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Cyberonics, Inc. (NASDAQ:CYBX)

March 12, 2013 1:30 pm ET

Executives

Daniel Jeffrey Moore - Chief Executive Officer, President and Executive Director

Analysts

Matthew Taylor - Barclays Capital, Research Division

Matthew Taylor - Barclays Capital, Research Division

I guess we're on. Thanks for joining me for this session after lunch. We're really pleased to have Cyberonics joining us. And we have Dan Moore, who's the CEO. Cyberonics has an exciting growth story in med tech, and they really dominated the epilepsy space, and they have a lot of exciting growth drivers for treatment of different disease states with their VNS technology. So to hear more about that, I think we're going to do a short presentation, and then follow it up with some Q&A. Dan, take it away.

Daniel Jeffrey Moore

Thanks, Matt. I'm going to begin with just our Safe Harbor statement to let you know that we'll be making forward-looking statements. Those forward-looking statements are based on assumptions that we believe are reasonable. For a full description of some of the risks that are involved in our business, you can refer back to our last 10-K, which was in April of last year, we're on a fiscal year, or any of the 3 Qs from the 3 subsequent quarters as far as fiscal year '13.

So Cyberonics overview. We are a medical device company, primarily focused on epilepsy. But I'll talk about some other areas where we have work going on. We're based out of Houston, Texas. We have international sales in approximately 70 countries, 570 employees and we have about 100,000 implants in 68,000 patients over the years. In the last quarter, we did $63 million, and that's split was about 80-20 -- 81-19, U.S. versus international. So if you look at the history of the company, we are celebrating our 25th year. The first 10 years were largely R&D, product development going for regulatory approval in the area of vagus nerve stimulation for epilepsy. Following that, we got excited about some other areas, depression and some other indications. So there was some work there in the next 10 years in addition to the epilepsy effort. And back in 2007, the new management team came into the company and refocused the company, starting with vagus nerve stimulation for epilepsy, where we believed then and still believe today there is an underserved patient population and a good potential for Vagus Nerve Stimulation Therapy for patients with epilepsy. We evolved that mission to expand it to medical devices for patients with epilepsy. And more recently have talked about VNS for other indications like chronic heart failure and depression and also other neuroscience opportunities in areas like obstructive sleep apnea. So in the future, we expect to become a broader neuroscience company. But today, most of the effort is still around epilepsy.

If we look at the -- just one market, the primary market for epilepsy, about 2.7 million people in the U.S. have epilepsy. It's about 1% of the population. When we look at our potential market, about 1/3 of those patients have refractory or difficult to treat drug-resistant epilepsy, meaning, they're not getting adequate relief of their seizure symptoms with their drugs alone. So that brings the market down about 900,000 patients for us. We treat one type of epilepsy, partial seizures that begin in one area of the brain. And we also are labeled for patients above the age of 12 in the U.S. So that brings the market size down from about 900,000 to 400,000 potential patients. And over the years in the last 10 to 15 years, we've treated 57,000 patients in the U.S. When we look at the incidence side, there's at least 125,000 patients who are diagnosed with epilepsy each year. You'll see numbers as high as 200,000 patients. It goes through that same algorithm, and you end up with 15,000 to 24,000 new patients. The point of this slide is that when you're looking at the pool of patients or new patients who are being diagnosed with epilepsy, there's plenty of opportunity out there. Despite the 5 years of good financial results, the reality is that last year we treated about 3,700 new patients out of this pool. So a lot more work to do. The other market mass for Europe and Japan are much the same. Actually, even more enticing because we have broader labeling in most markets. Our opportunity starts with our replacements. This is a product that will last anywhere from 2 to 11 years. Call it an average of 5 years. Typical patient's implanted on average around age 29 or 30, so they may go through multiple implants during their lifetime.

This was a slide from a recent analyst meeting where we looked out and projected what our replacement activity would be. This year, we expect about $100 million in replacement activity. And you can see as we enter fiscal '14 in the next quarter and then on to fiscal '15, we expect continued growth in that replacement business that we modeled at $100 million, roughly $100 million in fiscal year '13.

