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Volcano Corporation (NASDAQ:VOLC)

Q3 2008 Earnings Call Transcript

November 5, 2008, 5:00 pm ET

Executives

John Dahldorf – CFO & Secretary

Scott Huennekens – President & CEO

Analysts

Mike Weinstein – JP Morgan

Tom Gunderson – Piper Jaffray

Jason Mills – Canaccord Adams

Matt Dolan – Roth Capital

Jose Haresco – Brean Murray

Operator

Good afternoon, everyone and welcome to Volcano Corporation's Third Quarter 2008 Earnings Conference Call. During the presentation all participants will be in a listen-only mode. Following the formal comments we will conduct a question-and-answer session (Operator instructions).

As a reminder this conference call is being recorded, Wednesday, November the 5th. A replay of this call will be available through November 12th by dialing 719-457-0820 with pass code 8632414 or via the Company's Web site at www.volcanocorp.com.

I would now like to introduce Mr. John Dahldorf, Volcano's Chief Financial Officer. Please go ahead, sir.

John Dahldorf

Thank you, and good afternoon everyone. With me today is Scott Huennekens, Volcano's President and Chief Executive Officer. Scott will begin today's call with a review of the factors contributing to our highly successful quarter, our strong presence at TCT and key developments in our clinical trial and product development programs. I will follow with a review of our financial results for the quarter and our updated guidance for fiscal 2008.

Before turning the call over to Scott, let me remind you that our prepared remarks contain forward-looking statements as defined under the Private Securities Litigation Reform Act of 1995. These include statements related to the guidance about financial results, growth strategies, product development and clinical trial programs, market acceptance of our product offerings, the functionality and capabilities of our products, as well as forward-looking statements that we may make in response to your questions.

Factors that could cause Volcano's actual results to differ materially from these forward-looking statements are described in our filings with the SEC including our 10-K for the year-ended December 31st, 2007, and our 10-Q for the quarter-ended June 30th, 2008.

Volcano cautions you not to place undue reliance on forward looking statements that may speak as of the date that they are made. Volcano undertakes no obligation to update publicly any forward-looking statements to reflect new information events or circumstances as of the date that they are made. Scott?

Scott Huennekens

Thank you, John, and good afternoon, everyone. Volcano had another great quarter delivering a 40% increase in year-over-year revenues for the second consecutive quarter and bringing our year-to-date revenue growth to 35%. This was the tenth consecutive quarter as a public company that our revenues exceeded Wall Street consensus.

As John will discuss, leading the way were our sales of IVUS systems and disposables and our growth was strong across all of our geographic regions. IVUS system sales increased 78% and IVUS disposable revenues increased 29% versus the third quarter of last year. We also continued to build upon our strong IVUS console placement program placing 238 during the quarter. This compares with 174 in the third quarter last year and 178 in the prior quarter.

We also achieved profitability on a GAAP basis through our revenue growth, gross margin improvement and leverage of our operating expenses. Based on our performance through the first three quarters of the year, we now expect that our revenues for the fiscal year will be in the upper end of the previous range of $164 million to $168 million, which represents an increase of approximately 27% to 29% over revenues in 2007. We're also raising our outlook for GAAP and non-GAAP earnings per share. John will discuss our financial results and updated guidance in more detail shortly.

Complementing our strong financial performance were a number of other important accomplishments, including the very successful TCT and new product launches. The general market trends continue in our favor as we continue to successfully build upon our hub and spoke strategy by leveraging a growing install base and our s5i multi modality integrated system through the sales of disposables.

As we have discussed with you before our growth platform has three legs, creasing our base IVUS and functional measurement businesses by more than 20% annually and achieving margin and operating expense leverage to increase profitability. Number two, generating additional revenues and profitability by broadening our offering of high margin disposables and things like OCT and forward looking IVUS. And three, adding complementary therapeutic solutions in key indications through acquisitions and end licensing of technologies.

Our base IVUS and FM business continues to benefit from several important growth drivers, including one, continued recognition that new integrated technology makes IVUS and FM faster, simpler and easier to use. Two, an increasingly favorable PCI environment. Three, a growing volume of positive clinical data for IVUS and FM. And four, an expanded direct sales effort that facilitates training and adoption and it compliments our partnerships with industry leaders.

The current market demographics support our belief in the future opportunity. While we believe that there are close to 5,000 IVUS systems in our key markets in the U.S., Japan and Europe many of these are the older, non-integrated roll around versions. Within these three geographies there are more than 6,000 cath labs with integrated IVUS in less than 15% of them. As a result, we believe that IVUS cath lab penetration can potentially reach 90%, including 80% integrated systems within the next five years. In addition, we feel that there are also growth opportunities available to technology upgrades and our product pipeline.

We believe and we think that our ability to gain market share bears this out. The customers want to buy a platform today that provides an easy pathway to future capabilities that they see as important, again, like OCT and forward looking IVUS. As I mentioned a moment ago, we are benefiting from the continued favorable tailwinds of increased stenting and PCI activity as well as the focus on achieving the best clinical outcomes.

Based on reports to-date from the major stent companies, stenting activity continues to rebound as worldwide PCIs were up 8% over the third quarter of last year with growth in the U.S. estimated at approximately 5%. This quarter is the third consecutive quarter that PCI volume has increased. Based on the 8% growth for IVUS reported by Boston and our results for the quarter, we estimate the IVUS market grew approximately 20% again in the third quarter with Volcano continuing to gain share.

