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Synergetics USA, Inc. (NASDAQ:SURG)

F2Q13 Earnings Conference Call

March 13, 2013 10:30 a.m. ET

Executives

Pamela G. Boone – EVP and CFO

David M. Hable – President and CEO

Analysts

Chris Cooley – Stephens, Inc.

Steven Crowley – Craig-Hallum Capital Group

Joseph Munda – Sidoti & Company, LLC

Raymond Myers – The Benchmark Company, LLC

Greg Simpson – Wunderlich Securities, Inc.

Charles Bellows – White Pine Capital

Paul Nouri – Noble Equity Fund

Craig Hoagland – Anderson Hoagland & Company

Bernie Harris - B.J. Harris

Operator

Good morning, ladies and gentlemen, and welcome to the second quarter earnings conference call. At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer session. Please note that today's conference is being recorded.

Synergetics would like to remind listeners that certain comments made during this conference call may be forward-looking statements for the purposes of the Private Securities Litigation Reform Act of 1995. In some cases, forward-looking statements can be identified by words such as believe, expect, anticipate, plan, potential, continue, or similar expressions. Such forward-looking statements include risks and uncertainties, and there are important factors that could cause actual results to differ materially from those expressed or implied by such forward-looking statements. These facts, risks, and uncertainties are discussed in Synergetics' annual report on Form 10-K for the year ended July 31, 2011, filed October 15, 2012, as updated from time-to-time in our filings with the Securities and Exchange Commission.

I would now like to turn the call over to Dave Hable, the Company's Chief Executive Officer. Dave, you may begin.

David Hable

Thank you, and good morning, everyone. Welcome to today's call that is being simultaneously broadcast over the internet as noted in our press release. With me on the line today is Pam Boone, our CFO. A press release was issued yesterday after the market closing outlining our earnings for the second quarter of fiscal 2012 ended January 21. Our Form 10-K was filed with the SEC yesterday evening as well.

Here is the agenda for today’s call. I will provide a high level overview of financial performance. Pam will then provide detailed financial color and I will return to provide an update on the commercialization of VersaVIT. We will then conduct a question-and-answer session.

Regarding the second quarter, we were disappointed with the 7% decline in revenue and the operating loss reported in the period. Our second quarter revenue performance was impacted by the ongoing competitive challenges in our base ophthalmic business, by fluctuations in the ordering patterns from our marketing partners in our OEM business. More detail on each of these in a minute.

On the positive side, we saw the continued progress in the early stages of commercialization for our portable vitrectomy machine VersaVIT. We remain confident that the future of the company will be driven by the powerful combination of this innovative machine and the associated high margin disposables used in each procedure and we look forward to increasing market adoption of this product franchise going forward.

In addition to the sales performance, our operating loss was driven by sharply lower gross margins due to the below plan sales and a write-off of excess inventory in the period. Higher operating expenses, primarily due to incremental spending on the commercialization of VersaVIT, also added to our operating losses in the period. Overall the financial performance was not strong in the second quarter and we are focused on improving results going forward.

Now for a brief overview of our Q2 revenue performance, specifically as it relates to the two headwinds I mentioned. I’ll start with the OEM side of the business which represents roughly 80% of the overall decline in total company sales this quarter. The majority of this decline is attributed to the timing of capital equipment orders from our largest marketing partners Codman and Stryker. We expect these generator sales to return in the second half of the year and we’ve already seen an uptick in orders for this product category in the current quarter.

Disposable sales to our OEM partners represent the rest of the year over year decline. In this case however, our two largest partners had very different performances. Codman posted nice volume growth in the period and appears to be on an increasing trend for the balance of fiscal 2013. On the other hand Stryker sales volume posted notable declines compared to the prior year driven by inventory rationalization efforts that reduced ordering patterns in the quarter. Importantly, we believe that the inventory rationalization was not a [search] [ph] specific event. Rather it appears to be part of an increased focus on working capital efficiency. We believe the impact of this inventory rationalization is likely to moderate as soon as our fiscal fourth quarter as evidenced by the anticipated order volumes associated with new products Stryker plans to launch during calendar 2013.

Our OEM partnerships remain strong despite the slowdown in ordering volumes this quarter. We continue to expect the sales to our marketing partners to contribute nicely to fiscal year growth based on our current forecasts with Codman and Stryker. And those apply to both capital equipment and the disposable sides of the OEM business, although occasional fluctuations in the ordering patterns may occur as we saw in Q2.

