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Thermage Inc. (NASDAQ:THRM)

Q3 2008 Earnings Call

November 10, 2008 4:30 pm ET

Executives

Doug Sherk - EVC Group

Steve Fanning - Chairman, President and CEO

Dan Ferrari - Vice President, Business and Financial Planning

Clint Carnell - Chief Operating Officer

Analysts

Keay Nakae - Collins Stewart, LLC

Dalton Chandler - Needham & company

Anthony Vendetti - Maxim Group

Jody Dai - Leerink Swann, LLC

Chris Cooley - FTN Midwest Securities

Hesham Shaaban - Maxim Group

Operator

Good afternoon, ladies and gentlemen, thank you so much for standing by. Welcome to the Thermage third quarter 2008 earnings conference call. During today's presentation all parties will be in a listen-only mode. Following the presentation the conference will be opened for questions. (Operator Instructions)

As a reminder, this conference is being recorded today on Monday the 10th of November, 2008. I will now turn the conference over to Mr. Doug Sherk of the EVC Group.

Doug Sherk

Good afternoon. By now everyone should have access to the third quarter of 2008 earnings release which was distributed this afternoon after the market closed. The release is available on the Investor Relations section of Thermage's website at www.thermage.com and with our Form 8-K filed with the SEC. In addition, you can call our office at 415-896-6820 and we will get one to you immediately if you don't have access to the Internet.

Before we get started, during the course of this conference call the company will make projections and may make other statements about the company's business that are forward-looking and are subject to many risks and uncertainties that could cause actual results to differ materially from expectations. A detailed discussion of the risks and uncertainties that affect our business is contained in the company's SEC filings, particularly under the heading Risk Factors. Copies of these filings are available online from the SEC or on the Thermage website.

The company's projections and forward-looking statements are based on factors that are subject to change, and therefore these statements speak only as of the date they are given. The company does not undertake to update any projection or forward-looking statement.

In addition, to supplement the GAAP numbers, we have provided non-GAAP net income and non-GAAP diluted income per share information that excludes the impact of the stock-based compensation. We believe that these non-GAAP numbers provide you with insight to conduct a more meaningful and consistent comparison of our ongoing operating results and trends compared with historical results. A table reconciling the GAAP financial information to the non-GAAP information is included in our earnings release.

With that, I would like to turn the call over to Steve Fanning, Chairman, President, and CEO of Thermage.

Steve Fanning

Good afternoon. Thank you for joining us for our third quarter 2008 conference call. Jack Glenn, our Chief Financial Officer, had to begin jury duty this afternoon, so Dan Ferrari, our Vice President of Business and Financial Planning, will be sitting in for Jack. Also with me today is Clint Carnell, our Chief Operating Officer.

This afternoon we released our financial results for the third quarter that ended September 30, 2008. We also announced the operating results of Reliant Technologies. While this was a very challenging quarter for the aesthetics industry, we believe our results, especially when combined on a pro forma basis with those of Reliant, demonstrate the strength of our business model and the strong strategic rationale for the Reliant acquisition.

Turning first to Thermage operations; our revenue fell 6% in the third quarter from the prior year, reflecting a decline in sales on both systems and treatment tips. While average selling prices of new systems were at the same level as last year and ASP on treatment tips increased compared with the prior year, unit volumes were down. The decrease was a reflection of the difficult market environment.

The credit squeeze has also slowed spending on capital equipment, which has affected some of our customer base. In addition, consumer demand for procedures has also declined.

However, we feel that Thermage and Fraxel have several advantages in this environment, and we are meeting the challenges better than many of our competitors. One major benefit for both companies is a strong recurring revenue business model. In Q3, treatment tips and other consumables represented 77% of Thermage's product revenue and 23% of Fraxel’s product revenue. Thermage's partner plan continues to be a driver for treatment tips sales. Under the plan, we offer doctors a set number of monthly treatment tips and consumable products at a fixed monthly price. The majority of our tips and consumables in Q3 were sold through the partner plan. Following the close of the acquisition of Reliant, we expect to implement a partner plan for Fraxel tips.

Finally, we believe our bifurcated sales force has been a benefit in this market. We have one sales force focused on selling new systems. A second team sells upgrades, tips, and other consumables. During the quarter, we sold 111 systems including 55 upgrades. Post acquisition of Reliant, we plan to apply this model to the Fraxel product line as well.

