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Cyberonics, Inc. (NASDAQ:CYBX)

F3Q09 (Qtr End 01/23/09) Earnings Call

February 19, 2009 9:00 am ET

Executives

Daniel J. Moore – President & Chief Executive Officer

David S. Wise – Vice President, General Counsel & Secretary

Gregory H. Browne – Vice President, Finance & Chief Financial Officer

Analysts

Thomas Gunderson – Piper Jaffray

Steve Brozak – WBB Securities

William Plovanic – Canaccord Adams

Anthony Petrone – Maxim Group

Scott Gutterman

William Plovanic – Canaccord Adams

Operator

Good morning. My name is [Nikisha] and I will be your conference operator today. At this time, I would like to welcome everyone to the Cyberonics Investor Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. (Operator Instructions). Thank you. Mr. Moore, you may begin.

Daniel J. Moore

Thank you, [Nikisha]. Good morning. Welcome to the investor conference call. I am Dan Moore. I will be joined this morning by our CFO, Greg Browne, and our General Counsel, David Wise. David would you please read the Safe Harbor statement.

David S. Wise

Thank you, Dan. This presentation includes forward-looking statements. Forward-looking statements may be identified by the use of forward-looking terminology, including may, believe, will, expect, anticipate, estimate, plan, intend, and forecast, or other similar words. Statements in this presentation are based on information presently available to us, and assumptions that we believe to be reasonable. Investors are cautioned that all such statements involve risks and uncertainties.

Forward-looking statements in this presentation includes statements concerning: achieving consistent annual unit growth of 10% to 20% per year, fiscal 2009 guidance for net sales, gross margin, and operating capital, equity compensation, depression, and R&D expenses. Achieving an operating margin of 25% by fiscal 2011. Growing our epilepsy sales including growth in Europe, Latin America, and Asia. DEMIPULSE generator market penetration, conducting and completing new clinical and R&D projects including projects relating to new stimulation parameters, seizure detection, and prediction, telemedicine, and efficacy prediction.

Securing regulatory approval in Japan, increasing R&D investment in fiscal 2010 and maintaining leadership in medical devices for epilepsy. Our actual results may differ materially. For a detailed discussion of the factors that may cause our actual results to differ, please refer to our most recent filings with the SEC, including our Form 10-K for the fiscal year ended April 25, 2008, and quarterly report on Form 10-Q for the quarterly period ended October 24, 2008.

Daniel J. Moore

Thank you, David. In this morning's call, we will be covering four areas. First, Cyberonics highlights, followed by an overview of our 3Q fiscal year 2009 results, specifically looking at sales and our financials. Those financials will be covered by Greg. And then I'll move into the epilepsy strategic focus before we enter our fourth area, which is the Q&A.

For those of you following on slide I am moving slide four, which gives an overview of the highlights for our quarter. Let's start with one of the most important profitability. The Cyberonics team delivered the highest operating income in the company's history in our third quarter. We had positive net income for the fourth consecutive quarter, while operating expenses remain stable. In the area of epilepsy, our main market, which as a reminder is a condition that affects some 3 million people in the U.S. and 50 million worldwide. Our Q3 net sales were up 22% over the prior year. The U.S. team produced unit sales growth of 19% while continuing to make progress with the conversion to the DEMIPULSE, which now stands at 43% and as expected we saw continued growth in our average selling prices.

Further another indication of our turnaround, in the area of debt management. If you go back five quarters ago, we owed more than a $130 million, a $132.5 million to be precise. Over the past five quarters, we have reduced that debt by more than $70 million to a very manageable balance of $62.3 million. Another highlight for the quarter, we continue to attract talent to our company and I am happy to report that we have found a very intelligent experienced leader to lead all of our R&D efforts.

Joining us as the Vice President of R&D is Milton Morris. Dr. Morris joined us earlier with this month and we have already seen contributions from what he has done for us. In the area of new business development, we signed our third R&D partnership for the important area of seizure deduction, and the team continues to execute on the strategic plan that we laid out last year that will maintain and grow our epilepsy device leadership.

Let's look at some of the specifics for Q3 in the area of sales. I'd move to slide seven, our quarterly net sales. We see once again continued strong U.S. epilepsy net sales growth, while overall sales grew at 20%, our epilepsy in the U.S. grew at 31%. International was disappointing down nearly 10%, but our overall epilepsy business grew at 22%. Depression is less than 1.3% of our sales now at less than a $0.5 million.

Moving to slide eight. On the unit side, we saw continued strong U.S. epilepsy unit growth. Overall unit growth for the company was double-digit at 11%, U.S. epilepsy units nearly 19% growth over Q3 fiscal year 2008. International down slightly, but we expect to see growth in that business in the longer term. Epilepsy total units again hitting that double-digit number of 13% that we're looking for.

Moving to slide nine, where we analyze our average selling prices, again continued strong U.S. generator average selling price growth. Not only on the generators, but also on the leads. Generator ASPs in Q3 fiscal year 2009 grew by 14%, while the lead ASP grew by 6%. International average selling prices were down as a function of currency impact, some benefit from price increases, but also a detrimental effect from the channel mix selling more through third parties.

