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Home Diagnostics Inc. (HDIX)

Q4 2008 Earnings Call

March 3, 2009; 08:30am ET

Executives

George Holley - Chairman

Joe Capper - President & Chief Executive Officer

Ron Rubin - Chief Financial Officer

Scott Verner - Senior Vice President of Sales and Marketing

Carol Ruth - Investor Relations, The Ruth Group

Analysts

Derek Leckow - Barrington Research

Larry Solow - CJS Securities

Tao Levy - Deutsche Bank

Tycho Peterson - JP Morgan Chase

Matthew O’Brien - William Blair

Operator

Greetings and welcome to the Home Diagnostics Inc. fourth quarter 2008 earnings conference call. At this time all the participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. (Operator Instructions)

It is now my pleasure to introduce your host, Carol Ruth of The Ruth Group. Thank you Ms. Ruth, you may begin.

Carol Ruth

Thank you, operator. On the call with us today is George Holley, Chairman of the Board; Joe Capper, the company’s newly appointed President and Chief Executive Officer; Ron Rubin, Chief Financial Officer; and Scott Verner, Senior Vice President of Sales and Marketing.

Before starting the call, let me remind you that the statements made in today’s conference call include forward-looking statements and are subject to risks and uncertainties. Such statements are only predictions and reflect the company’s expectations and assumptions as of the date of this conference call, based on currently available operating and financial and competitive information.

The actual events or results may differ materially from those projected and as such forward-looking statements due to a number of factors, including risks and uncertainties identified in the company’s most recent Annual Report on Form 10-K and other filings with the Securities and Exchange Commission, may differ materially from those projected.

Now let me turn the call over to George Holley, Chairman of the Board.

George Holley

Thank you, Carol and good morning to everyone. Thanks for joining us on our earnings call. It’s great to be here with such good news. First and best news, I would like us all to welcome Joe Capper as our new HDI Team Leader.

Joe joined us just last week as President and CEO of Home Diagnostics and you folks will recall on our last conference call, we did announce that we plan to begin a search for leadership that would take HDI to the next level. Well, that has been accomplished. We are both pleased and quite honestly fortunate to have attracted Joe.

Joe is steeped with experience in the industry, has got a stellar track record in affecting growth. His background in leading Bayer’s sales organizations and more recently his work at CCS Medical where he was its CEO, brings an incredibly important skill set to HDI to leverage our strategy, to leverage our outstanding new products and to leverage an existing strong management team.

I think both the Board and our management team are excited. We look forward to the next several years of accelerating growth with Joe, but before I turn this call over to Joe for his comments, I would like to recognize Dick Damron for his significant contributions to HDI, in strengthening our financial position and in growing our management team. We have got a solid platform for growth and I think we are now in a position to accelerate that.

With that I’ll turn the call over to Joe Capper and his team for their comments. Joe, take it away.

Joe Capper

Thank you George and good morning everyone. Let me start by expressing my sincere excitement to be part of the team here at Home Diagnostics. For obvious reasons I will not be commenting on the details of our fourth quarter business performance on this call; I will leave that to Ron and Scott. I do however want to make a few short comments on why I chose to join Home Diagnostics and some of my observations about the company.

As you can see from our press release last week, I have the extensive background in the diabetes market; working both on the manufacturing side of the business and then for a service provider. In a way joining Home Diagnostics is a bit of a homecoming, as I return to the manufacturing world. However, I come back with a deep understanding of our customer base, given that I have been one for the past six years.

Home Diagnostics was a particularly attractive organization for me, given our position in today’s market, the emphasis on today’s market. What do I mean by that? Let’s start with the fact that Home Diagnostics is the clear leader in the value segment of the blood glucose monitoring business. Given where we are in the lifecycle of blood glucose monitoring technology, conventional wisdom would dictate share movement in favor of value brands.

Now there are a lot of variables, which could slow or speed this type of market share shift over time, especially in a business like ours, which is subject to influences such as managed care formulary access. However, I believe the current economic conditions will make consumers vastly more price sensitive, so here is the great news.

For most consumers of blood glucose monitors and testing supplies, Home Diagnostics can save them money and quite often, we can save them a meaningful amount of money. These savings translate into benefits for people living with diabetes, as well as for our distribution partners.

We have a well developed competency around delivering high quality value products, a strong portfolio, and excellent relationships with our distribution partners; all of which will serve to reinforce our position in the value segment of the market. Clearly, we will be looking for ways to leverage these strengths, given the current market trends and economic conditions.

The second thing that attracted me to Home Diagnostics was the collective talents of the management team. We have gifted individuals who are relatively new to Home Diagnostics, as well as leaders who have been here for most of the company’s many battles.

I spent the better part of last week getting to know the functional heads of the business and coming up to speed on the various issues and opportunities before us. It is a knowledgeable and balanced team that will clearly enjoy a good fight in a competitive market. Additionally, we are fortunate to have the guidance and oversight of an experienced Board, which is anxious to accelerate the growth of our company. I look forward to working with these teams.

During the next few months I will work through an assessment and planning phase, which is intended to refine our near term plan and to determine how we want to allocate resources, in order to drive the organization over the long term. On future calls I will be in position to provide you with more insight into our strategic thinking.