Based on Boston's estimate of 14% IVUS penetration in the U.S. our catheter revenue suggests that Volcano now represents approximately 50% of the coronary IVUS catheter market volume, a significant milestone that highlights continued Volcano IVUS penetration. While confirming the market acceptance of our new imaging console that is capable of solid state IVUS, rotational IVUS and FFR pressure. As our Revolution IVUS catheter continues to gain momentum we expect to see the continued market share gain as physicians and cath lab managers look to equip their labs with a flexible system capable of all three of these platforms.

I should add that we are currently seeing only a minimal impact to our business with respect to hospital capital equipment purchasing activity as well as uncertainty resulting from the general market and political environment that we continue to monitor situation closely.

In the meantime, we have a strong order pipeline which we believe reflects the growing volume of evidence that demonstrates the clinical value of our technology. In addition, our systems represent relatively small outlays for these hospitals and there is a growing recognition that the use of IVUS can provide both clinical and economic benefit to the hospitals and physicians.

An equally important driver for the growth of our business is the continued release of data that demonstrates the value of IVUS and FM in delivering desired outcomes with both drug eluding and bare metal stents. This factor was in full effect at the recent TCT. There were a number of IVUS and FM related data presentations and IVUS was used in many of the live cases.

I should also note that during TCT we announced the introduction of our PrimeWire, our new and enhanced pressure guide wire and held our first ever evening symposium which addressed all of our imaging technologies and drew more than 200 attendees.

It was clear that the issues that were top of mind among clinicians at TCT included number one, am I stenting the right lesions? Number two, am I stenting the right patient? And three, is the stent fully expanded and opposed? There were a number of important data presentations related to these issues and I'll take a couple of minutes to review the most important including FAME, which address the lesion issue and DEFER, which address the patient selection topic.

In particular data from FAME or FFR versus Angiography for Multivessel Evaluation study presented by Nico Pijls from Eindhoven Hospital in the Netherlands with Bill Fearon from Stanford as the principle investigator generated a great deal of interest and attention at TCT.

This study, which involved just over 1,000 patients in 20 U.S. and European centers explored the value of FFR or Fractional Flow Reserve in diagnosing and treating patients with multivessel disease. The patients were randomized between these treated with angiography guided PCI or FFR guided PCI using current DES regimens. The objective was to compare angiographic guidance to FFR guidance and determine which coronary lesions required revascularization at one-year and what the outcomes would be in those patients.

The findings demonstrated that FFR guidance resulted in clinically superior outcomes and reduced the composite of death, documented myocardial infarction and repeat revascularization by 30% at one-year. The incidence of major adverse cardiac events or MACE, at one-year was 18.4% for the angiography group versus 13.2% for the FFR cohort representing a 28% reduction in composite MACE.

In addition, patients in the FFR cohort experienced lower average hospital stays, 3.4 days versus 3.7 days, and the number of DES per FFR patients was 1.9 versus 2.7 for non FFR patients.

Other benefits of FFR included lower use of contrast agents and reduced cost for overall treatment of approximately $675 or 11% lower and the procedure time with FFR was comparable to that of angiography. Dr. Pijls noted that the use of FFR improved the outcome of PCI significantly and because it helped indicate which lesion should be stented supported the evolving treatment approach to stenting ischemic lesions in medical treatment of non-ischemic lesions.

The DEFER or deferral versus performance of PTCA in patients without documented ischemia trial was a landmark study demonstrating that patients with intermediate disease not treated with PCI based on FFR guidance achieved long-term outcomes at up to five years equivalent to patients who underwent PCI for similar intermediate lesions.

The finding suggests that the stenting of lesions that are FFR normal can be treated medically reducing unnecessary and costly stenting. The data from this study as well as the FAME study highlights the importance of treating only truly ischemic lesions, a characteristic that can often be missed with angiography alone.

Another important presentation was made by Dr. Constantino Constantini of Brazil. He looked at the experience of 1,350 patients with coronary artery disease, evaluating indications for PCIs with DES. There were two cohorts with 952 patients receiving IVUS guided DES implantation. The IVUS patients were more likely to have multivessel disease and bifurcation lesions.

At follow up, IVUS patients had lower target vessel failure defined as depth myocardial infarction stent thrombosis or target vessel revascularization at 13.5% versus 18.8% for non-IVUS patients or a 28% reduction due largely to lower stent thrombosis rates of 0.096% for the IVUS cohort versus 2.5% for the non-IVUS cohort.

He noted that the use of IVUS lead to better clinical outcomes by reducing target vessel failure and long term follow up and that the incidents of DES failures restenosis and thrombosis are consequences of technical problems during stent implantation that can be avoided if IVUS was used during that procedure. These findings are similar to prior findings from the Washington Hospital Center data set.

Data were also presented from the PROSPECT Study, the Abbott Vascular and Volcano Trial using VH IVUS to study the natural history of plaque. Dr. Gregg Stone presented baseline demographic and imaging data from a complete set of nearly 700 patients.

This is truly groundbreaking data critical to understanding the progression of coronary artery disease and the findings represent the first step toward identifying patients at high risk who may benefit from preventative therapy. They indicate that angiography misses severe lesions more than one-third of the time versus IVUS.