Slide 10, when we look at the breakdown by product line, by geography, you will see our U.S. generator business grew by nearly 19%, our lead business by nearly 9% it's that high single digit number that we're looking for in the U.S. for our lead business, where we have work to do is down below in international, you can see generators up couple of percent and leads up nearly 12% more work to do in that area. I am going to turn it over to Greg. And Greg is going to go into more detail on the financials.

Gregory H. Browne

Thanks Dan. I'm going to comment on our financial results for the third quarter including the income statement, balance sheet, and cash flow. And my first comments are directed to slides 12, beginning this discussion with a graphical representation of the improvement to operating income. A historical look at how far the company has come over the last two years. As you can see, the consistent top line growth, along side relatively stable expenses is driving continued and improved operator earnings.

When we turn to the next slide 13, comparing the income statement for this quarter to the third quarter of the prior year, it is pleasing to again report the highest quarterly operating income ever recorded by the company. Dan mentioned our overall sales growth of 20%, which represents a continuation of the trends that commenced in the final quarter of last year. Our international sales performance of $6.2 million comprised 18% of total revenue. With as Dan mentioned, unit sales somewhat lower than expectations.

Foreign currency movements contributed to a decrease in revenue of approximately $800,000 to the third quarter number, when compared with the third quarter of last year, and about $500,000 when compared to the second quarter of this fiscal year. These reductions in revenue unfortunately offset local currency pricing improvements. This quarter so international distributor sales account for 25% of unit sales, unchanged from last year, but down compared with the second quarter of this year.

Our gross margin was significantly higher at 86% than the third quarter of last year, but consistent with current year trends. Consistent unit sales volume, higher prices and a strong performance by the production team have combined to raise this number in the current fiscal year. Operating expenses at $25.3 million were higher by some $1.36 million than last year. And approximately $1 million lower than Q2 of this current fiscal year. As we stated on the last call, we expect expenses to fluctuate between $25 million and $27 million on a quarterly basis.

Our expectation is that R&D activity relating to epilepsy will continue to increase in the coming quarters, consistent with our strategic focus and priorities. Overall spending on depressions has declined to approximately $1.6 million this quarter as sales resources both in U.S. and Europe have been reallocated and should be lower again in Q4 as we await the results of discussions around the number of subjects in our D-21 study. As mentioned earlier, our operating income of $5 million was the highest ever recorded by the company. Tax expense primarily reflects alternative minimum tax only as discussed on the last call and we've reported fully diluted earnings per share of $0.15 for the quarter.

Turning our attention to slide 14, highlights for the nine months were again the consistency in sales growth of 20% for the year-to-date, gross margin, and operating earnings. As a result of these improvements, our operating income for fiscal year '09 to-date is almost $24 million higher than the comparable period of fiscal year '08.

Turning to slide 15, I mentioned our gross margin at 86% for the quarter we are expecting approximately 85.5% for the fiscal year as a whole. We expect that expenses directly attributable to depression for this year, which were $1.6 million during the quarter, would approximate $7.5 million to $8 million for the full fiscal year. We also incurred equity compensation expense of $2.2 million in the quarter and this is expected to be approximately $10 million for the full fiscal year. Although, we do expect the number to be some 15% to 20% lower in fiscal year '10.

Selling and administrative expenses of $21.5 million represented 57% of revenue while research and development was 15%, resulting in an operating margin of 14.1%. The gain on early extinguishment of debt, net of tax effect and the amortization of deferred issuance costs was $5.7 million. Adjusted third quarter net income would have been $4.1 million. I am now going to turn to slide 16, 17, and 18 and comment on the balance sheet and cash flow. Our balance sheet continues to improve and reflects increases to the positive stockholders' equity, we discussed on the last call.

We have debt of $64.8 million at the end of the quarter represents a total reduction of approximately $68 million in the last 15 months. And as Dan mentioned earlier in the call, we have purchased a further $2.5 million since the end of the third quarter. Bringing the balance of today down to $62.3 million. Our year-to-date cash flow on slide 17, stands at $18.3 million and we finished the quarter with almost $63 million in cash. Our cash continues to be invested conservatively in government obligation money market funds and on which the yield is now less than 0.7%.

Turning my attention to slide 18. Operating cash flow for the quarter at $7.7 million was very strong driven by the higher earnings and smaller improvements in our working capital position. Our day sales outstanding remain within the recent range at 51 days. Capital expenditure and investment totaled $865,000 for the quarter, and $1.5 million on a year-to-date basis, compared with depreciation and amortization expense of $488,000 for the quarter and $1.7 million year-to-date. Our expectation for fiscal year '09 is that capital expenditure will be approximately $2.2 million and that depreciation and amortization for this year would be a similar number.

Slide 19 is again a graphical illustration of the significantly improved ratio of debt to cash bought about by a combination of strong positive operating income over the last four quarters, careful working capital management, a license fee we received in the third quarter of last fiscal year, repayment of the line of credit in the third quarter of last fiscal year and the repurchase of the convertible notes at varying discounts in the current fiscal year. Slide 20 provides a summary of the convertible note repurchases through to the date of this call.