Our gross profit remained high at over 75%. Treatment tips' ASPs increased to $363 in the recent third quarter compared with $316 a year earlier. Expense management is crucial during economic slowdowns, and we have focused very hard on controlling our costs. During the third quarter operating expenses declined by approximately $400,000 from the prior-year period. Importantly, we also generated $1.4 million in cash from operations during the quarter. Our solid gross margin, good expense control, and cash generation during a difficult quarter continues to demonstrate the strength of our business model, and the proposed Reliant acquisition will further enhance our position.

Now, turning to Reliant, in contrast to most of the industry, Reliant generated a 22% increase in sales over the third quarter of last year. Driving the growth was continued demand for its proprietary Fraxel skin resurfacing and rejuvenation products. Especially strong in the quarter were our sales of Fraxel Re:Pair launched earlier this year. This product targets plastic surgeons and dermatologists and is considered the premier technology for fractional resurfacing.

Reliant had an operating loss in the quarter of $1.6 million on a GAAP basis. This operating loss included $1.6 million in stock-based compensation charges and approximately $1.1 million in transaction expenses related to the pending merger. On a pro forma combined company basis, revenue for the third quarter would have been $32.9 million, an increase of 9% over pro forma combined results for the same quarter last year.

The combination of the two companies is highly complementary and synergistic for three key reasons. First, Reliant's business model, like Thermage’s, has a component of recurring revenue. Second, product innovation has been a hallmark for both Thermage and Reliant. We continue to commit resources to our R&D efforts to ensure the consistent rollout of new products and applications, and we have a robust product pipeline. Third, we see significant opportunities to further reduce overhead and costs. Now, originally when we announced the acquisition, we had identified approximately $14 million in annual cost savings. As of today, the cost savings we have identified have increased to approximately $19 million.

The combination of Thermage and Reliant will bring together two of the most recognized brands in the aesthetic market with a broad innovative product offering in the fastest-growing areas of aesthetics. We will continue to generate high percentage of recurring revenue, and we anticipate that with the cost savings and our continued focus on expense control, we will be able to further leverage our business model and drive more to the bottom line.

Now, looking ahead, we believe we will continue to face a difficult operating environment. While we cannot control the economy, we are very optimistic that our financial model, based on innovative products, recurring revenue and good expense control, will help us successfully weather the storm. We are focused on moving the Reliant acquisition forward, gaining approvals as quickly as possible and closing the transaction so that we can begin to gain some of the benefits. We remain optimistic about our prospects despite the current market, and we are very excited about the opportunities from the merger for improved profitability and enhanced shareholder value.

Now, I would like to turn the call over to Dan to provide further details of our third quarter financial performance and update you on our 2008 guidance.

Dan Ferrari

Before we discuss the details of our Q3 financials, I would like to provide an update on the status of our Form S-4 filing with the SEC on the Reliant transaction.

Since our original S-4 filing in mid-August, we have filed several amendments, including our latest filing on November 3rd. To date, nearly all the questions and comments from the SEC have been of a legal nature regarding the merger agreement and shareholder approval process. We still expect to complete the acquisition in the current quarter.

Now I'll turn to our Q3 financials. First-quarter revenue was $13 million, a 6% decrease compared to the same period last year with US revenues declining 10% and international revenues down 1%. The geographic split between US and international revenues was 51% US and 49% international.

Q3 systems sales of both new and upgrade units were 111 units worldwide, a decrease of 9 systems or 8% over prior year. New system placements for the quarter were 56 units, and upgrades were 55 units. Our installed base of systems at the end of the quarter grew to 2617 systems, of which 1352 are in the US and 1265 are international.

The gross profit margin for the quarter was 75.4% as compared to 77.6% for the prior-year period. The relatively high proportion of system upgrades in relation to other product revenue and increased manufacturing costs in relation to lower sales volume resulted in lower gross profit margin levels than those realized in Q3 2007.

Total operating expenses declined to approximately $10.6 million in Q3 from approximately $11 million for the same period last year. Total stock-based compensation charges for the quarter were $887,000. The breakdown of these charges on the P&L is as follows: Cost of goods sold $47,000, sales and marketing $352,000, R&D $80,000, and G&A $480,000.