Turning to our ophthalmology segment in the U.S, sales declined 3.6% driven by weak sales in our base business, slightly offset by a full quarter contribution from the recent commercialization of VersaVIT. These trends are not unfamiliar on U.S ophthalmic segments as we have shared with you in the past quarters. This segment continues to face competitive headwinds that directly impact the sales performance in our business of older generation or legacy products.

We are seeing more aggressive pricing strategies by the largest retina player both in terms of lower box pricing and in terms of disposables, the latter of which came in the form of heavy promotions across multiple categories in the second quarter. Let me remind you of our longer term strategy to drive growth in the ophthalmic business, specifically the commercialization of VersaVIT and the associated high margin disposable packs. Unfortunately, we’re not yet at the inflection point where the contributions from the strategy are material enough to offset the impacts of the market share losses in the smaller, more mature retinal markets which represent the majority of our base business sales.

Internationally, ophthalmology climbed 1% overall, primarily due to the impact of foreign currency. Underlying performance was driven by a combination of pluses and minuses across the main global markets in which we operate. Continental Europe remains a mixed bag in total as economic challenges continue to impact these base business results. New products however have been performing very well in Europe as a compelling cost benefit proposition of our VersaVIT machine appears to be well received as reported by our distribution partners in these countries.

Other notable O-US activity included sales in Latin America growing nicely while sales in Japan were weaker compared to last year due to the increased competitive activity. Finally, our emerging markets business continues to contribute to overall international growth although on a smaller scale over the near term given our measured approach in these markets. We saw year over year growth in three of the four emerging markets in which we operate this quarter.

Pam will discuss the rest of the P&L performance in detail, but before I turn it over to her I’d like to touch on the topic of our gross margin, specifically our long term goal of 60% plus gross margin for the company. While this objective remains a goal of ours going forward, our ability to achieve this level of gross profit in fiscal 2013 is necessarily more difficult given the increase in cost of goods sold in the second quarter.

In summary, we were disappointed with our sales and earnings performance in the second quarter. Admittedly second quarter results were not entirely due to external factors, particularly as it relates to our margin performance in the period. Organization wide, we are holding ourselves to a higher standard of accountability. We understand that this performance is not acceptable. Further, there were individual performance issues that were identified and that are being addressed. We are undergoing a major transition at Synergetics spearheaded by the global product introduction of the VersaVIT vitrectomy machine which we expect will reposition the company for stronger growth prospects in the years to come. This transition will take time and while we have made significant progress in recent years, our work is not done.

With that, I’ll turn it over to Pam for a detailed review of our financial performance in the period.

Pamela Boone

Thanks Dave. Total net sales in the second quarter declined 6.8% to $14.1 million versus $15.1 million in the prior year period. Total sales declined 3.9% sequentially in the second quarter. Total U.S sales declined 8.6% to $10 million while total international sales declined 1.5% to $4.1 million. International sales represented approximately 29% of total company sales this quarter with the balance of 71% coming from domestic sales. Our international sales mix last year was approximately 27.5%.

Total company sales by product category, disposables and capital equipment reflect a 3.9% decline year over year in sales of disposables and a 15.1% decline in sales of capital equipment. Disposable sales accounted for approximately 81% of total sales in the second quarter of fiscal 2013. The decrease in disposables revenue was attributable to weak trends in the ophthalmic base business due to competitive pressures and a reduction in orders from our second largest OEM partner Stryker for disposable neurosurgery products due to year-end inventory rebalancing measures.

On the ophthalmic side, we saw declines in our larger product lines, our laser and illumination probes which together represent nearly half of our worldwide ophthalmic sales. On the plus side, sales of disposable forceps to our largest OEM partner Codman improved in the second quarter, though the growth only partially offset the aforementioned decline.

Capital equipment sales pressure was largely due to the slippage of order volumes to our OEM marketing partners and the difficult compassion in the prior year.

Turning to a review of second quarter performance in our two main business segments, ophthalmic and OEM, which represented approximately 52% and 37% of total company sales respectively this year. Total ophthalmic sales declined 2.5% to $8.7 compared with sales of $8.9 million last year. Total segment sales performance this quarter was driven primarily by a 3.6% decline in domestic ophthalmic sales and to a lesser extent, a 1.2% decline in international ophthalmic sales.