The total consideration for the face value repurchased is $50.4 million and the face value of the remaining debt is $62.3 below half now of the original amount. A final item before I turn things over to Dan, who will conclude our prepared remarks. I want to provide a heads up that there will be an extra week in the fourth quarter of our fiscal year 2010 for a total of 14 weeks in that quarter and 53 for the year. This is due to the way our fiscal years are structured with a catch up week occurring approximately over six years will impact both sales and expenses. I am now going to turn back to Dan for an update on our epilepsy strategic focus.

Daniel J. Moore

Thanks Greg. As you can see the evidence would suggest that we have seven quarters of good results. But we are believers that our best days are ahead of us. We are very bullish on our epilepsy strategic focus as mentioned earlier 3 million patients in the U.S. really impacted by epilepsy in their daily lives. 50 million patients worldwide, there is plenty we can do to help those patients. Our goals, we want to continue to build upon the epilepsy medical device leadership that we have today by bringing new technologies into this patient population. We expect to have consistent annual unit growth of 10% to 20% and we are on-track to achieve our operating margin target of 25% during fiscal year 2011. As Greg mentioned in Q3, we were at 14% after being half way there in our last quarter at 12.5%.

Our epilepsy strategic focus the growth from the U.S. is validating that our strategy, which is based on customer focus is working. On the international front, we have put four sub-regions in place and those sub-regions are now building their teams. But we have more work to do there. Despite that we are seeing unit growth in some of our European Union Countries, in Latin America and in Asia, whereas in China we've experienced our first orders and our business is underway there. In Japan, we continue to work on securing regulatory approval and then we'll go for the reimbursement approval as well.

On slide 24, research and development progress, we know we've turned the company around financially. Our future is really going to be dictated by how well we can do in R&D. We think we'll have a good future if we did nothing other than continued with VNS for patients with epilepsy because of the size of these markets. However, we believe we can have a great future if we execute in the area of R&D. We have the building blocks in place, we have good people with institutional knowledge some going back nearly 20 years. We have good technology, four generations of generators, and new lead thing introduced as we speak. We have the vision for what can be done with devices for patients with epilepsy. And as stated earlier in the call we have our new leader Milton Morris, who is going to help put it all together to ensure that we continue to lead and our future goes from good to great.

We already start to make the investments in R&D as we increased our investment in fiscal year 2008 and again in 2009. And once again we are planning to increase those investments in 2010 and beyond as our P&L allows. Our internal efforts will be supported by external collaborations were appropriate. We will be focused on parameters, seizure detection and prediction, telemedicine, and finding new ways to predict the efficacy of VNS. On slide 25 to close out our goals, we expect to deliver increased sales in the range of a $140 million to $142 million for fiscal year 2009. We are managing the business for the short term quarter-to-quarter for the medium-term and for the long-term.

And we expect to continue to be a leader in medical devices for epilepsy, and it’s all about execution. I remiss not to mention other areas of the company, because what you are seeing here in the financial scorecard that measures a couple of things. The measure is how well we are managing the company, but it's also a measure of how many patients we're getting to. If you look into any one of our functions, each function is doing well and managing their particular discipline and this truly is a team effort that allows us to talk to you about to the kind of results that we have been seeing over the last quarter. So, with that what I would like to do is open it up for questions-and-answers.

Question-and-Answer Session

Operator

(Operator Instructions). Your first question is from the line of Tom Gunderson.

Thomas Gunderson – Piper Jaffray

Hi good morning. I have two questions that I will ask here, one is on just simply on the income statement sequential reduction in actual dollars in SG&A. Can you give us a little more granularity on that and is that sustainable?

Gregory H. Browne

Some of that is driven by the currency movements, which reduced our expenses coming from Europe by somewhere in the range of $350,000 to $400,000 for this quarter compared to last year, and probably 200 to 250 compared to the previous quarter Q2. Some of it was driven by the reduction in equity compensation expense, that's 400,000 I think we've said that we want to stay within the range, we expect to be within the range of $25 million to $27 million overall including R&D. So, I think it will bounce around from quarter-to-quarter within that range.

Thomas Gunderson – Piper Jaffray

But the U.S. sale force is stable, marketing is stable if not up et cetera.

Gregory H. Browne

That's correct. And our administrative infrastructure here in the United States is stable, we still have some work to do in building at the international side, as Dan alluded to and from an R&D perspective of course, we are engaged in balancing that perhaps between the anticipated and growth so further growth in epilepsy R&D expenditure offset by reductions starting to P&L in the depression spend.

Thomas Gunderson – Piper Jaffray

And then the question is on reimbursement quite a lot of discussion among investors on the change in CMS reimbursement that was effective January 1 this year. Have you seen or heard anything coming back from the hospitals now that there are many of them getting paid a little bit less or is it too early to tell?

Gregory H. Browne

I have not heard anything Tom, maybe early to tell, but as we've said in the past we don’t expect a material impact here.

Thomas Gunderson – Piper Jaffray

Okay that’s it for now, thanks.

