay a $10 or $20 co-pay isn't certainly where we would like it to be. I think it's clear that in the DTC areas, we've messaged that quite well. In other areas, we're still somewhat dependent on doctors to message that. And as we've said often times, we're not necessarily confident that they do a very good job of it. So I think that's where our hesitation comes in. But as we continue to proliferate these media campaigns, and get out to more and more people, and more and more people visit our Web site, they'll find that information out. And as our doctors even tell us, even now, people are making economic choices. So I think that bodes well for us. But directly to your question, the awareness of the fact that it's a $10 or $20 co-pay is probably the thing that worries us most.

Eric Snyder – UBS

Do you think it's partly psychological and partly that, of that 80% to 85%, some will lose their insurance with increased unemployment, is that right?

Mark Sieczkarek

Well, that could also be the impact. And again, not being through that before, we don't know how that's going to – cycle through and impact people. I mean, there is an argument on the other side. Many of our physicians tell us that some of their patients, the last thing in the world they're right now they were thinking about becoming sterilized, if you will, or not having any more children, they now more than ever want to make sure that they're sterilized and therefore will choose the Essure. Again, that's anecdotal. That's some doctors talking to us. But that's certainly what we hope for. But we can't say that's going to happen as a certainty.

Eric Snyder – UBS

Okay. And then just one other question. When you acquired SAS, I believe you inherited some hedging contracts but they roll off this year. How big could the impact be, I realize currency has been all over the map lately, but if you looked at current numbers on comparison into '09, would the impact be all in the top line or would it be top line and margin, and if it is margin, how does it affect margin? Just could you walk us through that cost structure?

Greg Lichtwardt

Okay, well, this is Greg. First of all, the currency impact on our P&L is as it relates to sales, gross profit and operating expenses, has nothing to do with the hedge that we inherited. That is really just the straightforward translation of an income statement that's denominated in euros to dollars, and when the dollar is strengthening, obviously we're seeing lesser U.S. sales dollars, lesser gross profit, but also lesser operating expenses. So on that affect, that translation affect, the operating income impact is pretty minimal. Then I describe in other income and expense that we do have exchange gains or losses, partly coming from that hedge and partly from the unhedged portion of our intercompany accounts. So far this year, that has been more of an exchange loss than it has a gain. And as the dollar strengthens, typically, we will report an exchange loss. You see for this quarter it was $200,000. So again, we're talking fairly immaterial numbers that don't really upset our ability to manage to our – to the guidance that we're giving.

Eric Snyder – UBS

Okay. Thank you.

Operator

Our next question will come from the line of Amit Hazan with Oppenheimer.

Angela Woodall – Oppenheimer

Hi, this is actually, Angela Woodall calling in for Amit today. I just have a quick question on, actually a little bit back to the co-pay. I just want to clarify one thing. The $10 to $20, is that the average or is that more for like one segment of your patient population?

Mark Sieczkarek

No, that's more or less the average, Angela. Again, the majority of our private patients fall into that co-pay category. Again, specifically, in the office.

Angela Woodall – Oppenheimer

Okay, great. And then also on little bit on the economy, could you talk about, perhaps in the past two months if you've had any pushback from the doctors that you're moving into the office on the purchase or finance of the hysteroscope?

Mark Sieczkarek

No, not at all. And I think, again, not that we're thinking of an economic downturn, but I think some of the programs we have in place, some of the lease to buy and some of the usage programs we have out there have really overcome that pushback from doctors on the equipment. We've really taken that whole capital piece out of the equation relative to them making a choice of doing Essure in the office or not. It's that simple for them. So that's worked out quite well for us. And is obviously part of the driver in terms of our continued success in executing 55% of our procedures being done in the office this past quarter.

Angela Woodall – Oppenheimer

Great. Thanks very much. Also, just on gross margin, you had really nice improvement here, and I'm wondering if you could give any directional guidance for going forward, whether that will be impacted at all by currency exchange or the new products, the new third generation or fourth generation products coming out. And how that might either continue to improve above the 80%, 81% or if we might see it fluctuating back towards the 80% level in the future?