Highlights of this data indicated that 43% of flow limiting lesions identified by IVUS were untreated and that 52% of the patients had thin-cap fibro-atheromas or tick buds more widespread than had been previously reported or thought. The next major milestone in this study will be the presentation of two-year follow-up which we expect will be at TCT 2009.

In addition, Dr. Patrick Seroyte [ph] presented updated data from IBIS II, trial sponsored by GlaxoSmithKline. The data showed the growth of necrotic core was impacted by GlaxoSmithKline's Lp PLA2 inhibitor, and that Volcano VH IVUS was essential in determining this and the other key findings. Dr. Seroyte noted that the use of VH IVUS was an effective tool for measuring the impact of potential drug regimens on coronary plaque and contributed to the development of therapies that dramatically improved patients outcomes. We believe that these findings will lead to follow up trials by GlaxoSmithKline utilizing Volcano VH IVUS as well as the use of VH IVUS in other future pharmaceutical studies.

I mentioned that many of the live cases at TCT featured IVUS and I want to spend a minute discussing one of the most groundbreaking cases that was performed by Dr. Darius Dudek in Krakow, Poland. Dr. Dudek used angiography, VH IVUS and OCT to demonstrate the culprit approach that has been promulgated by our Medical Director Dr. Paulina Margolis suggesting that the disease may not be located where the actual blockage occurs in the artery.

The underlying premise is that the lesion ruptures within a vessel it produces a secondary lesion downstream, a condition that often gets missed with angiography. Dr. Dudek's case showed that VH IVUS and OCT confirmed the findings that the rupture was upstream from the most significant narrowing identified by the angiogram. The use of IVUS and OCT enabled Dr. Dudek to achieve stent placement to cover both the thrombus and the actual site of the original plaque rupture. This is an important clinical issue as failure to do this can result in potential patient issues such as disembolization, stent thrombosis, vessel closure, restenosis or plaque progression.

As I mentioned earlier, the TCT was also marked by the launch of our new PrimeWire pressure guide wire, which is compatible with the s5 family of integrated console. This device was featured in two live cases at TCT, the first ever using the device. Its introduction further symbolizes our commitment to the FM market and represents a significant improvement to our FFR product line with an integrated multi modality platform that also includes IVUS.

The PrimeWire measures intra coronary pressure to drive an FFR index for measuring maximum achievable blood flow in a coronary artery with the presence of an abnormal stenosis as a fraction of maximum blood flow achievable in the absence of the stenosis. FFR is 100% specific in identifying lesion creating sufficient restriction of blood flow to cause ischemia.

With respect to our clinical trial some quick updates. The ADAPT Study which is examining the role of IVUS in ensuring accurate stent placement has now enrolled just under 2,300 patients out of the 11,000, including 562 in the IVUS arm out of 3,000. These are 10 sites – there are 10 sites in total involved with this trial with five enrolling patients in the IVUS cohort. This is a Cardiovascular Research Foundation study of patients with coronary artery disease undergoing PCIs with DES.

The Blast Study, which is exploring the value of great scale and VH IVUS in the diagnosis of atherosclerotic plaque and bifurcation lesions now has three sites in the U.S. and Europe approved for participation and we expect to begin enrollment in the study in the near future.

In terms of our sales and marketing programs we continue to leverage our strong relationships with major stent and cath lab equipment companies such as GE. While we recognize that GE has compatible testing with other IVUS and FM providers they are still pre-cabling 100% of their cath lab installations for Volcano IVUS.

In addition, GE is still only offering Volcano compatibility with their controller. They also have significant investments in integrating their offerings only with Volcano, not with others and are making further investments including incorporating the Revolution catheter and Volcano FFR into their offerings as well.

At the same time we continue to build our direct sales force, which at the end of the quarter numbered 137 versus 132 at the end of the second quarter. We've also continued to build out in Japan and had 16 sales reps in that market at the end of the quarter.

The transition with Goodman that we discussed last time is going well. We are achieving console placements and adding new accounts. Given the market response we are planning to accelerate our efforts in Japan to go direct and we'll discuss that in more detail in our fourth quarter conference call.

At the outset of my comments I referenced our hub and spoke strategy and the vision of our multi modality technology serving as a platform to add new offerings that can address markets even larger than those we are addressing today. We have a very vibrant product line – product pipeline and I want to provide you a quick update on it.

We had planned to have our first demand use of our image guided therapy that combines IVUS in a balloon on the same catheter with both coronary and peripheral applications in the fourth quarter this year. However, due to our desire to develop a truly state-of-the-art device we are continuing to enhance the balloon design. As a result, our timing for the product is slipping a bit and we now expect to begin initial studies with the device in the second half of next year with commercial launch late in the first half of 2010.

In terms of the OCT technology acquired through CardioSpectra transaction we continue to hit key milestones. We have added personnel to this effort to facilitate our research and development and commercialization program. We expect to file our U.S. regulatory submission later this year and with the commercial launch of the first generation product in the first half of 2010 in the U.S. and Europe.

Our program with forward looking IVUS technology acquired from Novelis is also proceeding well. As we've discussed in the past, we are working on two offerings, the first of which we expect to have first demand in use in the first half of 2009 with commercialization by year-end 2009.