Operator

Your next question is from the line of Steve Brozak.

Steve Brozak – WBB Securities

Well gentlemen we have been covering your company for four years and I really want to say for the first time congratulations. I have got three quick questions. Can you give us any visibility as far as replacement versus new patients, can you give us any visibility in terms of demographic shifts or anything that you have detected in terms and any kind of elegant pattern shifts on insurance, whether a lot of people were trying to get in under the last calendar year because they weren’t covered or anything like that because our questions really have to do with declining insurance coverage. What kind of predictor do you have as far as that goes, but you seem to be able to have a strategy to compensate for it so, can you give us a little color on that please?

Daniel J. Moore

Yeah I'll take the second question first because I do think the strategy and the focus that compensate for any losses on the insurance side is something you have just pointed out, and that really starts with the 50 million patients worldwide 3 million patients in the U.S. But coming down to a more realistic level when we look, and when we talk to our internal teams about what we expect out of them in this business, if you go back to the last caller some of the prior callers, we have shown the bubble chart of 400,000 patients in the U.S who fall within our current labeling for VNS, and 14,000 or more patients who are being added to that pool every year, and yet if you look at new patients I think in the U.S last year we treated less than 4000 new patients. So, there's as much as we could talk about insurance losses and patients that may fall out. The pool of overall patients, and if we continue to focus on that larger pool is so much greater that we quite frankly don't spend a lot of time thinking about the ones we are missing because they maybe loosing insurance at the end of the year or at specific point in time, and much more of our effort is aimed at capturing as many as we can coming into the pool each year, the 14,000 and that pool of 400,000. So, that's where our focus is, I don't have specifics to say how many people I know, there are 2.5 million jobs lost in the U.S. last year, lot of those people I think only 10% of them went on with their Cobra and yet the government is going to come back and subsidize now to a level of 65%. We don't spend a lot of time thinking about that because there is so much opportunity on the other side. On the replacement versus new, from the time we came into Cyberonics that's a question and that many people have asked, we have a lot of in-house data, we've taken several approaches to looking at that going probably all the way back to Q3 of fiscal year '08 when we outlined each of the model numbers, how many that we have sold in each of the model numbers. In last quarter earnings call we talked about the number of implants, and we gave the experience so far that we've had with the Model 100 where about 70% of people came back for an initial reimplant once their battery had gone to end up service, and then if you looked at subsequent reimplants to that we were approaching a 100% of patients so when you implant one you get another. So, we do watch it, but it's a difficult number to get to really precisely estimate the impact of replacement versus new patients, bottom line there like the big pool, the bottom line is we're encouraging our teams to grow both populations. Don't shy away from the replacements because there is a very good patient population of replacements out there and go out and get new patients because every time you get one evidence would suggest that those patients are going to come back for reimplant, so we are focused on growing both.

Steve Brozak – WBB Securities

Great thanks again gentlemen I will jump back into queue.

Operator

Your next question comes from the line of Bill Plovanic.

William Plovanic – Canaccord Adams

Good morning.

Daniel J. Moore

Good morning Bill.

William Plovanic – Canaccord Adams

Congratulations on a fine quarter.

Daniel J. Moore

Thank you.

William Plovanic – Canaccord Adams

Couple questions here, just, Greg, clarifications first on the extra week, is that, did you say fiscal 2009 or fiscal 2010 in the fourth quarter?

Gregory H. Browne

Fiscal 2010.

William Plovanic – Canaccord Adams

Okay. So, next year. And then I was wondering if you could elaborate on Mr. Morris's background a bit and maybe what his three near term goals are in terms of, this probably all rolls into the whole seizure detection in that collaboration on that, extrapolate on that a bit more? Thanks.

Daniel J. Moore

Milton did his undergraduate work at Northwestern, a degree in Electrical Engineering went on to University of Michigan where he got a Ph.D. in Electrical Engineering as well so he is definitely a one of the smarter additions to the team, and can challenge any of us, intellectually so had a fine academic background, but probably more important had the opportunity to apply that academic background by first joining Guidant and spent nine years at Guidant before Boston Scientific took Guidant and spent another two years with Boston Scientific. Milton has managed teams of up to 60 people, and knows how to do R&D from piece of paper all the way through to commercialization in fact at one point in his career, he was a Director of Marketing, so he understands the customer part and the aftermarket as well. Knows how to set up clinical trials, so pretty much knows it from the front end, and has the academic background and the R&D background to do just about anything, we think we want to do all the way through commercialization. So he is well versed there and on the leadership side I mean we were looking for someone else as we are investing more money in R&D who can manage larger teams and more complex projects. So, obviously we are very happy to be able to attract him to our team.

William Plovanic – Canaccord Adams

And then just a three near term goals and again on the whole seizure detection you announced your third, that you signed your third deal give us some little more color on those?