Q3 operating income on a non-GAAP basis was $223,000, which excludes the stock-based compensation charges of $887,000 and merger-related costs of $165,000. On a GAAP basis operating loss for the third quarter was $829,000. Below the operating income line we recorded a loss on investments from a Lehman Brothers bond for $863,000. Interest income for the quarter was approximately $635,000, and we recorded a tax provision of $89,000.

Net income for the quarter on a non-GAAP basis excluding stock-based compensation charges, merger-related costs, and loss on the Lehman Brothers bond was $735,000 or $0.03 per share. This compares with net income of $1.6 million or $0.07 per share on a non-GAAP basis last year. On a GAAP basis net loss was $1.1 million or $0.05 per share compared to net income of $423,000 or $0.02 per share in the third quarter of last year.

Turning to the balance sheet; as of September 30, 2008, we had approximately $46 million of cash and marketable investment security and no debt. During Q3 we generated approximately $1.4 million in cash from operations. Please note that during the quarter we also lent $5 million to Reliant as part of the merger agreement.

Accounts receivable at the end of the third quarter were $5.9 million, resulting in days sales outstanding of 42 days. The increase in DSOs from the previous quarter’s 36 days was the result of a large proportion of international sales occurring in the last month of the quarter, which follows a typical seasonal pattern exhibited in the third quarter of the year.

Please note that additional financial information is available with this afternoon's filing of our Form 10-K with the SEC.

Finally, as were stated in our press release, due to the pending completion of the Reliant acquisition and the uncertain economic environment, the company is withdrawing previous guidance for full-year 2008. I would like to point out that we're in the process of building our 2009 annual operating plan. During our earnings conference call anticipated to take place in February 2009, we plan to make appropriate comments about our 2009 operating plan as it relates to our financial goals.

With that I conclude my overview of Thermage's Q3 financial performance and would like to turn the call back over to Steve.

Steve Fanning

Now I'd like to turn the call over to the operator for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question is from the line of Keay Nakae with Collins Stewart.

Keay Nakae - Collins Stewart, LLC

Dan, can you give us the split, US/o-US, for both system revenue and recurring revenue?

Dan Ferrari

Sure. System revenue was $2.9 million roughly for the quarter and tips and other consumables was about $9.9 million.

Keay Nakae - Collins Stewart, LLC

And what was the split US/o-US, of those?

Dan Ferrari

On systems, it was about 60% international and about 40% domestic.

Steve Fanning

Number of systems; 54 total US, and 56 total internationally.

Keay Nakae - Collins Stewart, LLC

Okay, and how about disposable?

Steve Fanning

If you look at the rev on that, looking at the total it was, on US, about $6.5 million, and about $6.2 million international.

Keay Nakae - Collins Stewart, LLC

Okay. So, outside the US, are you seeing a more significant decline in certain geographies like Europe versus Asia?

Steve Fanning

I would say that Europe now is starting to follow the US. Asia still is holding up.

Keay Nakae - Collins Stewart, LLC

Okay. And, which one of those now represents the larger share of your o-US revenue?

Steve Fanning

Asia, and it always has.

Keay Nakae - Collins Stewart, LLC

Okay. As far as Reliant, they had good numbers; you talked about the new product having a strong start, but any other reason you can point to why they had such a positive showing when the overall market is struggling so much?

Steve Fanning

Well, I think when you look at those companies that are offering proprietary technology in the marketplace, that new products continue to drive this business, and yes, it's very difficult, but when you have new, innovative products that have very good efficacy, they're still being accepted well in the marketplace. I think that's what Reliant has been able to demonstrate.

Keay Nakae - Collins Stewart, LLC

So for yourselves, then, you've got the new cellulite tip. How much did that contribute to the mix?

Steve Fanning

We continue to see cellulite and it's contributing between around 8% to 9% of our overall mix.

Operator

Our next question is from the line of Dalton Chandler with Needham & Company.

Dalton Chandler - Needham & Company

You mentioned you are now up to about $19 million in identified cost savings. Could you talk about where that incremental $5 million came from?

Steve Fanning

Sure. It predominantly came from a reduction in some programs and from some headcount which we had as vacancies and we are now not planning to fill those vacancies.