The second device which incorporates RF Energy that will tunnel through the plaque is on track for first demand in the second half of 2009 with U.S. and European commercialization in the second half of 2010. As you can tell we have a very active pipeline of products under development that will emerge over the next two years and that address very large markets with potential value in excess of $2 billion or five times larger than our current IVUS and FM market.

We're also seeking complementary technologies to address market opportunities such as PTOs, AMIs, bifurcation, intracardiac echo and vulnerable plaque and we'll continue to update you on our progress in those areas going forward.

As we enter the final weeks of 2008, I'm very pleased with our ability to execute as represented by Volcano's performance during the year and highly enthusiastic about the opportunities ahead of us. Because of our strong financial condition, we are well positioned to capitalize on opportunities that can facilitate our continued growth. However, we will continue to be judicious in the use of Company resources as we have a proven model through which we can realize our growth objectives with our core businesses.

As we have indicated in prior calls, we anticipate that at least in the near-term any strategic acquisitions will be tuck in technology additions similar to the CardioSpectra and Novelis transactions involving complementary technology that will enable us to more quickly and thoroughly address our target markets.

Thank you again for joining us today, and I'll now turn the call over to John. John?

John Dahldorf

Thank you, Scott. Revenues for the third quarter 2008 were $44.1 million, a 40% increase over revenues of $31.5 million in the same period a year ago. Factors contributing to our revenue growth included strong sales of IVUS Systems and disposables and FM disposables.

We also had meaningful revenue growth in our key geographies of the U.S., Japan and Europe. Our revenues for the third quarter of 2008 included a benefit of approximately $800,000 versus third quarter a year ago for foreign currency conversions.

For the first nine months of 2008, we generated revenues of $122.2 million versus $90.6 million in the same period a year ago and $130.6 million for all of fiscal 2007. Our revenues for the first nine months of 2008 included a benefit of approximately $2.9 million versus the first nine months of 2007 related to FX conversion.

With respect to the revenue breakout for the quarter, consolidated sale of IVUS systems and related equipment were $10.6 million, a 78% increase over sales of $5.9 million a year ago. In the U.S. IVUS system revenues were $5.6 million versus $3.4 million, a year ago, or an increase of 62%. In Japan, they were $2.5 million versus $522,000, reflecting current product sales recognition of deferred revenue and revolution upgrade kits for our s5 console sold to our distributors. And in Europe they were $1.8 million versus $1.5 million a year ago.

We continue to be highly successful in growing our installed base, an important driver of our growth. During the quarter, we placed 238 IVUS consoles including 66 related to our initiatives in Japan versus 174 in the third quarter a year ago. For the first nine months of 2008, we have placed 537 consoles versus 420 in the same period a year ago and we now have more than 3,700 IVUS and FM consoles placed worldwide.

On a consolidated basis, IVUS disposable revenues were $27.2 million versus $21.1 million a year ago or a 29% increase. In the U.S. IVUS disposable revenues were $13 million versus $10.1 million, a 30% increase. In Japan, they were $8.9 million versus $7.5 million a year ago. In Europe, they were $4.6 million versus $3 million a year ago, an increase of 51%.

FM revenues in the quarter were $4.9 million versus $3.3 million at third quarter a year ago. In the United States, FM revenues were $2.3 million versus $1.4 million a year ago. In Japan they were $483,000 versus $169,000 last year and in Europe, they were $1.7 million versus $1.5 million a year ago.

The growth of our FM business reflect increased market acceptance and a renewed focus on this business by our sales force. We believe that the data presented at TCT that Scott discussed earlier will provide continued momentum for this business going forward.

Other revenues on a consolidated basis were $1.4 million versus $1.2 million in the third quarter a year ago. Gross margin in the quarter was 62% versus 61% a year ago and 62% in the prior quarter. Contributing to our increased margin versus last year were the favorable impact of our cost reduction programs and higher manufacturing capacity utilization.

Operating expenses in the quarter were $27.2 million. This compares with $21.6 million a year ago and $27.9 million in the prior quarter excluding $12.2 million of charges related to the Novelis acquisition. In comparison to the second quarter this year, we reduced our SG&A expenses by approximately $1.3 million, a result of lower sales related expenses and the timing of trade shows and training events.

Our R&D expenses increased by approximately $600,000 due to a ramp up in spending on our OCT development project and a full court of expenses related to our forward looking IVUS program.

In comparing operating expenses to the year ago period sales and marketing reflects – expenses reflect increased spending due to higher headcount globally and promotional costs. G&A costs increased due to infrastructure growth and higher stock-based compensation expense while R&D increased by $2 million reflecting our expanded programs related to OCT and forward looking IVUS.

On a GAAP basis we reported net income of $744,000 or $0.01 per diluted share. In the third quarter of last year, we reported a net loss on a GAAP basis of $652,000 or $0.02 per share. Excluding stock-based compensation expense of $2.5 million, we reported net income of $3.3 million or $0.06 per diluted share. In the third quarter of 2007 excluding stock-based compensation expense of $2 million we reported net income of $1.3 million or $0.03 per share.

Weighted average diluted shares in the quarter were 50.3 million versus 41.7 million a year ago, reflecting the impact of our equity offering that was completed in the fourth quarter a year ago.