Greg Lichtwardt

Okay, this is Greg. And certainly the only really near-term guidance that we're giving is for Q4. We feel confident that no matter what comes in terms of exchange rates or channel mix that our gross profit margin will come in between 80% and 81%. We will provide our guidance probably late in January or early February of next year for 2009. And I think that would be a more appropriate time to talk specifically about what we think we'll see for 2009. I will say, in a general sense that this is and remains for us a very high gross margin product. We obviously get very good average selling prices around the world, and certainly, don't see gross margin going below 80%, and there is some possibility that with cost improvements and so forth that we can move it even higher than it is right now.

Angela Woodall – Oppenheimer

Okay. Thank you.

Mark Sieczkarek

Thanks, Angela.

Operator

Our next question will come from the line of John Putnam with Dawson James Securities.

John Putnam – Dawson James Securities

Thank you very much, and a nice quarter. I wondered, if Mark, you might talk a little bit about what it takes to push the physician into practicing in the office from your perspective, and from your – what kind of resources you have to put towards that. And I guess if you have adequate resources to be able to continue to do that?

Mark Sieczkarek

Yes, I think as we continue to push and get more procedures being done in the office, I think that says by itself that we do certainly have enough resources to continue to go that way. We kind of said in our scripted remarks, that it is a longer type of process because if you've had for instance a doctor doing this procedure in the hospital up to now, you now have to go in and not only get the doctor comfortable doing it in the office, but also his staff. We have to advise them in terms of what to expect. Staff gets very reticent in terms of doctor bringing something that he previously did in a hospital, and especially if he did it in an OR into the office. It's a little scary. We've got to get in there and we have a specifically trained group of specialists that go in and help train staff. We have to make sure that they got their reimbursement issues taken care of, and there is some heavy lifting that goes along with that. But I think it's easy to say though that once it's done there, use the often used term “seeing is believing,” and when doctors see the impact of the patient and the almost joy of the patient in terms of what a simple procedure this is, I think that's kind of a turn on for everybody, doctor, staff and certainly, patient who goes and tells the world about it. So it is a little bit more labor intensive for us. We have the specialized group, again that goes in and takes care of those things. And we're seeing continued success in rolling this out in the office.

John Putnam – Dawson James Securities

Just a follow-up, does it require the physician to hire any additional staff?

Mark Sieczkarek

No.

John Putnam – Dawson James Securities

Specialized staff.

Mark Sieczkarek

No. Normally what we try to do is we try to identify within the practice. I'll call it an Essure counselor for lack of any better term, and that's one specific go-to person. It might be a nurse, a nurse practitioner who becomes a little bit more of the specialist on Essure, and can talk and answer the questions of a woman. So we tend to work that way in terms of identifying that specialty within the office. And that works out pretty well then in terms of having somebody specific that when there is a call about Essure, somebody comes in for a consult, they know who to go to.

John Putnam – Dawson James Securities

Right. Thanks very much.

Mark Sieczkarek

Thank you.

Operator

Our next question will come from the line of Jayson Bedford with Raymond James.

Jayson Bedford – Raymond James

Good afternoon, guys. Just a couple quick questions. First on the strength internationally, I'm just wondering, can you comment on where the strength is coming from, meaning, are you adding new countries, have you added new reps or distributors, or maybe you're benefiting from a broader label in France?

Greg Lichtwardt

Good question, Jason. Year-to-date, we've sold nearly 20,000 units internationally. That's approximately a direct sales unit growth of 38%, and a net sales dollar growth of 54%. France still makes up about half of our international sales, and remains a very promising growth opportunity. Currently, in France, we are growing at 62% year-over-year in net sales dollars. The other primary countries for Essure are going to be Spain, Holland and now Latin America. Latin America is a near-term growth initiative for us as well as Asia. And these will be part of our future growth that we report to you, we're currently working to identify partners and obtain necessary regulatory approvals in a number of different areas in the world. Probably the most current opportunities, let's say within the next 12 months, might be entering the Brazilian and the Korean markets. Brazil regulatory approval is possible within the next couple of months. While Korean, KFDA approval might take more to the end of that range of 12 months. We're currently negotiating distributor contracts in Taiwan, Singapore and Indonesia.