Dalton Chandler - Needham & Company

Okay. You had mentioned the importance of new products, and I think maybe after the end of the quarter Reliant had announced another new product that, if I understood it correctly, has interchangeable hand pieces. Can you talk about that and how you expect to promote it and how the product might be priced?

Steve Fanning

I really can't talk about that because we are not merged together yet, so I'm not allowed to speak about that.

Operator

Our next question is from the line of Anthony Vendetti with Maxim Group.

Anthony Vendetti - Maxim Group

Can you talk a little bit, Steve, about which countries in particular are still strong? Is it just Asia or are you seeing strength in Latin America? And then, where exactly are we with the close on the Reliant acquisition? Are we just waiting for a final okay or are there still outstanding questions there?

Steve Fanning

Question number one, it would definitely be Japan and Korea. And, question number two, we are just waiting for some final information. It's more of a technical nature and hopefully we will see that close very shortly.

Anthony Vendetti - Maxim Group

So, it could be any day up until the end of December, correct?

Steve Fanning

That's correct, Anthony.

Operator

Our next question is from the line of Jody Dai with Leerink Swann, LLC.

Jody Dai - Leerink Swann, LLC

On average, how many inventory do your customers carry in terms of tips or number of treatments? We are just trying to get a sense of visibility for the next quarter and possibly for '09.

Steve Fanning

I would say, on average, it's less than one month. One key indicator that we use to look at inventories is that we normally ship tips, for example, in a 2- to 3-day window, that's normal shipping, but a lot of times doctors run out of tips, and we ship a lot of next-day delivery by way of FedEx. So doctors are not carrying a huge amount of inventory at this time.

Operator

Our next question is from the line of Chris Cooley with FTN Midwest Securities.

Chris Cooley - FTN Midwest Securities

First, a housekeeping, and then a follow-up. In your response to Keay's question earlier when you were doing the splits there on the consumables, in particular, would you repeat those data points? I thought you said $6.5 million and $6.2 million, I apologize; that would be excess of your consumable revenue, is that for total sales? I just was trying to make sure I was backing this correctly.

Dan Ferrari

For tips and consumables, for international was about $4.9 million for Q3. And then, on the US side, was also about $4.9 million.

Chris Cooley - FTN Midwest Securities

Okay, I apologize; I misunderstood that earlier. Secondly, Steve, we just had the ASAPS meeting here roughly a week now back, and there has been some discussions about changing financing packages to the consumer and how that may or may not affect practitioners. Anything that you could maybe just provide some color on here in this short run as to maybe how this, as we think about it from the practices standpoint, might be beneficial for either Reliant or for Thermage or should we say NewCo here, because it clearly looks like financing is drying up, both at the commercial and the consumer end, and with the higher price points, how that may or may not affect demand for alternative procedures such as Thermage or Fraxel.

Steve Fanning

Well, I think there's two parts to that. One, I really can't comment overall relative to what the doctors are doing to try to entice consumers. I can tell you that during these times, I think doctors are understanding perhaps more so than before that companies like ourselves who offer opportunities to work with doctors to build their practice where we have programs that we can do that, that they are now partnering more with us. That's number one. So, I really don't think I can comment overall how that will help our business. I can tell you though that people who were thinking about perhaps having a facelift are now looking at alternatives to that. So, things like a Fraxel or a Thermage together can provide some very nice results, but here again, Chris, I don't have any data, third-party data, that indicates that that is occurring. It's only anecdotal that I hear, and as you heard, that's what I basically heard on the floor, that there is an opportunity for people to trade down, if you will, instead of doing surgery, to do minimally invasive and noninvasive procedures like Thermage and Fraxel.

Chris Cooley - FTN Midwest Securities

And maybe if I could, just one additional follow-up. When you look at your systems, and I realize we are not giving guidance for the balance of the year, but any thoughts there in terms of the new initiatives just to expand the installed base because it clearly looks like you are able to leverage that as you move forward with Reliant. I'm just trying to think about whether its new alternative plans, sale/leaseback, pay-per-click type models, just any thoughts there on ways to enhance the installed base in these type of difficult times?