We look at what the other things we're doing. We are data-driven. We continue to accumulate more data. We use data in the exercise of market development. We're focused on U.S. market development and invest in U.S. market development. We are also focused on increasing our penetration in markets outside the U.S., which also is a market development exercise. And then from a product development standpoint, we've got a good pipeline of products with the AspireHC, recently being launched in the last year or 2, fully in the U.S. and a limited commercial release in Europe. And the AspireSR product, the seizure response product is in clinical trial in Europe, has a clinical trial approved in the U.S. We hope to implant our first patient in that trial soon.

We look at the future. The future is bright. We start with the 3 products that we have available today, generation 3 of the Pulse product, generation 4 of the Demipulse product and generation 5 of the AspireHC. Got an expanded MRI labeling and some other MRI work going. When we look at clinical activity in addition to the AspireSR that I mentioned, we also have a ProGuardian product that is an external device that's meant to monitor seizure activity, and its first iteration would serve as a nighttime monitor, where we'd be sensing for seizure activity and communicating with the base station that someone's about to have a seizure or had a seizure to alert a caregiver. So these 2 products are both in clinical trials. A little bit further out, we've got a new programmer and then a wireless device, the next generation of generators, the Relay, will be wireless. I mentioned, we're primarily an epilepsy company, and that's where all of our revenue is coming from, almost all of our revenue. We sell 10 or 12 devices a quarter for depression. But besides that, it's about epilepsy. And as we go forward in addition to trying to overturn a noncoverage decision for vagus nerve stimulation for depression, we are also -- we also have a chronic heart failure program, so vagus nerve stimulation for chronic heart failure, and we've made an investment in a company called ImThera for using generators and leads neurostimulation for obstructive sleep apnea. Over the past 5 or 6 years, we've done 21 different agreements with 16 different parties.

If you look at the financial results in the last quarter that was just reported, we had 15% growth in that $63 million. And see that U.S. sales at over $50 million, again 11% growth versus prior year. International numbers $12 million, with very impressive 37% growth. Our operating income was leveraged and grew by 25% overall, adjusted EBITDA at 14% growth and then earnings per diluted share, up 38%. So we're getting good leverage throughout the P&L.

If you look at the consistency story going back over 5 years, you can see good unit -- or quarter-over-quarter growth when it comes to the sales, and we've got $62 million in the last quarter. And we're getting some of that through average selling prices. You can see good improvement to the average selling prices. This is the U.S. generator price where we saw a 5% increase again last quarter for our U.S. generators over the same quarter a year ago. As we look at the -- historically, what's happened here, we inherited a business that was losing a lot of money in the first year. Although we got to break even within our third quarter, we still had generated losses in the first and second quarters that led to an overall loss for the year. From that point forward, it's driven to profitability and continued to grow the profitability. As we look at the guidance that we've given, and we are in our fourth quarter of our fiscal year '13, we raised guidance again to $248 million to $250 million on the top line and $75 million to $77 million in operating income.

I think that's what I had, Matt, for slides.

Question-and-Answer Session

Matthew Taylor - Barclays Capital, Research Division

Sounds good. So going to do a few minutes of Q&A. We also have audience response questions today. So it's been a fan favorite we had a couple of years. So why don't we actually start with our first audience response question. So that is about the Cyberonics potential. The question is, what's the biggest potential area of upside for Cyberonics over the next several years? And the choices are increased penetration, geographic expansion, depression, CHF, sleep apnea or new generators with closed-loop systems.

Daniel Jeffrey Moore

How much time do you give me, Matt?

[Voting]

Matthew Taylor - Barclays Capital, Research Division

Look at that.

Daniel Jeffrey Moore

The survey showed...

Matthew Taylor - Barclays Capital, Research Division

Depression, the big one. But certainly, there's a little bit of geographic expansion expectation baked in there as well. So maybe if you want to talk about depression a little bit more first. And then what you think that could be in, not broadly, but the indication? And then also I guess geographic expansion as a potential driver?