On a separate note, I will like to bring you up to speed on discussions we have had with the FDA. The agency has recently conducted meetings with a number of leading manufacturers of blood glucose monitoring systems, including Home Diagnostics, which used the GDH-PQQ enzyme in their test strips.

These meetings with industry manufacturers are centered on the enzymes potential effect on the accuracy of blood glucose readings in patients who receive medical treatments or IV therapies that are known to contain maltose or maltose derivatives. Our two test strips currently use this enzyme.

As the company discussed on its second quarter earnings call, when we spoke to the FDA prior to the launch of the new products, the agency requested and we provided educational labeling which is currently used on TRUE2go and TRUEresult labels.

We will present a plan to respond to the FDA that further mitigates the risk of inaccurate readings that may arise in certain groups of patients who are undergoing these medical treatments. We are working through this plan internally and expect to continue talking with the FDA regarding this matter.

At this point, I would like to turn the call over to Ron.

Ron Rubin

Thanks Joe and good morning everyone. Our fourth quarter results are in line with the guidance we provided on our third quarter earnings call. Total revenue was $29.5 million, an increase of 6.4%, compared to revenue of $27.8 million in the fourth quarter of 2007. Growth in the quarter was driven by the continued rollout of our new no coding products with our retail partners.

Revenue in our retail channel was $8.5 million, up 14.6%, compared to $7.4 million in the fourth quarter of 2007. As I mentioned, growth in the retail channel was driven by the continued rollout of our TRUEresult and TRUE2go no-coding meter systems at Walgreens and Rite Aid during the quarter. We are pleased with the initial traction of the products at Walgreens and Rite Aid and are currently launching the products in CVS.

We are also very pleased to report that we have secured nationwide distribution of our TRUEtrack product at Wal-Mart. Wal-Mart now carries both our Sidekick product and the TRUEtrack product, which strengthens our relationship with Wal-Mart and presents a meaningful growth opportunity. We are also encouraged that the out sales unit trends at our major retail partners continue to be strong in the quarter, despite weakness in the overall economy.

Revenue from our mail service channel was up 5.6% to $4.4 million compared to fourth quarter 2007 revenue of $4.1 million. Fourth quarter mail service results included the first shipments of our private label no coding product to Liberty Medical under our new agreement announced last quarter. We are very excited about the long term opportunity of our partnership. We’re the largest mail service provider of diabetic supplies in the country and an active consolidator in the mail service channel.

As we discussed the last quarter’s call, mail service revenue in the fourth quarter was negatively impacted by an inventory build at a large customer during the third quarter, relating to the stocking of a new distribution center. Revenue from our distribution channel was $12.4 million, up 2.7% compared to $12.1 million in the fourth quarter of last year.

Results in the fourth quarter benefited from stocking orders by certain national wholesale distribution customers that took advantage of promotional pricing. In addition, we began to ship our new no-coding products to McKesson Medical Surgical which serves the long term care market.

Out sales in the distribution channel declined in the mid single digits during the quarter, largely due to the timing of our customers’ trade shows and the related product shipments in the third quarter of 2008. That is why we believe it’s better to look at the out sale trends on a year-to-date and for the full year 2008 out sales units increased mid single digits.

Our out sales growth and distribution in particular has been impacted by the continued decline of our photometric test strip business, as customers shift to biosensor systems. Our biosensor system units out sales, were up high single digits for 2008.

Moving to our international channel results, fourth quarter revenue was $4.2 million, up 3.1% from $4.1 million in the fourth quarter last year. Prior year sales included increased orders from our German distributor to fulfill contract minimums.

As we have stated in prior calls, changes in management at our German distributor STADA has impacted our sales in 2008. We’ve taken steps to solidify our distribution in Germany, by signing a new distribution agreement with Hemofarm, a division of STADA, and are optimistic we will see improved performance in 2009, given their commitment to our product line, more consistent ordering patterns, and a planned expansion of our products into other Eastern European markets. Excluding Germany, our international business was up just over 17%, reflecting strong growth in Latin America and Australia.

Gross profit for the fourth quarter of 2008, was $15.1 million compared to $16.4 million in the fourth quarter of 2007. Our strip to meter ratio declined to 6.1:1 versus 7.3:1 last year, reflecting the meter investment associated with the launch of the new no-code TRUEresult and TRUE2go meters.

Our gross margin decreased to 51.2% compared to 59% in the year ago period. The decreased gross profit margin was primarily attributed to the continued launch of the TRUEtest product platform which negatively impacted gross margins by 640 basis points due to discounts and promotions designed to build an installed base of customers, a low strip to meter ratio, and increased costs during the scale-up of manufacturing.

Gross margins in the quarter were also impacted by lower pricing with certain mail service and durable medical equipment distribution customers, driven by the achievement of volume based pricing tiers.

Selling, general, and administrative expenses were $12.5 million for the fourth quarter of 2008 as compared to $11.7 million in the fourth quarter of 2007. The increase in SG&A primarily reflects higher expenses for sales and marketing to support the new product launch, which totaled approximately $1.2 million in the quarter.