Ophthalmic sales, both domestic and international benefited from increased sales of VersaVIT vitrectomy systems and procedural kits this quarter. Unfortunately this new product growth was not sufficient enough yet to offset the continued pressure we’re seeing in our base business.

Shifting to our other main business segment OEM sales declined 13.3% to $5.2 million compared with $6.0 million last year. OEM sales performance was impacted by the aforementioned inventory rationalization at Stryker. We grew capital equipment sales for both Codman and Stryker and by lower deferred revenues year over year. Specifically, we recognized $322,000 in the second quarter of fiscal 2013 compared to deferred revenues of $453,000 recognized in the prior year period. Excluding the impacts of lower deferred revenues, second quarter OEM sales declined 12% year over year.

Now for a brief review of the rest of the P&L for the second quarter of 2013. Gross profit for the second quarter of fiscal 2013 was $5.2 million, or 36.8% of sales, compared with $9.0 million, or 59.5% of sales, in the second quarter of fiscal 2012. As detailed in our earnings release, there were multiple factors behind the year over year increase in cost of goods sold this quarter. This write-off amounted to approximately $2 million or 14.3 percentage points of gross margin, including both the product costs and the associated labor and overhead costs. This excess inventory was identified as part of our ongoing lean manufacturing initiatives and importantly, we’ve isolated the source of the errors that caused this over ordering of products and have enhanced our feedback processes to avoid similar drains on working capital in the future.

Total commercial expenses increased 14.6% to $7.3 million or 51.8% of sales, compared to $6.4 million or 42.1% of sales last year. Total commercial expense growth was driven by a 23.2% increase in selling and marketing expenses to $3.6 million and a 13.75 increase in G&A expense to $2.9 million, offset by a 10.4% reduction in R&D expense compared to the prior year. Q2 commercial expenses deleverage was primarily a result of the below-planned sales performance this quarter, but also included the above average investments in our new product launch initiatives which we discussed on last quarter’s call and those are not indicative of the leverage profile of the business longer term. That said, in the future, we will focus on further controlling expenses to minimize the impact on profits the sales are slower than planned.

Operating loss for the second quarter of fiscal 2013 was $2.1 million compared with operating income of $2.6 million in the second quarter of fiscal 2012.

The company reported a net loss of $1.4 million for the second quarter of fiscal 2013, a change of $3.2 million from that income of $1.9 million for the same period in fiscal 2012. Basic and diluted earnings per share from continuing operations for the second quarter of fiscal 2013 were a loss of $0.05 as compared to basic and diluted earnings per share of $0.07 for the second quarter of fiscal 2012.

Turning to the balance sheet, at quarter end we had $11.7 million in cash and no debt. Our DSO ratio was 68 days, down from 72 days at the end of Q1.

Our inventory position was $15.2 million, down 3% year over year and down 12% sequentially. This inventory balance represents 192 days of inventory on hand versus 242 days at the end of Q1. The sequential decline in inventory is due primarily to the write-off of excess inventories related to the transition to our lean manufacturing system offset partially by new products inventory related to the commercial launch of VersaVIT and other new products.

Total cash usage from operations during the first six months of fiscal 2013 was $671,000, compared to cash usage from operations of $3.1 minion during the first six months of fiscal 2012. The year over year change was driven primarily by the absence of a $5.8 million tax payment related to the Alcon settlement agreement which occurred in the second quarter last year and the working capital benefit associated with the write-off of excess inventory in the second quarter of 2013. Despite the second quarter use of cash, we anticipate cash flow from operations to be positive in fiscal 2013.

Now I’ll turn the call back to Dave to discuss our outlook and recent developments.

David Hable

Thanks Pam. I would now like to update you on the commercialization of our VersaVIT vitrectomy technology which we launched around the start of our first fiscal quarter. We remain very pleased with the early adoption of our innovative, portable vitrectomy machine. The feedback from our sales reps has been extremely positive from surgeons as the differentiated, compact configuration clinical effectiveness and compelling cost benefit equation is fueling interest and evaluations and eventually in adoption.

To that end, we continue to increase the number of evaluations in progress across the country and remain focused on closing each evaluation as quickly and efficiently as possible. Additionally, we’ve performed over 1200 retina procedures with the vitrectomy machine to date. This is notable because it reflects the numerous opportunities not only to observe the system’s performance real time, but it also allows us to receive and respond to feedback from the clinicians and surgeons, both of which help our sales force build clinical credibility and improve their evaluation of closing effectiveness over time.