So those are all opportunities for us of new distribution. Also in the UK, we already have regulatory approval and a distributor, but we're looking to gain reimbursement coverage through a favorable review by the National Institute for Clinical Excellence that could open up that market for us as well. So really, it's the strength in France, it's potential strength in the UK, which are existing markets, and then opening up new market opportunities in areas where we haven't been before.

Jayson Bedford – Raymond James

So it sounds like the growth this year has largely been through existing countries. It's not like in the third quarter you added one or two new countries.

Greg Lichtwardt

Yes. With the exception of Latin America, I would say that's true. Yes.

Jayson Bedford – Raymond James

Okay. And then you did comment on kind of the '09 DTC landscape. I'm just wondering, are you going to be flexible with the spend, meaning, here in the third quarter, you did 13% operating margin, it looks like your fourth quarter guidance implies 19%, 20% plus. I guess the concern is that you spend aggressively in '09, step back a bit. Is there any comfort you can give that you are truly running the business for sustained profitable growth?

Mark Sieczkarek

Yes, Jayson, we have always talked about that, and I think, if you will, the skeptics out there have said even this year, it would not necessarily be possible, I think we just proved that one wrong. And as we go into next year, I think one of the questions I previously answered, I talked to the ability to be given the leverage of this business, and even the ROI that we're anticipating, and it's starting to play through here that we can do both. And as – also as an answer to another question, as we get more efficient with that spend too, I think that brings us even more additional upside. So I think all of those things can be accomplished. And it really comes back to one key piece, which is the leverage of this business. And you can go back historically up to now and see that just in the numbers. I think Greg wants to – he is biting at the bit here. I think he wants to embellish that a little bit. Go ahead, Greg.

Greg Lichtwardt

Yes, we've only been saying for quite some time that it's our intention to scale our DTC spending to fit our sales growth and profitability goals, and that works out well for us because we never really thought about a nationwide campaign. It is quite possible to model a P&L that shows sufficient revenue growth at an 80% gross profit margin and reasonable growth in other SG&A expenses that could cover a $10 million to $15 million DTC program, as an example, and still generate very substantial profits for the year.

Now, obviously to the extent, that our program involves a bolus of advertising that will run in Q1 and Q2, when the ads are turned on, while we will be at a considerably higher run rate in sales, that quarter's profitability on a percent of sales basis as you were mentioning probably will decline. But we certainly expect to maintain at least break even in those quarters, and then with profitability being very heavy in the third and fourth quarters, just as we've seen this year. So I do think it's fair to say that given the nature of the kind of advertising that we're doing with the bolus of ads in Q1 and Q2 that does temporarily depress profitability, but we do expect to remain profitable in those quarters, and then we'll drive a surge of profits in Q3 and Q4.

Jayson Bedford – Raymond James

Okay. That's helpful. Thank you, guys.

Operator

Our next question will come from the line of Klaus Von Stutterheim with Deutsche bank.

Klaus Von Stutterheim – Deutsche Bank

Hey, guys, congratulations. Beautiful quarter. One quick question. Greg, did you say for the guidance for the fourth quarter what the non-GAAP EPS number was expected to be are the range?

Greg Lichtwardt

I did not. But you can see from this quarter that it accretes fully diluted EPS by about $0.05 a share. We're still toying with whether or not we're going to officially provide the non-GAAP measure as part of our guidance. But for now, you can simply add $0.05 a share and that gets you to the range.

Klaus Von Stutterheim – Deutsche Bank

So then what was the GAAP number?