Research and development expenses were $1.8 million for the fourth quarter of 2008, as compared to $2.4 million in the fourth quarter last year. The reduced R&D expense in the quarter resulted from lower costs related to new product development, following the 2008 launch of our new no-code products.

Operating income for the fourth quarter of 2008 was $0.8 million, compared to an operating loss of $1.2 million for the fourth quarter of 2007. Last year’s fourth quarter results included a $3.5 million litigation settlement charge related to the Roche patent litigation.

Net income for the fourth quarter of 2008 was $1.7 million or $0.09 per share, based on weighted average shares outstanding of $18.3 million. Net income in the fourth quarter of 2008 benefited from a $600,000 or $0.03 per share decrease in our tax provision, reflecting lower reserves following the expiration of certain statutes of limitation.

Net income for the fourth quarter of last year was $109,000 or $0.01 per share based on 19.2 million weighted average shares outstanding. Net income for the fourth quarter of 2007 included a $3.5 million patent litigation settlement charge of approximately $0.10 per share after income taxes.

Our 18.3 million weighted average shares outstanding for diluted EPS in the quarter includes 800,000 shares for dilution of stock options. At December 31, 2008, we had 17.5 million shares outstanding and 3.1 million total stock options outstanding.

During the fourth quarter of 2008, we purchased 37,000 shares of our common stock for an aggregate cost of $364,000. This completed our previous $10 million Board approved share repurchase program. In January we announced the new Board approved share repurchase program of $5 million and initiated purchases under this program.

Moving on to our balance sheet and operating metrics. At the end of December we had cash and cash equivalents of $30.4 million and no debt outstanding. We have $10 million available on our unsecured revolving line of credit. Total equity at December 31, 2008 was $112.1 million. Our free cash flow was negative $3.1 million in the quarter, due to capital expenditures for our previously announced TRUEtest manufacturing capacity expansion.

Our capital expenditures for the fourth quarter were $9.2 million, which included approximately $7.1 million related to the expansion. For the full year in 2008, our capital expenditures were $13.1 million. Capital expenditures in 2009 are expected to be $16 million to $19 million, reflecting additional costs for the expansion.

We remain on track with our TRUEtest capacity expansion and have placed purchase orders for the majority of the equipment. We’ve also hired a contractor for the upgrade of the facility which will house the new equipment and remain on track to significantly expand our capacities early in 2010.

For the fourth quarter of 2008 total meters distributed were 400,000. Total strips were 2.4 million based on 50 count equivalent units. Our strip to meter ratio for the quarter decreased to 6.1:1 compared to 7.3:1 in the prior year period, reflecting the higher meter distributions related to the new product launch.

Now turning to 2009 guidance; as we announced in our press release, due to the recent appointment of Joe Capper as President and CEO, we’ve decided to defer providing formal 2009 financial guidance until our first quarter call in early May. We would however, like to provide some color on our expectations for 2009 including expected first quarter performance.

In 2009 we plan to continue our investment in the business, which includes rolling out the new products of the retail and distribution channels and with Liberty in the mail channel. While we remain optimistic that our value model positions us well during an economic recession, we have been seeing a reduction in inventory with some customers and expect wholesalers to reduce their inventory day supply, as they look to improve liquidity in response to the economic downturn.

Based on these factors we anticipate revenue growth in 2009, to be in the mid single digit range, driven primarily by growth in our mail service channel. Our mail service channel will benefit from our strategic agreement with Liberty Medical, which represents a substantial long term revenue and earnings opportunity.

As is usually the case in the acquisition of a significant new customer such as Liberty, the meter investment required to build a base of customers has a negative impact on our gross margin. This investment in the Liberty agreement and the continued rollout of our new products will have a negative impact on gross margins in the full year 2009. Therefore, we expect 2009 gross margins to be in the low 50% range.

While we are not providing specific earnings guidance at this time, we do expect our overall earnings to be relatively flat to slightly down in 2009, as compared to 2008 on an adjusted basis for 2008, excluding the $0.08 per share EPS contribution from the tax reserve adjustments.

With regard to our first quarter, we expect revenue to be down mid single digits. This is primarily due to anticipated reduction in inventory day supply, with our large wholesale customers following strong trade show purchases in 2008.

Gross margins in the first quarter are expected to be somewhat below the range we expect for the full year of 2009 due to reduced test strip sales in the distribution channel. Additionally, gross margins will be impacted by the continued rollout of our new no-code products at retail and with liberty.

Due to these factors, as well as severance and other costs associated with the CEO transition, we expect to report a net loss for the first quarter in the range of $3 million. We look forward to providing more specific full year 2009 guidance on our Q1 earnings call.

I’ll now turn the call over to Scott Verner, our Senior Vice President of Sales and Marketing.

Scott Verner

Thank you, Ron. On today’s call I’ll discuss our performance for the fourth quarter of 2008, and provide insight into our strategies, initiatives and opportunities for 2009. In 2008 we achieved a number of significant milestones.

First, we expanded our relationship with Wal-Mart, the world’s largest retailer; we entered into an agreement with the country’s largest mail service provider, Liberty Medical; we established a position as the value offering for Medco, one of the largest PBMs in the industry; and we won the co-branding business of the third largest retail pharmacy chain in the country with Rite Aid.