Daniel Jeffrey Moore

Okay. On the depression indication, we have an FDA approval for Vagus Nerve Stimulation Therapy for patients with treatment-resistant depression. We have had that since 2005. In 2007 we received a noncoverage decision from CMS. And then since then, we made the decision even though we were coming in to run an epilepsy company, we made the decision to continue to invest in the area of depression based on some clinical results that we thought were pretty encouraging. We continued with 2 post-market FDA trials and more recently, unblinded one of those, the D-21. And over the last couple of years have gotten 4 publications. We resubmitted to CMS in February. And hope that we will overturn our noncoverage decision in the area of depression. Geographical expansion. I mentioned in my slides that market development continues to be important wherever we are in the world. The reality is, despite the financial results that you see, we're less than 20% penetrated around the world. So the idea of going to new geographies where we know typically around the world 1% of the population has epilepsy, we can bring a device solution to those patients, and we continue to invest in both expansion and the depth within a country to try to get better penetration once we're in a geography.

Matthew Taylor - Barclays Capital, Research Division

I want to talk a little bit about use of capital. But let's turn to the audience again and see what the audience wants you to do with excess cash.

Daniel Jeffrey Moore

Excess cash. Okay.

Matthew Taylor - Barclays Capital, Research Division

Go to the next question. The question is, what do you believe Cyberonics should do with excess cash? Bolt-on M&A, larger M&A, buybacks, dividends, internal investment or debt pay-down?

[Voting]

Matthew Taylor - Barclays Capital, Research Division

Next year you're going to pick your own music. So looks like buybacks was kind of an even split on the other categories. So maybe just take us through your internal thinking currently on use of capital broadly. And what you think about the results?

Daniel Jeffrey Moore

You guys must know the story because there is no debt to pay down anymore. We have over $100 million in cash. We, first and foremost, like to invest in the pipeline. I think I've seen numbers that suggest an average device company invest about 12% in R&D. We said we would do up to 18%. The last quarter, I think we were roughly 16.5% in product development as defined by R&D, clinical, et cetera. So first and foremost, we like to take money and reinvest or invest in our pipeline, that's number one. Number two is, after having paid down over $100 million in debt and eliminating the debt, we started to get more active in share buybacks, and I think we have shown over the last couple or 3 years that we've been buying back shares, and we were coming to the end of another 1 million share buyback program with a couple of hundred million -- or couple of hundred thousand shares left in that one and announced another 1 million that we hope to complete over the next year or so, or the next fiscal year or so. So we will take cash and buy back shares. On the dividend thing, we've so far made a decision not to pay a dividend. We like reinvesting the money in the business at this point.

Matthew Taylor - Barclays Capital, Research Division

Great. And so we have another question here on EPS growth. And I want to get a sense of what the audience thinks the long term EPS growth of Cyberonics could be relative to peers. So above, slightly above, in line, below or slightly below?

[Voting]

Matthew Taylor - Barclays Capital, Research Division

So that's good.

Daniel Jeffrey Moore

High expectations.

Matthew Taylor - Barclays Capital, Research Division

So above. So I guess maybe you want to talk about maybe just give an overall sense of how the pieces kind of work together to create that above-average earnings growth in terms of the top line growth drivers that you have with epilepsy and some of these other indications, but also continual improvement on the operating margin side and then with some financial leverage as well.

Daniel Jeffrey Moore

Yes. When you're blessed with over $200 million in revenue or when I came in over $100 million in revenue, I believe a company largely decides whether or not they're going to make money, and we can all argue about when it makes sense to be losing money or investing in the business or when you need to turn to a profitable company. This was a 20-year-old company that had margins roughly 80% or above. And from our perspective, it was time to come in and make money. We were able to turn around the top line and get that growth. But from the beginning, we've modeled it as a company that would be profitable. On the profitability side, we try to do better on the growth -- earnings growth than we do on the top line. I mean, we historically have been running about 15% in the top line, and we'd like to do better than that in the operating income line. So it's a model that we've used. We like that, and I think we'll continue to try to leverage that bottom line.