Daniel J. Moore

I’d say the first thing for Milton to do is to come in and run with the team. As he is getting up the speed in learning, because as mentioned we did not wait to find Milton before we started our investments in R&D, our project focus. We didn’t wait to go out and if we saw things out in the market that we thought we like, like certain things in the area of seizure detection. We went out and completed those deals so that when Milton arrived he could began working with the team that was already off and running. So, I think job one for Milton to get up to speed as quickly as he can, and I think he has done a very nice job in the four or five weeks, he has been here of doing that. Job two is to access all of those projects and ensure that we've got the right things from his perspective as well, and I think priority three, and these are no particular order is to look at the team he has to assess that team and to fill that team out. I think it's not a matter of removing people as much as adding people because as I mentioned I think we have the institutional talent that had gotten us through four generations of generators good lead technology, hardware expertise, software expertise, Milton is going to fill that team out because we have much bigger expectations for what we can do by bringing devices to seizure detection than what was in the original Cyberonics model.

William Plovanic – Canaccord Adams

Okay fantastic. And then just one last question for Greg and I know this is extremely difficult for you guys to model but according to our numbers in battery lives and what have you, we see that over the past four quarter it seems like you are hitting an acceleration in the percentage of patients that are getting replacement. It would seem that we are actually hitting the peak cycle there in terms of initial implantations, just any commentary you can provide for us on that as it relates to your guidance, as I look to the fourth quarter guidance for the year which is 140 to 142, it seems a bit conservative considering that your fourth quarter is typically your strongest quarter I just want to see if I am missing something here or if you are just classic conservative nature that you have and that’s all I have thanks.

Gregory H. Browne

Thanks Bill. I think in terms of the guidance, we are facing some headwinds in a couple of areas and some unknowns in terms of, some of the economic issues, both here and internationally. We have the foreign currency moving against us, and so that remains unchanged into our fourth quarter that comp gets harder compared to last year. So, I think there are good reasons to be fairly conservative despite what Dan said about the opportunity and the size of the market and our confidence in the sales team both here and the changes that have been made internationally as far as modelling the replacements are concerned, it is difficult we have seen some acceleration this year. We would be I think surprised to see that fall back in a significant way going forward but from quarter-to-quarter it’s a very difficult number to be more precise because we’ve got overlapping replacement cycles for the different models, in the Model 101 with a longer battery life than the 102 for example. We're now starting as we saw last and talked about on the last call, we'll start get into the second replacements on the Model 100. So, as I don't expect necessarily to pull back that, we will change a little bit quarter-to-quarter and hopefully continue to grow for us as we go through into next fiscal year.

William Plovanic – Canaccord Adams

Great, thank you.

Daniel J. Moore

Bill if I could just way in on the peak. As Greg mentioned on the predictability of battery life if you guys have found a way to predict this and that we are at our peak. I wouldn't mind learning more about that because given that there are now four model numbers out there with varying battery life and the ability to predict because programming is all over the map not only, from doctor-to-doctor but also from patient-to-patient and during the patients course of treatment, it is very difficult to predict battery life and add on top of that use of the magnet to try to dampen the effects of seizures or stop seizures, it's very hard to predict and I don't think we can't get to a peak, we can understand a peak, because we mentioned in last call some 6,000 patients with Model 100. We pretty much know what's happened with those, because we think most of those are out of the field and I think our Model 101 we sold about 9,000 of those and about 22,000 during the last call we mentioned 22,000 102s and now we're into the DEMIPULSE as well. So, what we know as we continue to sell 102s and we continue to sell 103s and there is varying battery life into us, as long as we are growing our quarters, we should expect to continue to grow our replacements I can predict a peak. Next question please.

Operator

The next question is from the line of Anthony Petrone.

Anthony Petrone – Maxim Group

Thank you. Congratulation once again. Couple, just I guess to follow-up on the prior question there in terms of replacement cycle and you have four models out there now. Can you give us a little bit more color I guess on what actually is the tipping point in getting a patient to I guess agree to one of the newer models, because it seems that overall pricing has been improving steadily over the past several quarters as we move through the replacement cycle. So, now that we have the selection here, I mean how is the approach when presenting to the patient what is actually getting into go for say, the higher price generator?

Daniel J. Moore

Well I think the tipping point is new technology as we released DEMIPULSE and we go into a center they can buy the old or the new, what we have seen I think is a pretty consistent conversion rate to over 80% of those accounts have converted up to DEMIPULSE. And I say up to DEMIPULSE that being up to a new technology, when and I’m not there for these interactions, but if when the physician is talking to a patient about the two models, you have got a 102 that the firmware in that Pulse product is locked, it can't be changed over time. And with DEMIPULSE now we are able to change the firmware on that product, the software the underlying software. So, a patient who takes a Demi implant as we are coming up with new software for the products if you have a DEMIPULSE, we now have a way to change that firmware in vivo after the thing has been implanted. So, it is the higher price product it has more capability and the switch over has been pretty consistent from patients, who comes in with one of the other models trading up to a newer model, but that's a physician, patient interaction that Cyberonics is indirectly involved in.

Anthony Petrone – Maxim Group

I see. Just two here general questions I guess you had an announcement early this year regarding the FDA and changing the structure of the TRD post approval study can you give us just an update there on where you're in the discussions and if the FDA has responded at all and then one follow-up would also be in terms of renegotiations with CMS, is there any updates there as well.