Entering 2009, we firmly believe that our product breadth, customer relationships, our managed care coverage have placed Home Diagnostics in a strong position that we can further build upon in 2009. During the fourth quarter, we continue the rollout of TRUEresult and TRUE2go, our new state-of-the-art, no-coding meters to retailers and they are committed to the success of these products.

Also during the fourth quarter, we made the initial shipments to support our expanded distribution of TRUEtrack in Wal-Mart. As you may recall, our TRUEtrack product was originally sold in 500 Wal-Mart stores. Thanks to the success that Wal-Mart is having with the product, TRUEtrack will now be carried in all 3,600 Wal-Mart pharmacy locations, substantially increasing patient access to our product. This is a significant opportunity to expand our TRUEtrack patient base with the world’s number one retailer, and further leverage the established TRUEtrack manufacturing platform.

During the quarter we began shipping our no-coding system as a private label product for Liberty Medical, the largest mail service provider of diabetic supplies in the US. As we said on our last call, we believe Liberty will continue to be an acquirer and consolidator in the channel. Most recently, Liberty acquired Access Medical, further expanding their dominance in mail service. Having a partnership with the channel leader, speaks well to our positioning.

Now turning to managed care; we continue to make inroads in the managed care market place. During the fourth quarter we added four new plans, with exclusive or Tier 1 status. As we’ve mentioned in the past, our ability to gain market share in California, in large part due to our relationship with Medco.

TRUEtrack has been a strong performer among our newly added plans with close to 40% of members selecting TRUEtrack as their product of choice in the Tier 1 category. This has lead to continued momentum in California. Additionally, we have implemented a successful campaign that has helped to drive share among our key plans in the area. In fact our number of scripts has grown 47% compared to 2007.

California will become an increasingly important proved source for other managed care organizations, pharmacy benefit managers, who might in the past question our ability to drive pull through after obtaining coverage. We have driven conversion while maintaining our position as the value player and also with the support of our co-brand partners.

On a national basis, IMS data indicates that Home Diagnostics again achieved double digit growth of 14.8% over the prior year. This compares to an overall market growth of just 4.6% and nearly double what branded competitors achieved.

During the quarter we also saw our market share increase to 3.6%, up from 3.3% in the fourth quarter of 2008. According to IRI data we have improved our share of the cash market to 28.7% compared to 25.6% at this time last year, trailing only one branded competitor and further validating the strength of our value proposition in this current economy.

Moving on to the international market, we continue to see consistent growth in Australia and Latin America and have taken steps towards replicating this success in other markets. In the United Kingdom we recently received reimbursement coverage for TRUEone, which is marketed as Sidekick in the United States.

In Germany, after a several quarters of uncertainty, we have solidified our distribution by signing a new agreement with Hemofarm, a division of STADA. We are working closely with Hemofarm on plans to drive the business in 2009, including the potential expansion of distribution into additional Eastern European countries, where Hemofarm has an established presence and we are optimistic we will see improved performance from this relationship.

We also remain on track to file for CE mark in the European Union during the fourth quarter of this year, which would provide a long term expansion of the addressable market for TRUEresult and TRUE2go and support our efforts to grow our business in the UK, Germany and other European countries.

In summary, we believe we are extremely well positioned to leverage our current product portfolio, strong customer relationships and expanding managed care coverage. We have constructed a strategic sales and marketing plan to achieve our objectives and are continuously strengthening our position and adding new customers.

Thank you and this concludes my comments.

Joe Capper

Thank you, Scott. Thank you, Ron. That concludes our prepared comments for this morning’s call. At this point we would like to open the call for questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) Our first question is coming from Derek Leckow with Barrington Research. Please state your question.

Derek Leckow - Barrington Research

Thank you. Good morning and welcome Joe. First question is about the unit volume growth. I am trying to gauge some of the comments here relative to market share. Did you give the total meter unit volume and can you also give us some more color on some of the IRI data outside of the cash market? You gave cash at I think 28.7% share. Do you have any other data around that?

Ron Rubin

Well, overall in terms of the price volume for the full year Derek, the…

Derek Leckow - Barrington Research

Yes, I’m just trying to get a sense for the unit volume in 2008.

Ron Rubin

Overall, for the year unit volumes are up about 14%. That is off-set obviously by about 6% price and about 1% related to increased rebates. The pricing like we discussed, is really primarily coming in the mail service area where we’ve gotten more aggressive in volume based pricing arrangements.

Derek Leckow - Barrington Research

Okay, and this is total units? Let me get this straight, is it meters and strips or are you talking just…?

Ron Rubin

Yes.

Derek Leckow - Barrington Research

Okay, that’s the total. Do you have it broken out by meters and strips or can I figure that out somehow by using the strip to meter ratio that you gave?

Ron Rubin

Yes, we haven’t traditionally given that out. I think probably…

Scott Verner

I mean IRI traditionally just gives us information based on 50 count equivalents on one hand and then IMS will give us information just based on strip volume. So we don’t actually get it in terms of meters. We also assume Derek, for background that our competitors will give out meters a lot of different ways than we do, but we have a very strong presence in the channels we do business with. They may give more meters upstream, so the most important metric is obviously the strips that are sold.