Greg Lichtwardt

I said a GAAP range was $0.16 to $0.21 per fully diluted share, so that would be $0.21 to $0.26 fully diluted in the fourth quarter.

Klaus Von Stutterheim – Deutsche Bank

Okay. Great. Thanks.

Operator

Our next question will come from the line of Greg Simpson with Stifel Nicolaus.

Greg Simpson – Stifel Nicolaus

Congratulations. The couple of follow-up questions, and you answered the main one about profitability in '09 and the impact of DTC, so I'll skip over that. But a couple I guess clean up questions here. First of all, can you guys maybe talk about the impact that you may have seen in the quarter from the medical approval, how much of that contributed to the upside in the quarter?

Mark Sieczkarek

At this point in time, Greg, I would say a little. We're in the process of getting those people now up to speed. And I should say that they're excited in coming up to speed quickly. But when I say up to speed, that means training, and putting equipment in place and things of that nature, not necessarily doing the procedures yet. We do – and I think I addressed this last quarter on the call I think we're going to see the biggest impact there is probably in the beginning in '09, as we're using the rest of this year to get things going. I know I talked to the regional manager just yesterday at the meeting here, and she is extremely excited and enthusiastic in terms of the impact that that approval has had in her region. But again a lot of it right now is in preparation.

Greg Simpson – Stifel Nicolaus

Okay. Great, and then Mark, on a different topic, you had mentioned the economics for Essure are obviously favorable versus the pill and more importantly, Mirena. Just as a review, can you contrast the all end costs to a woman for Mirena versus Essure?

Greg Lichtwardt

Well, I think generally speaking, what we find is that Mirena and ParaGard, the two main IUDs are generally not covered by private insurance. Obviously, some plans do, and it's a little difficult without trying to canvass all of them to really understand this. We don't have the resources to do that. But by and large, most insurance companies will say that IUDs have a very small market share, that their clientele does not ask for coverage of IUDs and so therefore they don't cover. So it's not all unusual to find a woman paying 5, 6, 7, $800 out of pocket for an IUD implant.

Greg Simpson – Stifel Nicolaus

Okay. Great. And then Greg, a question for you and I'm not trying to get ahead start here on your guidance call. But can you maybe talk about at least initially, quantify the impact of new FASB rules regarding convertible debt expense and the impact that might have on earnings next year?

Greg Lichtwardt

Okay. That's a fair question. Rule 14.1 is what you're talking about and it will impact how we account for our $86 million convertible note. This new accounting will become effective for us at the beginning of 2009, and will require retroactive restatement of our financial statements beginning with the year we obtained the note, which is 2007. This again background for those of you that are maybe not familiar with this, the likely impact is that we will have to increase in the P&L, the amount of interest expense that we report allocated to the conversion option, which in and of itself would correspondingly decrease net income. Now at this time, we have not completely analyzed the additional expense that results from this accounting change, and so it's just too early for us to provide that information to you. But, don't forget that we will have higher cash balances, we'll have higher rates of interest on our investments, which will in part, offset the impact of that Rule 14.1 on that other income and expense line item. It's also important to know that Rule 14.1 will have absolutely no impact on cash expenses and therefore it will be excluded from our non-GAAP net income measure that we've begun to provide.

Greg Simpson – Stifel Nicolaus

Okay. Fair enough. Obviously, you will talk about this on the guidance call, but will you provide that information prior to that, once you have that impact fully analyzed?

Greg Lichtwardt

We will do it with the guidance announcement for 2009.

Greg Simpson – Stifel Nicolaus

Got you. Okay. Great. Thanks very much.

Mark Sieczkarek

Thank you.

Operator

Our next question will come from the line of Vivian Wohl with Federated Kaufmann.

Vivian Wohl – Federated Kaufmann

Hi there, guys. I'm in the hole and you're not in the hole any more. Just a quick question on Medicaid. I'm wondering if you're seeing a spill over positively from the California decision to other states.