Turning to the balance sheet, we ended the third quarter with $176.7 million in cash, cash equivalents and short-term available for sale investments versus $189.1 million at the end of 2007 and $178.3 million at the end of the prior quarter. Keep in mind that our cash balance versus the end of last year was impacted by the $12.3 million expenditure in the second quarter this year related to the acquisition of Novelis.

With respect for our outlook for fiscal 2008, we are updating the guidance that we provided in our last call. We now expect revenues to be in the upper end of our previous range of $164 million to $168 million, which represents an increase of 27% to 29% over 2007 revenues.

As we mentioned earlier in the call we are seeing minimal impact to our business today from the current economic and political environment, but are remaining cautious and continue to monitor the situation closely.

We now expect gross margins to be in the range of 62% to 63% versus prior guidance of 60% to 61%. We are still expecting the upgrade kits sold to our Japanese distributors to have a negative impact on margin, but believe a substantial portion of that impact will be offset by favorable manufacturing variances.

We continue to expect operating expenses will be 74% to 76% of revenues. This includes stock-based compensation, the due diligence costs recorded in the first quarter, in process research and development costs incurred in the first half of the year, and approximately $3.1 million of intangible amortization.

Due to our performance in the third quarter and improved gross margins, we now expect to record a net loss of $0.30 per share to $0.32 per share on a GAAP basis versus prior guidance of a net loss of $0.33 per share to $0.37 per share. We also expect to be profitable on a GAAP basis in the fourth quarter.

Excluding stock-based compensation of approximately $10 million due diligence expenses and research and in process research and development costs, we expect to report non-GAAP net income of $0.18 to $0.20 per diluted share. This compares to prior guidance of non-GAAP net income of 14% to 18% or $0.18 per diluted share. Weighted average shares outstanding at year-end 2008 are expected to be 47.4 million basic shares and 50.4 million shares on a diluted basis.

In closing, we will be participating in the Canaccord Adams Cardiovascular Conference later this month, the Piper Jaffray Healthcare Conference in the first week of December and the J.P. Morgan Healthcare Conference in January.

Thank you again for joining us today and we'll now open the call to your questions.

Question-and-Answer Session

Operator

(Operator instructions). We'll take our first question from Mike Weinstein with JP Morgan.

Mike Weinstein – JP Morgan

Thanks. Good afternoon, guys.

John Dahldorf

Hi, Mike.

Mike Weinstein – JP Morgan

Hi, there. Let me start with a couple items. First, I would hope that you could just elaborate a little bit on what you're seeing at hospitals right now. You commented that you were seeing very little impact in the credit environment. If you can add anything to that that would certainly be appreciated by everybody. And second, could you talk a little bit more about the FFR opportunity the same day it was probably the highlight at TCT. It would certainly seem like there is a bigger opportunity there than what we focused on. So, could you spend a few minutes on how you capitalized on that and any potential involvement from either the FDA or from CMS would be interesting? And then I have some product pipeline follow up. Thanks.

Scott Huennekens

Yes, so, on the hospital question, first. You saw our numbers for capital placements in the quarter well over 200 units, our projections are for well over 200 again in the fourth quarter. And we have – we're U.S., Europe and Japan. If you look at the U.S. deal, we don't see anything in Europe or Japan. It's like a handful of things in the quarter out of 100 plus deals where people are delaying or waiting maybe a quarter. This is usually in the case of hey, we're going to add a fourth room or fifth room and we'll just wait on that room. But if they're just retrofitting their existing four rooms with IVUS those are go aheads because the capital is not much. It's when it's tied to a new room that may be over $1 million and they want to just see what's happening or when they're building in. Even the people who are building new hospitals like at a Cleveland Clinic and the like there is no slowdown. They're committed to capitals raised. They're doing it. So in our view it's ending up being a very, very, very small portion of the business when you talk about a small percentage of the 25% of our business and it being only the U.S., which is 50% of that.

Mike Weinstein – JP Morgan

Scott, maybe what would also be helpful is what percentage of your console sales are tied to new cath labs versus existing labs?

Scott Huennekens

I don't know the exact number, but less than 10% of the U.S. ones –

Mike Weinstein – JP Morgan

Of the US consoles sales, less than 10% would be tied to new labs and that's basically where you might see a closure, but otherwise

Scott Huennekens

Yes, that would mean less than 5% of the capital deals and not all of them are going to go away. So, it's nominal. Like John said, we're watching it carefully and paying attention to it. And we have different programs, whether its selling equipment outright, whether its catheter utilization programs, whether its leasing programs for the hospital. Usually it's a case where they put a $1 million plus order on hold, not that they're putting a Volcano order on hold.

Mike Weinstein – JP Morgan

Right. And FFR?

Scott Huennekens

On the FFR opportunity, we see this as a great opportunity across hardware, wires and geographies meaning that it's a differentiator that's helping us drive placement of our system versus Boston because our system has both capabilities. So, going in and being able to talk about this data and now center saying FFR is not a luxury, it's a must and we want it integrated and you can do it in two steps in two minutes or three minutes versus rolling a system in. That's a big deal for us. That's going to help us win the install base versus Boston. But then on the wire side wires in the U.S. are used in less than 5% of the procedures and multivessel disease alone is upwards of 15%. So, we think the FM market over the next two years to three years can double in size and that would be very much a positive. That's globally. So, if it's $60 million globally, it could be a $120 million market and we feel like we'll take more than 50% of the share. So, that's a nice opportunity for us to drive. So, in Japan there's reimbursement for FM even though IVUS is used a lot more.