Derek Leckow - Barrington Research

Okay. So your units were up 14% and what does that equate to in terms of share? Do you have that figure?

Scott Verner

Our overall IRI share?

Derek Leckow - Barrington Research

Yes.

Scott Verner

Our overall IRI share improved to 20.7%.

Derek Leckow - Barrington Research

But that was in the cash market only, right? That wasn’t the total?

Scott Verner

Do you want IMS, which is managed care?

Derek Leckow - Barrington Research

Yes. Do you have the total number?

Scott Verner

You mean our blended share; we don’t break that out that way. We just give IMS and IRI separately.

Derek Leckow - Barrington Research

What was the IMS?

Scott Verner

IMS we are now up to a 3.6 in total share and we grew 14.8%. The branded guys grew a little bit around 7% plus.

Derek Leckow - Barrington Research

And then just getting into your guidance for 2009, the preliminary single digit, top line growth; is that assuming additional 6% price erosion and are you talking about unit volume growing in that sort of low double digit range? What are you assuming there?

Ron Rubin

Yes, we’ve got similar assumptions in terms of volume and pricing going into ‘09, but we’ll get into more details on that when we quantify the guidance next quarter.

Derek Leckow - Barrington Research

Okay. All right, let me stop there. Thanks a lot.

Operator

Our next question is coming from Larry Solow with CJS Securities. Please state your question.

Larry Solow - CJS Securities

Hi, good morning and welcome Joe. On the distribution side, did you give a number for the outsourcings and out sales for the year, what that was? You said it was down 5% in the quarter?

Ron Rubin

Yes, on a year-to-date basis, our total out sales were on a unit basis for the 2008 and the test strips were up about 4% on a year-over-year basis.

Larry Solow - CJS Securities

Okay. That is for 2008 you are saying, and the full year?

Ron Rubin

Right. Part of that is like I stated, the photometric business continues to decline as the biosensor systems become more dominant in the market. So if you look at the biosensor systems on a full year basis, we were up high single digits, but when you offset that with some of the decline on the photometric all-in, it was about 4% growth.

Larry Solow - CJS Securities

Okay, got you. Then obviously you are going to have a decline and it’s mostly related to the economy. Is there any way to quantify how much wholesale inventory de-stocking you expect?

Ron Rubin

Yes, I think Larry, we’ll probably get into more details when we give full year guidance, but just generally speaking, the end of the year, the wholesalers were carrying upwards of about 150 days supply. So we are expecting them to end the year potentially somewhere between the 60 day and 90 day category, so we expect a fairly significant drop.

Larry Solow - CJS Securities

So it sounds like you expect a lot of it to occur in the first quarter or do you expect it to occur gradually through the year? It seems to be more front loaded or…?

Ron Rubin

Yes, a portion we’ll see in the first quarter and then in the tradeshow period where we traditionally see significant purchasing, we would expect their purchases to be less significant.

Larry Solow - CJS Securities

Less of a bump up, I guess. Right, and then on gross margin, and then specifically with Liberty which obviously the new product is dilutive in the beginning and with Liberty that kind of exacerbates it a little bit; do you expect trends to improve in the year as Liberty starts to ramp up? Is there any way we can better gauge that or look at that?

Ron Rubin

Yes, Larry that will gradually improve each quarter as we roll out. You are building a base of customers so as you continue to get meters installed in the system, you are going to improve the ratio. So on a overall basis for the year, that was relatively breakeven gross margin the first year and then as you get out to 2010, it starts to contribute significant EBIT dollars.

Larry Solow - CJS Securities

Right, and if we just kind of look at it, you did like a low 50s this quarter if you add back the 640. I know historically your gross margins have been high 50%s, 60%. Would you think a normalized number maybe beginning in 2010, at some point would return to the 60% range or any way to look at that?

Ron Rubin

We are not going to comment on 2010 at this point, Larry.

Larry Solow - CJS Securities

Right okay, but just long term do you see…?

Ron Rubin

Well, we are not going to quantify it. I will state that, to the extent the Liberty business goes as planned and starts to become a greater mix of our revenue, they may have an effect on the composition of our operating income margin. In other words, the gross margins may come down a little bit, but our overall operating income margins will improve.

Larry Solow - CJS Securities

Okay, then just speaking of Liberty, anything anecdotally you guys are seeing. I guess competitive bidding just began, right? Anything going on with that you can comment on?

Scott Verner

Yes, Larry its Scott. Competitive bidding continues to be pushed out as recently as yesterday and we believe for the purposes of the new President’s administration to have more time to review it, they keep pushing out the data we are viewing in this category. Right now we believe however it falls we are well positioned to do business. We are very close with our customers and being the value player I think we’ll do very well, but the government’s got to do what the government’s going to do and then we’ll respond accordingly.

Larry Solow - CJS Securities

Then just last question and I’ll move on. Just on the risks of inaccurate blood glucose readings, what is the prevalence of maltose based therapies? Is there a percentage I can look at and is there any risk that this will impact your sales or has it impacted or could it in the future? Could things get more troublesome for you on that area?

Joe Capper

This is Joe. It’s really too early for us to comment about impacting the business. We need a little bit of time to work through this. It’s a fairly recent issue for us. We just met with the FDA a few weeks ago and we are working through a plan with them and then we’ll determine what kind of impact if any it will have on the business.