By way of review, the worldwide vitrectomy market is estimated at approximately $425 million annually, including both the machines and the associated disposable packs. The VersaVIT system and associated packs are our first entry into this lucrative market. Data suggests that this market is growing mid-single digits fueled by multiple drivers, the most important of which is the shift of procedures from the hospitals to the Ambulatory Surgery Center or ASC.

In the era of post conscious healthcare providers, the ability to deliver hospital equivalent treatment to patients in the cheaper, faster outpatient environment of ASC is a true competitive advantage for medical device manufacturers and VersaVIT fits this model exceptionally well. We have three primary segments we are targeting, high volume ASCs, corporate entities that own and operate the ASCs for profit and select teaching institutions. Of the three, the high volume ASCs represent our sweet spot and this is our top priority during the initial stage of commercialization. Longer term, the teaching institutions will help us become top of mind for aspiring retinal surgeons of tomorrow.

As I mentioned last quarter, we have been pleasantly surprised with the broad based response for VersaVIT, including the smaller facilities and those surgeons who had previously not prioritized retina procedures in their practice. While all of these potential customers are important, we remain focused on our sweet spot of targeted accounts to optimize sales force time. However, we have necessarily shifted some of our focus away from these target accounts as we have hosted evaluations in some of the country’s largest, high volume centers in the whole United States. While these accounts are technically outside of our sweet spot, successfully placing units in these leading retina facilities will drive significant share gains for the company while building awareness for the VersaVIT franchise across the broader U.S retinal market.

We are excited by this interest from these leading retinal facilities, but this potential significant opportunity comes with unique challenges, specifically the longer evaluation period required to satisfy these multi-surgeon operations. We are in the early days of our commercialization strategy which is a razor and a razorblade model as we are working to build an install base of VersaVIT machines. We expect to drive sales of high margin VersaVIT disposables over time as the install base increases utilization.

While VersaVIT disposable revenue represents a small portion of sales today, these procedure-related pack volumes will become an increasingly important contributor to topline performance in future quarters and eventually will be the primary driver of the business. As we have communicated, given the relative size of the VersaVIT franchise today, it is unlikely to offset the declines in our base ophthalmic business in fiscal 2013 despite the positive response since launch, though we conservatively do not see this crossover occurring until fiscal 2014.

I’m sure that some of you are thinking why can’t we go faster? The answer is we’re committed to making each and every placement right the first time. This is a labor intensive evaluation process. Our sales reps are not selling across the desk. They’re in the surgical suite with the surgeon. They’re working with surgeons and staff to train and demo, support the eventual users of the VersaVIT technology. All these factors are particularly challenging in larger accounts.

Importantly, each of these high touch evaluations offers us the opportunity to better understand the decision points involved in making the purchase decisions. Which procedures need to be involved in the evaluation, what functionality needs to be witnessed firsthand versus what can be communicated the rest of the physicians in a group practice without the need for a live demonstration.

The key takeaway here is that the evaluation process is lengthy, approximately 15 weeks on average currently. While we are focused on improving the duration of evaluations, the average has been challenged in recent months by the larger account dynamics I just mentioned. We are pleased to date with the outcomes from the evaluations that have concluded in the first few months since launch. Importantly, consistent with our commitment to getting it right the first time, we will be investing in strategic growth initiatives to ensure we capitalize on this valuable early market response.

This targeted investment is focused in several areas. Let me tell you about two programs, first in the field support managing the ongoing evaluations and conduct the requisite level of follow up in each new account. And second, we are building out a physician referral program to allow surgeons to personally introduce new surgeons from the network to the VersaVIT product. We expect these investments to drive further adoption of VersaVIT and are timely and we expect these strategic initiatives to capitalize on the positive market response we receive from our launch. Know we appreciate the need for careful monitoring of the performance of these programs to ensure we are earning the appropriate level on investment required to justify this allocation of capital.

While we remain very positive and optimistic about the VersaVIT franchise, we are mindful of the competitive market and are well positioned to respond to any market dynamics that could potentially inhibit our strategic commercialization plan to drive VersaVIT growth.

To wrap up, we are pleased with the early market response to VersaVIT and believe we have a compelling commercialization opportunity to capitalize on the positive demand from the retinal surgery community. We look forward to the increasing contributions to topline growth from the VersaVIT franchise, although we continue to expect that material contributions to total company growth will not occur until early fiscal 2014.