Daniel J. Moore

On the FDA front you saw that we've put out the announcement saying that we had submitted to FDA to request the change to change the enrollment down from 460 patients down to roughly 330. We had said at the time that we expected to be finished with enrollment if things were going as expected in January that we would finished around the end of February we are pretty much finished with the enrollment of the D-21 to that, roughly 330 patients and we did submit to the FDA and are in discussions now with them about the 330 versus the 460.

Anthony Petrone – Maxim Group

Can you quantify I guess what the cost savings would be with the lower patient count?

Gregory H. Browne

I think we can, I mean at approximately over a 12-month period you would expect that savings to be around $3 million to $3.5 million in terms of implant and follow-up costs. So, its significant for us that we await what the FDA says.

Daniel J. Moore

The other thing I’d like to point out there is even though there maybe savings in depression consistent with what we've done since we arrived here, we would continue to take those monies and reallocate them on the P&L to do more as we strengthen and our R&D and our capabilities and our abilities, we will be doing more on the epilepsy side. So, coming back to, those top line numbers, we do expect to continue to spend in the $25 million to $27 million in the quarter. We will move things around the P&L, but this is not one where, we expect to save our way to success. We were able to I think take a lot of the risk out of the company, by getting one break-even and two profitable and getting some cash flow and paying down debt, but as mentioned at the beginning of the epilepsy strategic focus section, we are much more bullish about our future than what we have done over the past several quarters and that will require continued investment on the epilepsy front.

Anthony Petrone – Maxim Group

And I guess one final question here would be again going back to the guidance here, in particular if I model out I guess year-to-date results have taken a consideration pricing, most previous pricing in the quarter. I am flushing out to about 9% year-over-year growth in just terms of total revenue and then even lower on in units. You mentioned economic headwinds, can you give us an idea I guess of the revenue cycle on the physician side when they purchase a system and how that may or may not be affected by CMS, I guess in terms of funding I mean physicians upfront on the [Indiscernible] are still in a position, we will have to fund the sub-front, are you seeing any kind of positioning there due to economic headwinds and the change in that process.

Daniel J. Moore

Just to recap we – we make our sales to hospitals, the hospitals of course are being reimbursed by CMS, private insurers and in some case Medicaid, the physician reimbursement is for their, the surgeon reimbursement is for their activity only in the operating room and has not been affected by new reimbursement changes. So, our feeling is that in that particular aspect wouldn't change. I think, when I referred earlier to the economic headwinds I think we have seen rapid currency changes internationally, which in some cases have affected purchasing patterns of our distributors. We've seen I think some isolated Medicaid issues here in this country, California, for example. So, I think there were reasons to be cautious. And I think if we were to hit the midpoint of our guidance with 141, we will be having significant revenue increase over the prior year. And our unit increase would also be strong, so, I think overall we feel it’s the right way to go as we head into Q4 and we have come off a very strong Q3.

Gregory H. Browne

Yeah. We have done it right, the low end of the guidance at 140 million I think it's more than 15% revenue growth for the year. Again we would like to do better than that but not a bad second year.

Anthony Petrone - Maxim Group

Thank you.

Operator

Your next question is from the line of [Scott Gutterman].

Scott Gutterman

Good morning.

Daniel J. Moore

Good morning.

Scott Gutterman

And most of my questions have been answered, just couple more, going back to the clinical development for seizure detection, could you give us a more color as to where exactly you are in those programs and are there any preliminary timelines that they are willing to share at this point?

Daniel J. Moore

No, I think what you can see is that we are assembling both internal capability and external those external things some involve software, some involve hardware, algorithm things and we have been into animals at this point, but beyond that, we are not going to release a lot about our direction. I don't think there is much upside in not doing that.

Scott Gutterman

Okay. And my second question on the DEMIPULSE penetration, its up to 43% I think from 40% last quarter. I mean, internally where do you expect the penetration rate to reach over the next several quarters and you still offer the older, cheaper generator. And do you find that hospitals are more hesitant to upgrade given the 25% price premium especially in today's environment?

Gregory H. Browne

I will take the last part of your question first. We haven't seen that yet. But I think, that in Q1 we were at roughly 33% penetration by Q2 we are roughly 40%, we are at 43% now. We would expect by the end of fiscal year 2010 to be somewhere between 55% and 60% penetration on DEMIPULSE. So, 3% to 5% per quarter we think is a very responsible approach, because remember it is new technology, DEMIPULSE is different we do go out and train prescribes; we train the implanters; we train the programmers. We don't want to go from 0% to 100% overnight. And the reason for that is that we've got more than 20,000 Pulse 102 generators and that represents a whole lot of patient year product experience, we are confident that we've done every thing we can do from design to bench top to all of the work that you would do prior to bringing DEMIPULSE, but part of leaving two products out there, as physicians have different views about how quickly they want to adapt new technology. This is very complicated stuff. It's hardware, it's software and we want to allow physicians to choose with their patients, do they want the older generation that has much more patients, many more patient years of experience, or do they want to be an early adopter and take on DEMIPULSE that has more capabilities over time? So, we do things this is very reasonable way to launch the product as we are launching new leads and we did get the new Perennia lead approved last quarter as well in addition to that generator field upgrade that I mentioned, we are launching our leads the same way, if we want to give physicians the choice as to which products they want to use based on individual patients and the way they think about this therapy for their patients.