Matthew Taylor - Barclays Capital, Research Division

Maybe -- I wanted to hear a little bit more about the CHF and sleep apnea opportunities. I know maybe they're not the biggest focus right now, but down the road, they could be pretty incremental. So do you want to talk about the investment that you've made in OSA and CHF? And give us an idea of how those could contribute to the longer-term growth?

Daniel Jeffrey Moore

Yes. Beyond epilepsy and depression, the chronic heart failure play for us is a next obvious place to potentially play. It's very early. We're into a pilot trial, but we've basically taken a small team of people who have come into the company just to work on chronic heart failure. They're dedicated to that effort. I think they've done a very good job of leveraging and building a global network of advisors and other people involved in the program. So it truly is a global program under the direction of Bruce KenKnight. And again, it's very early, so until we have some clinical results, we really don't have anything. But I think Bruce and his team did a very good job of making slight modifications to the product or the approach, capitalizing on some animal work that had already been done and enhancing that with more animal work, getting a study designed and then getting that study approved and beginning to implant patients. But going forward, it will depend on how we do in that initial pilot trial. As you probably know, we're not the only ones that like chronic heart failure for vagus nerve stimulation. There's a couple -- there are a couple of those others big companies, one that I came from. Boston Scientific has a program on chronic heart failure, specifically vagus nerve stimulation for chronic heart failure. Medtronic has an agreement with Biocontrol, where they also have a chronic heart failure program, specifically using again vagus nerve stimulation for that. And more recently, Sorin, bought a company called Neurotech, that also has a CE mark on a vagus nerve stimulator for epilepsy. And in that announcement -- in that merger announcement or acquisition announcement, they talked about potentially using that technology for chronic heart failure.

Matthew Taylor - Barclays Capital, Research Division

Maybe we can jump off there and talk a little bit about the competitive environment for epilepsy. All those companies that you mentioned are -- a lot of them are working on an epilepsy indication as well. How do you see that evolving over the next couple of years? And how are you going to stay ahead in terms of keeping and gaining market share?

Daniel Jeffrey Moore

Yes. We're believers in devices for epilepsy. I showed that in the second arrow that we quickly evolve for devices for epilepsy because we believe that beyond drugs like many other indication devices play a role. Going forward, I think we have a lead in the area of using vagus nerve stimulation for epilepsy. I think we're in a very good position with that because we are able to impact the brain without doing brain surgery. Nothing against DBS, I think it has or will play a role in the future. But again, we're able to take really an outpatient procedure and implant the device, impact the brain without having to go through an inpatient procedure and brain surgery or something like deep brain stimulation. So as we look competitively, I think we're positioned very well. And also, we're not stagnant. I mean, I touched a little bit on the slide about the seizure response product. So as we evolve Vagus Nerve Stimulation Therapy, we hope to make that therapy even more efficacious through things like AspireSR, and we'll continue to push the IP out with that as well. So I think we're in a good position as it relates directly to vagus nerve stimulation and what we'll do to raise the stakes. But also just given our relative invasiveness, to me, vagus nerve stimulation makes sense as the device of choice. I'm biased of course.

Matthew Taylor - Barclays Capital, Research Division

How have things been on the pricing front? Your dynamics have been pretty good. Can you talk about your outlook for pricing and how you think that can evolve?