In the U.S. it's similar to IVUS in that the physician gets reimbursed under a CPT code. This data is powerful and it has the ability to potentially change guidelines and also change CMS decisions. That's all take time to make happen. It would be next October at the earliest, but we want to start having those discussions with them because they can reduce costs and reduce events by 30%. In Europe, FM has grown faster over the last two years than IVUS for us and we think that trend will only continue based upon their higher focus on reducing and maintaining cost and driving patient outcome.

Mike Weinstein – JP Morgan

Just a follow up. The comment about potential to double the market size over the next couple of years. A, what do you think needs to happen? What do you need to do in order for that happen? And then B, what's your ability with the market the same data? Can you use that data actually in your marketing?

Scott Huennekens

Absolutely. We're using it already. Every single one of our reps has multiple printouts at every single account. I traveled to eight accounts last week. They all had it posted up on their boards in their cath labs. So, we're aggressively using that. I presented it at three different doctor dinners that had 10 plus physicians last week. Absolutely. So to do it, Mike, it doesn't require any reimbursement changes. That's our estimate based upon driving more volume of integrated solutions into the field using our existing FM base or adding an existing FM base. They're aggressive push. So, if you were to get some kind of reimbursement change in the U.S. it would go faster than that. The point is that reimbursement change wouldn't be for a year now anyway so.

Mike Weinstein – JP Morgan

Operator, go ahead and let somebody ask.

Operator

Thank you, sir. We'll go next to Tom Gunderson with Piper Jaffray.

Tom Gunderson – Piper Jaffray

Hi. I'll keep on with the FFR a little bit because it is interesting, Scott. CMS is one thing, but that's slow and that got some budget issues. But if I were a private payer right now I'd almost demand FFR be used because it's in the patient's best interest and me as a payer. What kinds of SWAT teams or outside agencies do you have that can go after those private payers in the short-term?

Scott Huennekens

Well, there's a process and there are reimbursement consultants. And that's all part of our upgraded FFR marketing program based upon the same data. So, we are in the process of putting those programs together and aggressively pushing starting here in the fourth quarter those kind of programs.

Tom Gunderson – Piper Jaffray Okay. And then you also pointed out that this helps differentiate even more your systems from Boston Scientifics. Do you believe that you're still getting 70% of the new installs and could that go up?

Scott Huennekens

Yes, we – from our market data that we track on salesforce.com we are achieving a 70% number for integrated systems. And could it go up? I mean it could. It just gets hard as you get higher market shares, to be perfectly frank. So, we'll see what happens. But the combination of having FFR and FFR being more meaningful to account versus the nice to have, it's a good thing, a great thing really, for us and then to also now being able to show people forward looking IVUS and OCT and that this platform that they're buying that they're going to live with for the next seven years have expandability to these other areas that they're very excited about is really powerful.

Tom Gunderson – Piper Jaffray

And then could you talk a little bit about Japan, the upgrade kits, the Revolution? Is rotational 75% of the market in Japan or has that now opened you and how is the transition going?

Scott Huennekens

Yes. Based on market share, up to this point you can define the Japanese market by Boston and Terumo's market share versus Volcano so that 70% to 75% of the Japanese market as rotational is true. We're basically right on plan with our distributors in terms of the upgrade kits that we processed in Q3 and we expect to continue to see that in Q4. So, the key is really getting these consoles for our distributors upgraded, and then as we also mentioned in our comments, in our scripted comments, we did place about 66 consoles between our direct efforts with our own sales force or through our distributors in Japan as well, which is – which will help and facilitate the introduction of rotational as we proceed through Q4 and into the first half of next year.

Tom Gunderson – Piper Jaffray

Okay. And then last question again on Japan. I think your sales force last we talked was at 20. Did you add more in the quarter?

Scott Huennekens

Yes. Actually, the real number at the end of the quarter was 16. Shortly thereafter it was 20 and we expect to have almost 30 by the end of the fourth quarter.

Tom Gunderson – Piper Jaffray

Okay. Thanks. That's it for me.

Operator

We'll take our next question from Jason Mills with Canaccord Adams.

Jason Mills – Canaccord Adams

Thanks, guys. Good quarter. I'm going to follow the question on Japan. It looks like the growth in disposables, Scott, accelerated a bit from the second quarter, probably not where you want them to be or were you think they will be. Perhaps you could give us some color on where you'd like to see them and how quickly you can get to that level if we're not there yet.

John Dahldorf

Yes, I think that we're actually quite pleased with the order flow and the disposable flow in Q3. And as we continue to fill out our direct sales force, bring those folks up to speed from a training perspective as well as continuing to push the introduction of rotational with Goodman and Fukuda. We're really kind of right on where we thought we would be. And I'm looking forward to continuing to push that through the end of the fourth quarter here and again into the first half of next year.