Scott Gutterman

Great. And the five-quarter penetration rate goal of 55% to 60% assumes that you're going to stick to the 25% price premium. Is that correct?

Gregory H. Browne

That's correct, I mean part of as we go forward I'm not saying that we will not encounter price resistance at some point and part of having two products up there again if someone is using the lower price, older generation pulse product and its working fine for them and that's what they want to continue to use that's fine, we do very little discounting of our products and we expect to continue on that same path if we're going to spend five years and a whole lot of money of shareholder money and invest it in new technologies we expect to capture every dollar that we can, we don't feel guilty about that once we do that we bring it back into the company and we spent it on geographical expansion, our R&D, our clinicals or more work. So, as we are bringing money back into the company that allows us to continue that mission and we're going to be responsible in the areas of pricing as well.

Scott Gutterman

Okay great thank you very much.

Daniel J. Moore

Thanks.

Operator

We have a follow-up question from the line of Bill Plovanic.

William Plovanic – Canaccord Adams

Great, thank you. These are more housekeeping type of questions just Greg for the tax rate for 2010, we continue to have a AMT on this?

Gregory H. Browne

Bill as we discussed on the last call, our current belief is that fiscal year '10, we will be using, we are paying alternative minimum tax only. The only caveat around that is that, the 382 limitation on the losses, we will be required to make another study, it could potentially have some impact because we have seen some changes on our shareholder register, we don’t believe so that, but that's the current thought.

William Plovanic – Canaccord Adams

Okay. And then I think you gave us this, but just a double check, the depression spend in fiscal ’09 is between $7.5 million and $8 million and assuming that the FDA does not change the study that, decreased number of patients you have to enroll in, I think it was the D-21, what would you expect for depression spend in fiscal 2010 at this time?

Gregory H. Browne

Assuming that for that we would continue the enrollment in D-21 up to the original number of 460 patients, we would expect that number to be approximately 5 million or so in fiscal year ’10, the significant reduction I mentioned in my remarks that we have reallocated from the beginning of this year certain now, we have continue to reallocate resources away from sale and marketing efforts both here and in Europe. Today, we have really no one dedicated full time to those efforts, although we continue to support some of the patients and some who are out there. So, that would account for most of the reductions even if we had to continue the enrollment in the D-21 study, even those expenses would be lower in fiscal year ’10 as we have now into the back quarter of the study. So, approximately $5 million.

William Plovanic – Canaccord Adams

Is that spread pretty evenly through the year.

Gregory H. Browne

The first three quarters would be higher than the fourth quarter, as we move to completion of that study.

William Plovanic – Canaccord Adams

Okay. And then the $25 million to $27 million operating expenses that you mentioned would that continue on a quarterly basis through fiscal 2010 as well?

Gregory H. Browne

Bill, I think it's a little earlier to say, we haven't completed our budgeting process, obviously some moving parts in terms of the FDA and the study. We will give some color on that on the next time around, we would expect it to be somewhat higher as we go into the new year, we talked about the R&D expenditure on the epilepsy side. We have some other expenses coming into the international business, as Dan talked about the teams in the regions continuing to build. So, I would expect it to be somewhat higher next year, but the final makeup will clearly have be significantly dependent on what the FDA says.

Daniel J. Moore

We are believers that this epilepsy business is a business that is worth investing in. So, again we don't expect to see our spend go backwards, we expect our revenues to go up and we will continue to leverage the bottom-line to get to that 25% operating income target, but we will be spending more absolute dollars then we have in the past if all goes according to plan, because we expect to get good returns on those spends.

William Plovanic – Canaccord Adams

And on that 25% target is that for all of 2011 or are you hitting it as you're exiting 2011?

Gregory H. Browne

We would expect to reach that target during fiscal year '011 and that's, when I say expect that's probably too strong, our goal is to hit that target during fiscal year '011.

William Plovanic – Canaccord Adams

Okay. And then in Japan, can you walk us through where you're in that process and what the expectations are I mean have you filed, what exactly have you done and what is left to do and any timelines to frame that would be helpful.

Daniel J. Moore

We have filed in our filing we are in discussion with the regulatory authorities there as far as giving an expectation still very, whether it's U.S. FDA or even probably more so in Japan very difficult and again I won't attempt to predict, because, all the things that can go wrong there, they ask one set of questions and that can fetch you back easily six months or a year. So, its I think it's too early to predict, but we are in active constructive dialog and going after that VNS approval for patients in Japan given that its been available in the rest of the world for more than 10 years, now.

William Plovanic – Canaccord Adams

In trying to pin you down a little here Dan.

Daniel J. Moore

So, I think I had that Bill.