Larry Solow - CJS Securities

Got you; and then just a housekeeping question on your guidance, or your sort of color for ’09. I know you mentioned a severance in Q1. I guess that’s not adjusted out of your guidance? So your guidance is kind of flat to down year excluding the tax benefit. It would include a severance payment, is that correct?

Ron Rubin

Correct. Yes, that will be about a $700,000 charge taken in Q1.

Larry Solow - CJS Securities

Perfect. Thanks a lot, guys.

Ron Rubin

All right, thank you.

Operator

Our next question is coming from Tao Levy with Deutsche Bank. Please state your question.

Tao Levy - Deutsche Bank

Good morning. I just had a question on the pricing front and the impact that you might be seeing in the marketplace. We’ve seen some releases from some of the large diabetes companies talking about wanting to dramatically reduce prices on meter strips because of the economy and offer sort of a low-priced version. Have you seen that affect your business at all and how does it affect the up charge in price that you are seeking to get with the no-code?

Ron Rubin

Scott, the announcement of the everyday low price strategy coming out from a couple of the branded companies, really has to do with how they market meters, not strips and primarily it’s with one of the large big box retailers.

What they’ve done is, they’ve gone from a product that’s priced in the high $50s to $60 range to lowering it more to the sub $20 range, but all along they are running pricing promotions to make the meters close, if not to free. So the point is they’ve lowered their meter pricing, but what the patients are really looking at is the cost of the strips and all the major retailers, including big box have done a brilliant job now, better communicating the actual cost of strips.

So the everyday low price, really only impacts the fact that there is less rebating going on, less on package promotion, but the cost of strips, those in particular that have made announcements, have either stayed the same or even gone up. So our value proposition is very strong at the retail shelf.

Tao Levy - Deutsche Bank

Okay and in terms of the pricing that you are able to capture with your new meter or your new strips?

Ron Rubin

You mean in terms of…?

Tao Levy - Deutsche Bank

Versus your old one, with the…?

Ron Rubin

It is priced as more of a premium product. No-code is a full featured set now in the marketplace. TRUEtrack has been more positioned for the cash and medi-medi business, so now we actually have a portfolio at retail. TRUEtest will also be very affordable for patients in any segment who want a no-coding product at substantial savings, but also in the long run will garner more managed care coverage because of the features, advantages, and benefits the new platform brings over our old technology.

Joe Capper

And the TRUEtest strips, again are priced higher than our TRUEtrack strip on the shelf, but still at a considerable savings to the branded guys on their test strips.

Tao Levy - Deutsche Bank

Fair enough. On the sales guidance for the first quarter, you provided a negative 5%, I’m still trying to understand. You talked about all the positives that are happening at Liberty, Wal-Mart, etc. and here you’re guiding to negative 5% growth in the first quarter. I have to go back in my model and basically the last time you did something in the sort of the $25 million range or $24 million range was back in 2005. So I’m just trying to put those two factors together and understand why you’re seeing that happen in your business, even though you have a lot of momentum which you’ve described?

Ron Rubin

Yes, I mean a big component of the first quarter is some of those inventory purchasing we saw in Q4. That will have an effect on our Q1 sales. Also, keep in mind last year in Q1 we launched TRUEtrack at Rite Aid, the private label brand that co-branded at Rite Aid, so we have got that as a difficult comparison against last year. That’s some color on the revenue expectations.

Tao Levy - Deutsche Bank

Your Q1 from last year is down 20% in the national distribution.

Ron Rubin

Again, last year we had the price increase. We did not do a price increase in distribution so there was some noise year-over-year in terms of purchases Q1, Q2 last year and distribution; that was a factor as well.

Tao Levy - Deutsche Bank

And you talked around 150 days worth of inventory. I thought the suppliers had been bringing that down pretty aggressively over the last several quarters.

Ron Rubin

Well, they have, but around these trade show periods and discounts they tend to bulk up and take advantage of those discounts, so seasonally it shifts.

Tao Levy - Deutsche Bank

Is that 150 lower than it where it was a year ago? Was it like 180 seasonally adjusted last time or 150 is still a high level for these guys, seasonally adjusted?

Ron Rubin

I think that it’s compared to where we ended the year in ‘07. The inventory day supply, I think it’s relatively similar, maybe slightly higher.

Tao Levy - Deutsche Bank

Okay, and then in my last question on the maltose, I know it was kind of asked earlier on. As we try to figure out the impact that that could have, I think we were hearing about this; you guys I think mentioned in the second quarter and in one of the medical meetings it came up a little bit. What could happen? What are some of the options that the FDA has? Could they come back and say all products have to address this with the risk that maybe your new no-code gets pulled off the market, I mean is that a possibility?

Joe Capper

I would hate to speculate at this point, where the FDA is going to go with this. I mean while it’s a more recent issue in terms of sensitivity, the maltose interference factor has been a well-known issue for many, many years and there are several other products in the marketplace that use the same enzyme or similar enzyme with the same interference factor.

So it doesn’t just affect Home Diagnostics. It affects a big portion of the market; so I don’t want to guess what the FDA will do, but I would like to think they are going to work with us as we work through this process. We are taking it very serious. We will put an excellent plan together, we will meet with them and we’ll work through this issue, but I’d hate to speculate as to what we’re going to have to do.