Scott Huennekens

Jason, this is Scott. The thing I would add is that we have a situation where we've talked about Goodman's had some financial challenges because they have the stat load and so their limitations with the capital that they can buy and roll out s5's with rotational put a certain limitation on us that we think will work to our benefit in the long run as we actually go direct more and faster that will allow us to take the market. We see what we're achieving with that direct rate group in Q3 and also this first month of Q4 and we're very excited about it. And then we're at that grossed up revenue number of not having it go through distributor.

Jason Mills – Canaccord Adams

Right. So the margins are improving, I assume John, that part of the efficiencies you talked about are also including the ASP differential you're getting now to keep via direct sales force in Japan without being more pronounced going forward as well.

John Dahldorf

That would be more pronounced going forward as well. The direct sales contribution that we had in the third quarter from our direct really didn't move the needle on the margin, but it definitely will have an impact probably in a more material way in the first half of next year.

Jason Mills – Canaccord Adams

Okay. So, the 18% year-over-year growth in Japan disposables is sort of around the level. It's caused – your long – your growth outlook for worldwide IVUS is 20%. I suppose what you're telling me is then you would expect Japan to be right at that level going forward even though we're seeing start to participate in three quarters of the market you didn't participate in and your placement seemed to be quite high relative to your current install base. The growth there seems quite high so. It seems like you're being a little conservative, but is 20% where we should expect you to be in Japan?

John Dahldorf

I think that's a reasonable number, yes.

Jason Mills – Canaccord Adams

Okay. That's helpful. And then Scott, I'm sorry if I missed or didn't hear your comments clearly with respect to Mike's question on FFR reimbursement, but perhaps you could go over that again in terms of what the process will look like over the next 12 months as it relates to CMS establishing reimbursement. Or should we think about a longer pathway in our modeling?

Scott Huennekens

Yes, I think you should consider a longer pathway if history is any indication. Having evidence based medicine that you reduce costs and improve outcomes doesn't mean you're going to get reimbursement in a one-year time span even though it makes all the sense in the world. So, today on an outpatient basis, there's no reimbursement just like IVUS. It's covered under the different APC codes. There are CPT codes for the physician if they use FFR and they get reimbursed. It's $80, $90 to $115, $120. Same thing on an inpatient basis. The procedure is covered under the DRG and the physician makes a fee for the CPT and a similar dollar amount to IVUS for use of FFR. So, that's the current situation. Now, you can lobby and work towards getting reimbursement levels changed and you know the process where there are proposals made and obvious different things happen and they become active October 1st. So, we're at the beginning of trying to lobby into that process as we move forward here.

Jason Mills – Canaccord Adams

Okay. That's helpful. Just two quick follow ups and then I'll get back in queue. The SG&A leverage was probably the most surprising thing and very positive in the quarter. Could you talk about – John, you mentioned you expect to be profitable again in the fourth quarter. I'm sure that you're not ready to talk about your 2009 plan in great detail, but perhaps you could give us just a bit of color about what kind of SG&A leverage you'd like to see or you think you're going to be prepared to talk about at some point in the relatively near future as relates to the – let's call it the next couple of years if you don't want to talk specifically about 2009. And then secondly, part and parcel of that gross margins in 2009, you've talked about additional improvements I think on the order of 200 basis points or 300 basis points off of a 63% level that you talked about in the fourth quarter last quarter. You now sort of updated that guidance. Where should we think about gross margins in 2009 at least sort of in a range relative to what you kind of told us in the past?

John Dahldorf

Yes, I think that what you're going to see in Q4 and going forward short of us having to account for some acquisition milestones is in process R&D. So, we're kind of setting those aside, but including everything else which would include stock compensation expense, amortization of intangibles, and the like. I think that as we've kind of talked about in the past that we expect our revenues to grow in the 20% to 25% range for the foreseeable future. Our margin improvement of 200 basis points to 300 basis points continues to be on par. So, I expect to see us in the 65% to 66% range over the next 12 months. And I think that you'll see the operating expenses will grow probably in the high teens in the next 12 months versus our revenue growth.

Jason Mills – Canaccord Adams

That's phenomenal. Thanks, guys.

Operator

We'll take our next question from Matt Dolan with Roth Capital.

Matt Dolan – Roth Capital

Hey, guys. Good afternoon.

Scott Huennekens

Hey, Matt.

Matt Dolan – Roth Capital

A follow up on the growth outlook specifically relative to your guidance, you had a quarter here that again beat our expectations. But looking to Q4 I think it suggests maybe mid teens growth for the quarter. So, are there any one off comparable issues there in that assumption for the quarter coming off a two 40% numbers? I think you mentioned it, but long-term 20% to 25% sounds like it's still a good gauge to go off of.

Scott Huennekens

Yes, I think, Matt, if you look at Q4 of last year we introduced the rotational on our Legacy IDG consoles in Japan and we had a number of upgrade kits as well as rotational catheters that went out to our distributors in the tune of probably somewhere between $1.5 million to $2 million of revenue. And so, you've got a tougher comparable there and then you also will have again as we've kind of talked about whereas we don't see a deterioration at all in our pipeline right now as far as deals are concerned this quarter, but we're continuing to be somewhat cautious about our projections. The other little headwind that we will have in the fourth quarter of this year versus prior year is now that the dollar has strengthened both in the Euro and the Yen that will work against us a little bit.