We appreciate the fact that our discussion of second quarter results has included a number of moving parts. Let me try to pull everything together for you now. As I mentioned earlier, increasing contributions from VersaVIT will offset underlying weaknesses in our ophthalmic business. And although our objective is for this crossover to occur in fiscal 2013, conservatively this is unlikely to occur until fiscal 2014, again our ophthalmic business continues to be pressured by competitive headwinds.

On the OEM side ,as I said earlier, we expect improving order flow over the balance of fiscal 2013 supported by early Q3 order trends leading the year over year growth in fiscal 2013. In terms of our gross margin, our long term goal of 60% plus remains intact, although this goal is decidedly challenged given the margin performance over the first half of 2013. To be clear, we are squarely focused on returning to historical gross margin performance this year, bearing in mind these margins will necessarily be influenced by our sales mix. Further, as Pam noted, our commercial expenses in 2013 include incremental sales and marketing expenses related to our commercialization of VersaVIT.

Finally, our cash flow performance this quarter is not indicative of the underlying cash flow profile of the company and we are squarely focused on returning to positive cash flow for the fiscal 2013 period. We are not satisfied with our recent financial and operating performance., though the future remains bright chiefly because we are focused on a four prong long term growth strategy.

Number one, driving accelerated growth in ophthalmology with the launch of new products foremost of which is VersaVIT. Number two, deliver improved profitability through enterprise wide lean initiatives. Number three, manage our OEM business for stable growth and strong cash flows. And fourth, obviously to return to constituent, solid financial performance.

Let me now open it up for questions and answers. Operator?

Question-and-Answer Session

Operator

(Operator instructions). The first question is from Chris Cooley from Stephens, Inc. please go ahead.

Chris Cooley – Stephens, Inc.

A number of questions here this morning if we may. So let me just maybe start, when I look at your VersaVIT performance in the quarter, it looks like you did quite frankly about as many procedures in the second quarter as you did throughout the fourth quarter in the fiscal 1Q. So seeing a pull through there. Help us get a better understanding of what you can do to stave off the losses in the base business. I guess I’m trying to get a better feel of here’s are we seeing the new normal for our base business fund rate at current levels or is there further pressure you think on that business that VersaVIT has to hurdle? And then I have two other follow ups.

David Hable

Yes. So basically what we’re seeing is increased competitive pressure which runs downhill to affect the base business categories. The two which are most impacted are illumination probes and laser probes. So we have a combination of some refreshes in terms of new products on those product categories to keep that line vital. But really the ultimate competitive response to that base business pressure is going to be the increased penetration of VersaVIT because that gives us a more powerful platform to deal from. We’re fundamentally trying to sell standalone disposable components that work with other people’s platforms.

So the all-important competitive strategy is to get our own platform in place there and that means VersaVIT and it’s related to disposables. The dynamic that we saw in the second quarter is enhanced competition and this very positive pull into much larger accounts than we had anticipated and had originally targeted is basically what’s going on. So we are being pulled upstream into these larger target accounts which is a much more complex and lengthy process to conduct the evaluation, train everybody involved in the institution and start generating sales and we’re at the front end of that process. Having navigated a number of these evaluations successfully, we’re now hopefully poised for the payoff in terms of disposable volume.

Chris Cooley – Stephens, Inc.

And then in regards to your two initiatives that you kind of from a 30,000 feet outlined to kind of address the OEM – sorry the ophthalmic base business, could you give us a feel for the magnitude of the allocations capital to these two programs and realistically when we could start to see some type of a pull through that’s meaningful from them both. I’m assuming not in the current quarter, but I’m trying to get a feel for whether it’s in the fiscal 4Q or if this is really something that starts to pull through in fiscal ’14.

David Hable

So I’ll turn over the how much piece of that, but the impact of these programs will really be a 2014 event. So program number one is to have more people supporting the after sales effort to make sure that the technology sticks. So we’ve been impressed by the complexity of these evaluations and are totally focused on making sure that they’re successfully insinuated into these particularly larger complex institutions. So that’s one program. The other program is designed to leverage the very positive feedback we have from the early users and the most powerful, the quickest way we can do that is to allow them to refer and place a unit with their colleagues and they respect their opinion.