Mark Sieczkarek

Yes. Vivian, what we're doing, when you say that, we just had a meeting, we're discussing, we've made gains in a number of states. I want to say somewhere between 10 states and 15 states, where previously they have had a reimbursement level that quite frankly was not enough to convince a doctor to do an Essure. And we've been able to go back to those 10 states, 15 states now and get a reasonable reimbursement. I don't want to say that was a direct impact on California. Some of those happened before California came out. But to your point exactly, we're kind of using the California decision and it's very good reimbursement rate, as kind of a proxy as we go back to these other states and work with them in terms of upping the reimbursement for Essure. And we have – it's a very big item on our to-do list, if you will. And we have specific people who are responsible for that. And as I said, they are getting some good success, both using some private pay proxies, using cost of tubal ligation as a comparison, and then as well as using now this California decision, which certainly works in our favor.

Vivian Wohl – Federated Kaufmann

Do you think we're seeing the impact of that yet in the numbers or is that something that we'll see next year?

Mark Sieczkarek

No, I think that's something we're going to see next year. I mean, again it's just like we've played with reimbursement in the past. When you get reimbursement, that's step one. And you usually see a lag impact of anywhere from six months to a year before you start to see the revenue impact of that.

Vivian Wohl – Federated Kaufmann

Okay. Great. Thanks very much. Great quarter.

Mark Sieczkarek

Thank you, Vivian.

Operator

Ladies and gentlemen, we have time for one final question. And that question will come from the line of Mark Regan with Watchfire Capital.

Mark Regan – Watchfire Capital

Hi. Very quick question, follow-up on the direct-to-consumer campaign. In the markets you picked, you said you were targeting net income profitability in 18 months to 24 months. And I was wondering if you can quantify what that might mean in those markets for what kind of market share you would expect to have? Where do you think you're pushing the market share to? And where would you have started the market in those two or in those eight markets?

Mark Sieczkarek

Just in round numbers, I mean, in some of these marketplaces on average are probably about a 15% penetration rate. And we're starting to see 50 in terms of market share. And again, that's more specifically where we're starting to then see that 18 month to 24 month piece kick in. And I should point out, even we were very encouraged in the seasonality season of the third quarter in the states, where we were able to maintain that difference in share versus our national. And that's again another metric that we look at. So maybe generally said we're looking for a doubling or even a tripling of market share in those areas.

Mark Regan – Watchfire Capital

I missed you. You said targeting 50 or you're targeting 50 or 15?

Greg Lichtwardt

No, we're starting at 15 and basically, we're moving up to 50.

Mark Regan – Watchfire Capital

Over an 18 month to 24 month period?

Mark Sieczkarek

Yes.

Mark Regan – Watchfire Capital

So if that were applied to your overall target market, you're saying the direct-to-consumer campaign would move you to 350,000 kind of units. Is that –

Mark Sieczkarek

If you're looking at in on national basis, yes, you could be certainly projecting that out. I think beyond that though, as well, and we continue to talk about this market being 7.5 million families, and we are starting to certainly see the impact of people who, number one, would not have chosen a tubal or vasectomy, but are choosing Essure. And again, I think that's proof positive that certainly our market is bigger than just the 700,000 tubals. I think there is a report out there that's public and done by a third-party, it's a small survey that also indicated that women are making the choice for Essure that previously would have stayed on temporary birth control methods, et cetera. So we're definitely infiltrating, if you will, that 7.5 million families.

Operator

And ladies and gentlemen, that is all the time we have today. Please proceed with your presentation or any closing remarks.

Mark Sieczkarek

Yes, I just like to thank all of you for all of your excellent questions and we appreciate you joining us on this call. We certainly look forward to speaking with you again in the fourth quarter conference call and hope to have once again some of the excellent results and interesting points as we move this business forward. I'll talk to you soon. Thanks again. Bye now.

Operator

Ladies and gentlemen, that concludes your conference call for today. We thank you for your participation and ask that you please disconnect your line.

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