Tao Levy - Deutsche Bank

Then, my last question; as it relates, would that slow down the rate of your expansion as you get more color from the FDA? Does it make sense to be investing in new manufacturing lines if they may come back and want you to change some of those lines to address this?

Ron Rubin

Again, don’t really want to speculate right now. I will tell you that we will look at all of our options and we’ll make sure that we have plenty of alternatives in place.

Tao Levy - Deutsche Bank

Okay, thanks.

Operator

Our next question is coming from Tycho Peterson with JP Morgan Chase. Please state your question.

Tycho Peterson - JP Morgan Chase

Good morning. Maybe I will just start off with one for Joe. I know it’s obviously early days, but can you give us a sense as you think about your strategic priorities here, where you envision maybe some areas of investment, and if you could also talk a little bit about infrastructure and areas that you think that are going to be important for investment over the coming year?

Joe Capper

Yes, I’m going to kind of hold off on comments as far as areas that I would like to invest in. There is certainly some kind of strategic alternatives I would like to explore with the company, but it’s premature for me to share them with you, especially in light of the fact that this is day seven and I haven’t really had an opportunity to vet it with my management team. So I will probably get strung up.

Anyhow, I think we have a lot of exciting options. As I mentioned in my I comments, I think it’s a wonderful organization, strong infrastructure, certain competencies around the manufacturing and production of quality products at a value price. So there is a lot to build off of here. I really just don’t want to get into on this call where we are going, what we are looking at, what the alternatives are. I think there are many, I will tell you that.

Tycho Peterson - JP Morgan Chase

Okay. Maybe taking a different tact; Scott, you talked a little bit about Hemofarm’s distribution network in Europe. Can you talk a little bit about how broad that network is and does that accelerate your plans in Europe at all over the coming year?

Scott Verner

I wouldn’t say it’s going to accelerate our plans in Europe at this point. We are in the early days. We have an agreement with them, we’ve had substantive meetings with them, and we have a good feeling about their commitment to growing our brand with them in Europe and in Germany, but it’s a little bit early to say.

We went through a lot of management changes with STADA and now this division is supposed to be fully dedicated on this project. We had a couple of meetings in Europe, and several here in Fort Lauderdale and we believe their commitment at this point to be strong, but accelerating maybe a little bit strong word than I would want to use.

Tycho Peterson - JP Morgan Chase

Fair enough. On the pricing, I appreciate all of the color you’ve provided, but I think, Ron you had said it was mainly pressure in the mail service channel. Can you give us a sense as to that 6% decline I think you commented on; how much of that came from mail service.

Ron Rubin

We are not going to quantify it by channel Tycho, but the bulk of that’s coming out of the mail service channel.

Tycho Peterson - JP Morgan Chase

Okay and as we think about Liberty, how do we think about ordering patterns there? Is there a typical kind of front end loading at the beginning of the year and then…?

Ron Rubin

One of the nice things is that we will get 90 days from the POs in advance under the agreement with them and there’s not as much of a front end loading. Scott, do you have anything?

Scott Verner

No, we are off to a great start with Liberty. They give us forecasts and they readjust them every 30 days and as Ron said, provide POs every 90 days. They are very excited about their new brand that we are making for them and have actually featured it on their website and promotional materials. So we feel very good about the early stages of our launch.

Tycho Peterson - JP Morgan Chase

Okay and then just one last one on FDA. Is there a next date to think about in terms of a meeting with them? I mean, how do we think about the timelines there?

Ron Rubin

Our next milestone is towards the end of March.

Tycho Peterson - JP Morgan Chase

Okay, terrific. Thank you very much.

Ron Rubin

Thank you.

Operator

Our next question is coming from Matthew O’Brien with William Blair. Please state your question.

Matthew O’Brien - William Blair

Good morning. Just on the guidance for gross profit in 2009, is it fair to say that the Liberty deal is actually a little bit better than expected, because it’s a gross profit well below what we were thinking?

Ron Rubin

The Liberty agreement is contributing to the reason we are seeing a decline to this day, but the first full year is more or less a breakeven from a gross margin standpoint.

Matthew O’Brien - William Blair

Okay, but it’s fair to say that it’s basically in line with what your expectations were, it’s not a little bit better. It’s just that the gross margin was 800 bps lower than what we were thinking for the full year, so you hadn’t provided much color, but there is nothing to kind of make out of the Liberty deal being better than expected?

Ron Rubin

It’s in line with our expectations.

Matthew O’Brien - William Blair

Okay and then on the distribution side, it’s clear you guys have been focusing on retail recently. Scott or Joe, kind of early days, what’s kind of your thought there to get that portion of the business reenergized?

Scott Verner

I think its several things. One, I think more importantly we were very focused with TRUEtrack, our core product, our legacy product, to reestablish ourselves in the Medicare, Medicaid space, as well as in cash and we are launching a new program in April called our Medicare Advantage program and it’s a multi prong attack to go after that business.