So while it sounds like it’s a long way off, hopefully it’s going to produce near term results. Program number one in terms of making the units that have been successfully navigated as part of this evaluation stick and generate disposable volume as soon as possible. And number two, getting more units in the hands of motivated users as quickly as possible, supported by the tailwind of the referral of the users with the most experience on the things. But with that said, I would suggest that the impact of those programs will be more significant in 2014.

Operator

(Operator instructions). The next question is from Steven Crowley from Craig-Hallum Capital. Please go ahead.

Steven Crowley – Craig-Hallum Capital Group

I want to drill a little deeper on you getting pulled upstream into these larger accounts. Can you give us a picture of why that’s happening and what the landscape for other vitrectomy equipment is in those accounts and the hook to get you upstream?

David Hable

So the basic motivation for going upstream is coming from the customers. So this is not a lack of discipline or willingness on our part. It’s that people who have been exposed to the unit are impressed by its functionality with how it actually operates in the condition and that word has spread and we are being drawn away from our the way I described it, sweet spot target onto these much larger institutions that want to operate more efficiently and economically overall. So the hook, Steven in your words is not only the – is first and foremost that it’s a compelling economic proposition relative to what they used to be using.

It’s also basically a much simpler system to use which requires less setup time, less calibration and programming of the unit and less expertise required of the surgical machine required to pull off the or conduct the procedure. All of which makes it not only to the ASC obviously, but to these larger accounts to degree that we’re positively attuned to. So basically the customers are pulling us upstream because of the resonance of the technology in the marketplace so far.

Steven Crowley – Craig-Hallum Capital Group

And the aspect of that question related to the topology of those accounts with other vitrectomy equipment, can you talk to us about what they have and what evidence you have that it’s not just intrigue on the part of this customer base and genuine buy interest.

David Hable

So relative to the topography is all over the place. You’ve got a mix of current generation vitrectomy machines and older generation vitrectomy machines of various stripes. So it’s literally all over the place. Now it’s – you didn’t say this, but it’s not a gimmicky sort of thing. They’re not looking at this as a novelty product. The view of the machine is very typical in these large accounts that they originally saw as more the limited use machine and once they use it in these environments they’re impressed by its functionality. So that’s why we’re so focused on making it stick and are going to support that demonstration and conversion effort with this field resource to babysit the machine as it works through different procedures with different surgeons and different teams that are supporting the surgeon which can change on a case by case basis is the reality of it. So on one case you’ve got a certain person on as the scrub, as the circulating tech and the next case it may be a different lineup and all that can lead to what would seem like several usage issues ,but are significant in our view in terms of the adoption of the technology. Making it seamless, making it trouble free, making the surgical event a positive experience for everybody involved.

Operator

The next question is from Joe Munda, from Sidoti & Company.

Joseph Munda – Sidoti & Company, LLC

Can you give us a sense of what the current install base is for VersaVIT and also as well as the number of sales reps you have dedicated to that product?

David Hable

I’m going to hold off on giving you a specific sales number on the install base of VersaVIT. We have 23 sales reps that are focused on selling the product. As you may recall we had three in August to get ready and to give us the coverage we felt we needed on a geographic basis. So the number is 23 sales reps right now.

Joseph Munda – Sidoti & Company, LLC

And in terms of your comment with the strategic growth initiatives, does that involve adding to that sales force number?

David Hable

Not to the sales force itself. These would be additional people that would support the backend of the process. So we want the sales people to go downstream and sale new evaluations and new products, generate new volume. It’s not the most optimal use of their time to as I said babysit these procedures. So these would be different folks doing that.

Operator

Our next question is from Raymond Myers from Benchmark.

Raymond Myers – The Benchmark Company, LLC

Dave, I wonder if you could give an update on the VersaVIT accelerator.

David Hable

Yeah. So for everybody listening, Ray is talking about the ultimate UV, ultimate bitten Hanser. That’s been a delay and a disappointment due to the person or the company that’s supplying the components. We’re literally supposed to get those in assuredly at the beginning of this – or we’re in ’13. So we’re supposed to be getting the components to support that which is used with the older generation machines to bring the speed up as we speak.

Raymond Myers – The Benchmark Company, LLC

So would that be going with the VersaVIT or you say with the older generation machine? Which did you mean?

David Hable

It could be used with both. It can be used with the older. It was originally designed for the older generation machines, but it can be used to accelerate the cost per minute for the VersaVIT as well.

Operator

The next question is from Greg Simpson from Wunderlich Securities. Please go ahead.