Steve Fanning

Sure. Well, a couple things. One, I think the biggest opportunity for us, once we complete the merger, is to have Thermage and Fraxel sold together. There's a huge opportunity, and I'm really looking forward to that. Also, as you know, we have a partner plan which we launched last year, and that really has helped us out in terms of providing opportunities for the doctor to purchase very similar to the way you get your cell phone with an established number of tips coming in each month at an assigned price. So, we believe that we kind of were ahead a bit of the curve and that that really has served us well. Do we have any other, for lack of a better term, creative financing models in place? No. We think that what we are currently offering represents good value to the physician.

Operator

Our next question is from the line of Hesham Shaaban with Maxim Group.

Hesham Shaaban - Maxim Group

I just wanted to verify something that was said earlier regarding the tip sales; the majority was sourced from the partner plan, is the correct?

Steve Fanning

Correct.

Hesham Shaaban - Maxim Group

And is that the affinity program?

Steve Fanning

Yes. Now, remember, that's only in the US. We have not launched that program internationally.

Hesham Shaaban - Maxim Group

Okay. So just a general feel, I'm pretty sure you won't be able to qualify it, but is it an overwhelming majority or are we just breaking 50%?

Steve Fanning

It's greater than 50%, and quite frankly, from the beginning of the year it has exceeded our expectations, and also the other good thing about it is that this is a 6-month program and we have been encouraged by the number of doctors, for lack of a better term, that have re-upped into the partner program. So all in all we feel it has exceeded our goals in terms of number of accounts and it has exceeded our goals in terms of the re-up rate.

Hesham Shaaban - Maxim Group

Just to follow on that. I know you're not giving guidance for 2008, but what are your thoughts on the consumables size, and in relation to the affinity program, do you believe that downside risk is limited at this point? Has the program taken off to that level or is it up in the air?

Steve Fanning

Well, remember, number one, it's only in the US, so that's about 50% of our business. And number two, I would say it's successful. So I think it really has served us well within the US market and I will tell you that we are now planning to launch it internationally. So we are very pleased by that. We are effectively doing that as we speak.

Operator

We have a follow-up question from Keay Nakae with Collins Stewart, LLC.

Keay Nakae - Collins Stewart, LLC

Yes, I did want to dive into the partner program a little deeper, Steve. You mentioned you're happy with the number of doctors re-upping. As those contracts roll off, what percent would you say are continuing to continue under the program? And, do they do so under the same terms or is their monthly price lower at this point?

Steve Fanning

No, they do so under the same terms. And I'm going to leave it at that, Keay, because one of our competitors has also launched a program very similar to this, which is basically a knock-off of ours, and I now believe that it's proprietary information, so I want to hold back a bit.

Keay Nakae - Collins Stewart, LLC

Okay, that's fine. With respect to cost savings with Reliant, can you give us a sense for how those might come on-stream in, say the first 12 months of the year, at what point in each quarter do you expect to realize those annual savings?

Dan Ferrari

In the first quarter, it would be a smaller amount, say about $3 million of the $19 million and then the balance split fairly evenly over the last three quarters.

Keay Nakae - Collins Stewart, LLC

Okay, that's helpful. And are there specific areas of the operation where those savings come from that allow you to have that predictability?

Steve Fanning

Yes, they are programs that we've identified, they are vacancies that we don't plan to fill; so they are very, what I would call, hard numbers.

Dan Ferrari

And then, we are transferring manufacturing, and manufacturing transfer will be done in Q3. So that's why the lower number, predominantly.

Operator

We have a follow-up question from Anthony Vendetti with Maxim Group.

Anthony Vendetti - Maxim Group

The 8% to 9%, Steve, for cellulite, that's as a percent of tip revenues, correct?

Steve Fanning

Correct, percent of tip revenue, yes.

Anthony Vendetti - Maxim Group

You usually give the percentage of tip sales are from your new tips, the DTC, the STC, the cellulite.

Steve Fanning

Yes, that's about over 65% at this point.

Operator

Gentlemen, there are no further questions at this time. Please continue with any closing comments.

Steve Fanning

Thank you. We really look forward to updating you on our progress in the near future.

Operator

Thank you ladies and gentlemen. This does conclude the Thermage third quarter 2008 earnings conference call. If you would like to listen to a replay of today's conference, you can do so by dialing 1-800-405-2236 or 303-590-3000 and input the passcode 11120695. Those numbers again, 800-405-2236 or 303-590-3000 input the passcode 11120695. We would like to thank you very much for your participation today and you may now disconnect. Have a very pleasant rest of your day.

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