William Plovanic – Canaccord Adams

If all went swimmingly well, what's the earliest the product could be on market I am not putting this in the numbers, I just want to know I'm going to wake up a morning and see a great headline and if that was the case when would that be from the earliest standpoint?

Daniel J. Moore

Well it's nighttime there now. So, if all went swimmingly well, sometime tomorrow morning we would get a call that they have approved the product and then we'd have to wait 60 or 90 days for reimbursement, but again that's that would be a nice surprise, but that is very heavy speculation.

William Plovanic – Canaccord Adams

Okay, okay. Well that's actually very helpful.

Daniel J. Moore

Just to say, to put it in perspective, I mentioned we've done our filings and in a normal course there are some audits along the way, either desktop or live audits. They can audit good clinical practice, the GCP, they can do GMP audits, and they can do quality system audits. And any one of those can be done desktop or in all likelihood they may make a visit here. So, in addition to the submissions and the discussions, there is usually an audit along the way. So, I again doubt that, I wouldn't bet a dollar that it would be tomorrow, we probably have an audit along the way here before we see a regulatory approval. And then after that you've got the reimbursement approval as well.

William Plovanic – Canaccord Adams

Okay, that's all I had. Thank you very much.

Operator

Your next question is from the line of Jonathan Block.

Unidentified Analyst

Hi, guys. This is [Maggie Jones] traveling at the moment. Congratulations on a good quarter. I was just wondering if you could break out the DEMIPULSE conversion rate specific to the U.S. And are your expectations, do they differ between the international and the U.S. market for the potential future conversion rate?

Gregory H. Browne

Maggie, the U.S. rate was between 41% and 42% last quarter. In fact, international was somewhat higher at 47%. Our expectation is that when Dan was referring to 55% to 60% over the next five quarters that would be a composite. In some quarters, we make it available to more accounts domestically versus internationally, and so on, so sort of moving in lockstep, but not exactly in parallel. The international rollout is very dependent on getting price increases, local currency price increases, approved by the appropriate bodies over there. So, but in general, the 55% to 60% is where we expect to be at the end of next year.

Daniel J. Moore

Globally.

Gregory H. Browne

Yeah.

Unidentified Analyst

Thanks. That's helpful. And then, could we also get a bit more color on the international sales division just in terms of timing. How much longer would you say before those four regional sales teams are largely all in place? And then from that point, how long do you think you would expect before those teams are pretty much fully ramped?

Gregory H. Browne

We are in a company where we expect to grow our businesses, and you can see international didn't do that, so the quicker we can restore growth the better. But we expect international to be growing in fiscal year 2010.

Unidentified Analyst

Okay. So, are there more hires that still need to be taken place and I guess more operational changes or is that pretty much all in the past?

Daniel J. Moore

The operational changes at the top have been done. Will we hire more people? Yes, we will opportunistically hire more people. Each region, each country, looks at their particular business and if they want to make an investment in a person, they need to justify the return on that investment. So, there will be some hiring along the way, but it's not something that's going to impact the P&L by a lot.

Unidentified Analyst

Okay, great. And then just in terms of your domestic growth strategy, are your reps focusing on increasing a particular center's utilization, or is it more about expanding into more hospitals?

Daniel J. Moore

It is primarily going deeper in the hospitals we are in. You have the comprehensive epilepsy center, so there is a concentration of patients and we think, we can penetrate those better and quicker than going wide. It's not that we won't go wide if there is a physician, who is interested in not only being a prescriber, but to get a neurosurgeon going in a particular hospital or another surgeon to do implant, is not that we will shy away from that, but you already have a model where they're prescribers with a ready group of patients and implants in certain centers, it makes more sense to have more of the effort by our sales force focused on those comprehensive epilepsy centers.

Unidentified Analyst

Great. Thank you.

Operator

The next question is from the line of Anthony Petrone.

Anthony Petrone – Maxim Group

Have been answered. Thank you.

Daniel J. Moore

I'm sorry, you said we answered it.

Anthony Petrone – Maxim Group

Yes. Thank you.

Daniel J. Moore

Okay, great. Hey, we were at an hour here and we would like to keep it to that at this point. I appreciate everyone's, your willingness to join the call to hear the Cyberonics story again I think we've had these seven quarters of success. We expect to continue to do that. As we look at the future, we are more optimistic about the future than what we done in the past, it does come down to investments, comes down to execution and we think we're in a great position to continue to stay focused on our epilepsy business, despite the economy and all the distractions and noise around us. We think there are so many patients out there that just because the economy has changed their day-to-day life has not gotten better with their epilepsy, and we think we are part of the solution to bringing this technology to patients. And we know that ultimately when we do, there are savings into the system, there is evidence out there to that. We just came off of an AES, where there were at least 10 posters about VNS and VNS Therapy. So, we are optimistic about the future and we believe that we have and are assembling the right teams to address this opportunity. So, thanks for your continued interest in our strong. And we look forward to updating you again in a quarter. Have a good day.

Operator: This concludes today's conference call. You may now disconnect.

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Source: Cyberonics, Inc. F3Q09 (Qtr End 01/23/09) Earnings Call Transcript
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