Matt Dolan – Roth Capital

Okay. Great. Thanks. And then on the competitive front I know we've talked a little bit about GE at TCT improving their work flow with Boston. They've also announced a new product on their conference call regarding tissue characterization with their 2.0 version of the iLab starting early next year. Scott, what are you expecting out of them competitively? Do you see that environment changing in even the slightest of ways? Do you expect any incremental pressure from them or what are you hearing?

Scott Huennekens

There is no announcement of any improvement in work flow at all. Their announcement was just that they have electronic compatibility with GE. So I just want to be clear there relative to that announcement. As it relates to tissue characterization, we don't have enough information to really comment, but if they're starting their clinical work after the first of the year, that means they're six years behind where we were or where we are because we've been out for six and a half years. And they would have to do a lot of work relative to validation and proof statements for a couple of years for people to validate its accuracy and the like. So, right now, tissue characterization is not a big driver of market share decisions. It's more the platform. It's ease of implementability, meaning we have three components, they have five, they require an extra boom, they require their unit to be within 10 feet of the table versus 100. We have a multi modality platform. They have a single platform. We have multiple IVUS platforms. They have one. We have 20 things to their two. So, I worry probably more about Terumo in the long term because they have IVUS and OCT than I do about Boston just because they have the same number of engineers they've had from before and it's not their primary focus.

Matt Dolan – Roth Capital

Okay. Great. Thanks a lot guys. Take care.

Operator

We'll take our final question from Jose Haresco with Brean Murray.

Jose Haresco – Brean Murray

Hi, guys. Can you hear me, okay?

Scott Huennekens

Yes, hear you fine, Jose.

Jose Haresco – Brean Murray

Alright. Just a last question. You've said again on a conference call that you foresee growing the base IVUS business still at the 20% to 25% level for the foreseeable future. Given the concerns, I think that have been voiced not just on this call, but on other calls regarding CapEx, and I know you haven't seen it yet, and I think it's true of many companies. Where do we get that comfort from with regards to your (inaudible) or the purchasing managers that you work with not changing their stocking habits or their inventory habits? You're not seeing any delays in your pipeline. Can you just walk us through some of the specifics that give you comfort around that 20% to 25% that you mentioned?

Scott Huennekens

Jose, you broke up and we only heard half of your question, if you could repeat it.

Jose Haresco – Brean Murray

Sure. Could you walk us some of the details that you see or some of the things that you're seeing in the hospital environment that give you comfort around that 20% to 25% revenue growth that you alluded to on the call?

Scott Huennekens

Sure. So the way we grow is multi factorial. So, we grow by going direct in Japan, so this gross up in revenue that occurs is part of that, by taking market share in Japan we go geography by geography. Those are our two drivers to grow at over 20% in Japan as well as new product introduction. So we feel very comfortable with our plan as it relates to Japan. In Europe and Japan represents 25%-ish. Europe represents 25%-ish of the revenue. Again, we gain by market share and increased penetration of the use of IVUS and FM in Europe and those continue to grow. They've grown over the last few years at over 30%. We continue to take a larger portion of that growth than Boston has or Radi has as we continue to grow. So, there's no indications that that slows down. The benefit of our business as you know is 75% disposable, 25% is hardware. So, you're really talking about the 25% and then a small part of the 25% as well as part of that. And then as you go to the U.S. it's driven by market share gains and by penetration increases again.

And so, penetration increases continue as we drive and there's more clinical data that supports the use of IVUS and FFR now. 4,000 patients plus study from Washington Hospital Center, 1,000 plus patient study from South America, all the same data. People are using more IVUS and FFR and they need integrated solutions to do that and do it cost effectively and fast and it's not a lot of capital to do it. You can outfit four labs or three labs for $150,000 to $200,000. So, we just don't see any slowdown. We haven't seen any slowdown. We have very sophisticated sales tools and programs with our customer relation management systems, salesforce.com. We see exactly what our pipeline is, number of opportunities and deals. We see closure rates by month as projected. We track it by month. So, we don't see anything really changing. Now, we do follow this capital crunch that is occurring in the world economy and look and see if it's affecting our customers. And I explained the only three or four instances where we've seen it on deals in the last four months.

Jose Haresco – Brean Murray

Okay. Great. Thank you very much.

Scott Huennekens

And to your question on disposables there's been – there's no change in stocking of disposables or other things. They need them to do their procedures.

Jose Haresco – Brean Murray

That's very encouraging to hear. Thanks, again.

Operator

That does conclude –

Scott Huennekens

The other thing I would mention is that we're not someone to stock a hospital with 1,000 catheters and they use them over a year. We're shifting the customers' orders of 8 catheters to 10 catheters that they use over a week or a couple weeks. So they don't maintain a lot of inventory. It's almost kind of just in time-ish. Sorry, was there another question?

Operator

No, sir. That does conclude our question-and-answer question. I'd like to turn things back over to you, Mr. Huennekens for closing remarks.

Scott Huennekens

Okay. Well, thank you guys all for joining us. We greatly appreciate it. We're very proud of another great quarter. We're very excited about Q4 and 2009. We feel like we've got a lot of momentum entering Q4 and entering 2009, so like I said, very, very enthusiastic. And look forward to either seeing you at the upcoming conferences or talk to you at the end of next quarter. Thank you.

Operator

That does conclude today's conference. Thank you for your participation. You may disconnect at this time.

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