Daniel Jeffrey Moore

Sure. I think philosophically, we look -- we're in an environment where costs are rising overall. Our costs are rising as well. And I think we've had the discipline from the beginning of coming in and taking some price. We don't feel guilty about taking price. If I go all the way to the economic argument, if we need to get into that with a payor, sure. A lot of companies, they were part of the solution. We're not part of the cost here. We can again point to a study that's been published that showed starting with 33,000 patients that we're looking at, they're use of drugs and whether they were compliant to their epilepsy drugs or not. But a study that was done across 5 states, 5 Medicaid programs and looking at a subset of that patient population, the patients with vagus nerve stimulation for their epilepsy, there were 1,655 of those patients in that group of 33,000 and looking at some cost comparisons before they had VNS versus after VNS, we saw about an 18-month breakeven with the procedure and the product overall. So I think we're in a good position there to continue to take some price. I never want to imply that that's an easy thing to do. There have been pricing pressures for as long as I've been in the business, which I know, it looks like probably 5 years, but it's been longer than that. Upwards of 20 years, it's been a while, but those pricing pressures were there. They'll be there tomorrow. Can we guarantee we'll continue to get price? No. How have we gotten price? We've gotten price year-after-year by taking 3 -- roughly 3% each January. And then when we come out with new technology, I'm sure you as shareholders as we're investing your money, you expect to get a return on that as the efficacy improves or in the case of AspireHC, for example, where it's got 35% to 55% better battery life than the preceding 2 products. We expect to capture some of that gain that goes into the system. So we didn't get 35% to 55% better price on AspireHC, but we do have about a 10% pricing premium on that product. So it'll be a combination of annual price increases and bringing new technology forward and then charging more for that new technology because I think we have the backstop of the -- of economic results that suggest that this is a viable, economically viable therapy as well.

Matthew Taylor - Barclays Capital, Research Division

Okay. And I think we have a couple more questions and maybe 2 good ones to end on. So let's move to the next audience question which is, what's Cyberonics' most significant opportunity to improve performance? What would you like to see, more core growth, margin improvement, capital deployment, better execution strategy or pipeline opportunity?

[Voting]

Daniel Jeffrey Moore

Me, I've had a number fixed on their chain to CEO. Please take that off.

Matthew Taylor - Barclays Capital, Research Division

So pipeline. So I guess going back to depression and some of those other opportunities you talked about before. And let's move on to the next one. This is an interesting question, which is, what would cause you to invest or invest more in Cyberonics? Higher revenue growth, continuous operating margin improvement or neither?

[Voting]

Daniel Jeffrey Moore

They want more revenue.

Matthew Taylor - Barclays Capital, Research Division

More revenue, that's right. We talked about high expectations before, so I guess how do you see the revenue growth rate as accelerating with potentially with the depression indication? That could be a big new one for you. But certainly, even the base epilepsy business has pretty good growth.

Daniel Jeffrey Moore

Sure. When -- there was a question coming into the business because the epilepsy business had been declining, could this business grow with 10-year-old technology, et cetera? Our hypothesis coming in was a large underserved patient population, which I think I demonstrated still 6 years later. So our hypothesis was, that this business could grow, should grow, and we started it off just with epilepsy and believed that was the way to grow. The reality is, that despite all of the investment that's been made, we're still less than 20% penetrated, so that's part of the upside going forward. And if you go back to December of 2009, when we had our first Analyst and Investor Meeting where we showed the pipeline, we talked at the time about potentially doubling the business over about a 5-year period, which spoke to that 15% annual growth rate. So I think we've largely been on track to do that. We came back in December of 2011 and put a range around that of like $288 million to $333 million. But so far, we've grown the business at about 15%, given the investments that we're making and putting our best minds to it. I do think with product development, product development will help. You can see that just in the last quarter, the 2 products that were 86% of our business or 84% of our business between Demi and AspireHC are relatively new products with HC being in the last couple of years and Demipulse being in the last 5 or so. So we know that with product development will come growth. So far, a combination of the product development we've done and the market development and the geographical expansion and everything we've done, it's been good for about 15%. We hope that over time, with other things coming off the pipeline, whether that's a ProGuardian product or a new generator for VNS for epilepsy or depression indication that we can get those growth rates beyond 15%. But now those -- we have no guarantee that's going to happen, of course.

Matthew Taylor - Barclays Capital, Research Division

Great. I think that might be a good place to end. But thanks a lot for your time.

Daniel Jeffrey Moore

Thank you, Matt. Thanks for the invitation.

Matthew Taylor - Barclays Capital, Research Division

We appreciate your interest.

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