Just to give you a little bit of color, it will have special packaging for the products that are purchased through our customers that buy through independent pharmacies, both in retail, as well as the customers that buy through national distribution. We have worked very closely with them to obtain edits in their system, so we called out the value and the featured advantages, and benefits of TRUEtrack and how it plays in those markets, as well as highlight the number of plans that we are on.

As you know, when a patient comes in with a script, even though 50% of them come in unbranded, the pharmacists are very busy, so how they go into their computer system and see a call out for Home Diagnostics products or their co-brand is very important. Then we’ve also made sure that the agreements that we have with our co-branding partners, highlight certain commitments that they need to make promotionally for supporting our products. These are all new initiatives and will all start taking hold in April.

As you know from previous calls, we are also backing that up with very strong support from our field as well as our telesales department.

Matthew O’Brien - William Blair

Okay and then Ron, a quick question on the burn rate. You kind of mentioned $30 million in cash, no debt, and then $10 million of a revolver that’s standing out there; I mean 2009 looks like an investment year. Is that burn rate somewhere in the $15 million range, is that fair to say?

Ron Rubin

I don’t think it will be that significant. I think we’re projecting close to a breakeven free cash flow, but we do anticipate spending the full $5 million on the share repurchase program. So I think net-net we would expect to eat into our cash by about $5 million.

Matthew O’Brien - William Blair

So, you were talking of kind of a flat net income number for 2009 and then you are spending CapEx at $16 million to $19 million, plus the $5 million for the repurchase, so I’m not sure where the $5 million burn comes from. Is my math off?

Ron Rubin

We can go through that in more detail off-line, but I think working capital may be an impact. There’s an impact on our tax payments due to some of the new legislation on accelerating the depreciation and so forth.

Matthew O’Brien - William Blair

Okay and then finally, just a broader question. There’s been a lot of the CGM provider, a lot of the private insurance payers are now reimbursing for continuous glucose monitors. Any thoughts on impact to your business, kind of 2009 or a little bit longer term?

Joe Capper

No, this is Joe. I don’t anticipate CGM having an impact on our business in the near term. Most of the technology on the market still requires routine testing with a blood glucose monitor to calibrate the systems; so I really don’t anticipate that being an issue for us.

Matthew O’Brien - William Blair

Okay, thank you.

Operator

Our next question is a follow-up form Derek Leckow with Barrington Research. Please state your question.

Derek Leckow - Barrington Research

Yes thanks, just two quick follow-ups here. On the maltose issue, do you have an idea for how many patients that are involved and maybe give us a sense for what percentage of your addressable market that represents?

Ron Rubin

Not at this point. We are really not comfortable sharing all of that data right now. We are still going through kind of the analysis phase of this. I will tell you that, I think that as an organization we have a smaller impact than the other players in the market and the other players are two of the big four. So it’s a pretty big issue collectively for the market. It’s not indigenous to Home Diagnostics.

Derek Leckow - Barrington Research

Okay. So does anyone want to talk more about what you are going to do yet at this point? One of the options might be just to make it more clear in your documentation, what this risk really is. Is that sort of what you’re thinking or…?

Joe Capper

Again, I think what we’ll present is several options or a multi-level option at this juncture is our thinking, and we need to have time to work through that, but again we are going to take it serious, it’s a big deal. We don’t want to sound deminimus about it, but I don’t want you think that it’s new.

This issue has been out there for a while; it’s an interfering substance that other people have to deal with. It’s not the only interfering substance, other enzymes we have other issues. So when you manufacture a product like this you use the best materials possible at the time you go into production and we think we did that. So we’ll work through the issue.

Derek Leckow - Barrington Research

Okay, great. Then the other question is on the Wal-Mart relationship, it looks like you’ve got TRUEtrack and you have the Sidekick product there, but none of the new products. Is that correct; and dose your guidance assume that you’re going to get any placement of the newer systems at Wal-Mart?

Scott Verner

I’ll take the marketing part and I’ll let Ron talk to guidance, Derek; it’s Scott. We are working closely with Wal-Mart. We are excited that we started out our 200 stores with Sidekick; it did so well, they went system-wide; the same thing with TRUEtrack.

Naturally Wal-Mart is aware of our plan, the new product launch of TRUEresult and TRUE2go. We meet with them regularly, particularly because of the success we are having in managed care and we have a rollout strategy right now and there is probably the opportunity down the line for those products to get into Wal-Marts, but that will be at a time that works well for both of us.

Derek Leckow - Barrington Research

Okay and then the CBS relationship you mentioned, is that also something you’re contemplating in your guidance right now, Ron?

Ron Rubin

Yes. We are actively launching the product.

Derek Leckow - Barrington Research

Okay, so that’s in there, but anything new from Wal-Mart would be the older products basically, right?

Scott Verner

That is correct.

Derek Leckow - Barrington Research

Okay, thanks a lot.

Operator

There are no further questions at this time. I would like to turn the floor back over to management for closing comments.

Joe Capper

Thank you everybody and, again I just want to reiterate just how excited I am to be here and I look forward to working and meeting with you all in the future. Thank you very much.

Operator

Ladies and gentlemen, this does conclude today’s teleconference. You may disconnect your lines at this time and we thank you for your participation.

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Source: Home Diagnostics Inc. Q4 2008 Earnings Call Transcript
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