Greg Simpson – Wunderlich Securities, Inc.

Dave, the commentary regarding VersaVIT and the interest from the larger accounts certainly seems encouraging even if the sales cycle is a little longer obviously the payoffs will be bigger. And call me optimistic, but even the increased competition from Alcon and the base business seems to suggest that they consider VersaVIT a threat and don’t really have a better answer for the product other than torturing you on some of the more basic products. So it leads me to zero in on the OEM business and the inventory adjustments, things like that. My thought was or my understanding was that you guys should become more integrated into the demand side of the equation for your OEM partners. So I guess I’m trying to figure out how we get greater comfort with the visibility of this business going forward because obviously it’s been a great business for you and the backbone of your business, why you developed VersaVIT and stuff, and that caught us by surprise obviously this quarter and you as well. So can you talk about that aspect of it and your visibility into the OEM demand and things like that going forward?

David Hable

Sure. First of all what happened in the second quarter was a surprise to us. We do have enhanced visibility into the demand in terms of their ongoing forecast. They brought that down, both Codman and Stryker the biggest factor was machines before their calendar end, close on the calendar year end. So that adjustment in the demand resulting in their forecast and what we build to was a surprise to us and we didn’t see that until December. Actually it happened in multiple steps. We didn’t see the first step until December. So given that it caught us by surprise, we have applied as much diligence as possible to understanding their demand going forward which describes improved performance in the second half of the year.

So including calling multiple levels of their management to verify those numbers and that is not somebody relatively low down on the food chain there. So that’s providing the input on the demand. So Greg, I’ll say that the amount of diligence we’ve applied to validating their go-forward forecast has been intense as a result of the second quarter surprise we realized which we believe was largely due to a result of the inventory rationalization on the boxes.. That was a component for the Stryker disposables as well and as I alluded to in the prepared remarks, they are doing some rebalancing as a result of introducing these three new ultra Sonic aspirate Tore tips farther down the line in second half of ’13.

Operator

The next question is from Charles Bellows from White Pine Capital.

Charles Bellows – White Pine Capital

I’m struggling a little bit with the evaluation process and conversion. Dave, when somebody goes through this evaluation process, what is the likelihood or what do you expect the conversion the system to be?

David Hable

So we had originally targeted accounts, ASCs that had an average of 250 vitrectomies per year and even more. So that was our original as I tried to describe sweet spot. These larger accounts have a profile of significantly more vitrectomies, significantly more procedures. So while they take longer there’s going to be a bigger payoff that should be significantly more than the accounts that we originally targeted.

Charles Bellows – White Pine Capital

Okay. But as you go through that evaluation, what do you expect as far as those who evaluated to in fact except that you’re going to have some that will say no, we’re fine and others that will take it. So what do you look for for conversion?

David Hable

So we try to manage that upfront by understanding what that work in these accounts before we engage in one of these labor intensive evaluations, which means is there an Alcon or other competitors sponsor embedded in the account? Is there some other hurdle that’s going to create a problem for us further down the road? So it’s premature to give a actual close rate because there’s so much noise in all the data, but I can tell you we’ve been successful in the majority of evaluations that we’ve engaged in.

Operator

The next question is from Paul Nouri from Noble Equity Fund.

Paul Nouri – Noble Equity Fund

looking at the gross margin coming down in the quarter, if you strip out the inventory reserves, it looks like it should go back up to around 51%. Is there any runway in the next couple of quarters for it to go closer to the 54% to 58% range we had been in before?

David Hable

The short answer is yes. I’m going to have Pam walk that backwards.

Pamela Boone

So Paul the $2 million write-off for excess inventory was one of the factors that impacted the quarter by 14.3%. Weak demand also impacted our ability to absurd labor and overheads and that impacts us about 3.3%. the benefit that we received in 2Q last year from foreign currency impacted the margin by 1.4% and the deferred revenue going down by $131,000 impacted the margins by 0.9%. so if you reconcile all that back you get back to about a 56.7% margin and then there was a if you will a mix within the mix as well. There was a favorable mix on our domestic ophthalmology business is that base business products of laser and lamination probe of fairly high margins and also was impacted by the drag of the international sales going from 27.5% to 29%.

Paul Nouri – Noble Equity Fund

With the focus of the company being on ophthalmology and getting the VersaVIT accepted, is there any thought as to divesting the OEM business or do you really see it as a core part of the overall company over the next few years?

David Hable

Eventually the answer is we could not now. It is a real contributor both on the sales line and the cash flow line to be an important part of the business. Given our forecast success in VersaVIT new products, ophthalmology should hopefully become more significant as time goes on. So the answer is eventually it could be an appendage we could live off.

Operator

(Operator instructions). We’ll go to our next question is from Craig Hoagland from Anderson Hoagland & Company. Please go ahead.

Craig Hoagland – Anderson Hoagland & Company

Just to follow up on the gross margin question. Pam, you answered those add backs. Do you have a view that some of that will be recovered in the coming quarters or if the largest chunk was weak demand, is that just going to be a feature of the environment going forward?

Pamela Boone

We expect those large chunk items to come back, the write-offs, the foreign currency, the deferred revenue which is a timing issue. We do expect to return to normalized margins.

Operator

Our next question is from Bernie Harris from B.J. Harris. Please go ahead.

Bernie Harris - B.J. Harris

I’m a little confused. Back in November, October we had this other big write-off and we’re supposed to have the inventory under control and now we’ve got another big write-off. What is the exact story on that?

Pamela Boone

So I think Bernie you’re referring to the third quarter last year when we took an obsolete inventory write-off. This time we analyzed our inventory position very closely, looked at the timeframes versus when we were expecting to use the component inventory that’s out there basis change in our ophthalmology demand on our base business and as we did that, we found two problems. One was older, slower moving inventory that was past the useful life that we can see forward and that it had risks that it would not be used on a go-forward basis and the second problem as Dave talked about those as performance issues as we went through and implemented the 2-bin Kanban system from our lean inventory methodology. We found instances where people did not understand the system. They were buying too much 2 full bins, that type of thing. They looked at factors that led to the bin size being over calculated and that we had overbuying of those component parts and those again fell out the end of the timeframe and we felt it necessary to reserve against the usage of those.

David Hable

The way I think of it is first of all the event you’re referring to was in the third quarter and there are two basic components to it. One as Pam said is this applying more analytical work to our base business, not the new product piece of inventory, but the base business inventory and that fundamentally meant creating buckets where we analyzed the movement of those components and finished goods and realized this gap. So that’s factor number one. Factor number two is undeniably as Pam alluded to, individual performance for some of the people who were managing this they had – some may have bought too much in some cases as a result of putting too much or estimating too much was needed basis an inaccurate algorithm that had leading times that described what essentially was buying too much product.

They weren’t cognizant that there was duplication of some of these components in other value streams and they frankly fell down on managing some of the complexities associated with this new system. So we traced those all back to the source, understood what was going on and have moved aggressively to address that. But I want to be clear that there are individual performance issues associated with that dynamic and I want to communicate to everybody that we recognize that and have acted to address it.

Bernie Harris - B.J. Harris

And do we have it under control for the future?

David Hable

We feel so, yeah.

Bernie Harris - B.J. Harris

Because this is the second time we’ve had problems with this whole system.

David Hable

Yeah. No, it’s a big change for us. So we’ve implemented the process change. We’ve now identified the performance issues who can step up and manage it accordingly. So we’ve got to take a mea culpa on that. But you’re right on.

Bernie Harris - B.J. Harris

What was it – you said there were two issues that you’ve addressed. What was the second one?

David Hable

That was – the performance issue was the second one. The first issue was by applying this additional analysis and creating these bins in which we classify the different inventory based on movement, that created a bigger base that we didn’t have before that put the base inventory in context. So it was down to more analysis showed us there were more slow moving products than we had realized.

Pamela Boone

And we have put additional controls in place.

Operator

And our next question is from Chris Cooley from Stephens, Inc. Please go ahead.

Chris Cooley – Stephens, Inc.

Thank you for the follow up. I just wanted to ask, Dave, I realize it’s a complex business and quite frankly a little different single lot to you in terms of scale at this point in time, but as management contemplated providing the street with some degree of guidance either on the topline, bottom line, both, either on a quarterly or annual basis, just wondering your thoughts on providing some semblance of guidance and what that might do to mitigate some of the volatility in the name. Thank you.

David Hable

So answer number one is yes. We have looked at – there’s an open question in front of us. Our current challenge is that given as you said relative little things may impact us in a substantial way. So we’re afraid to provide guidance because we know how – there’s nothing worse than missing what is the direction you provide. So we’re trying to achieve a state where we have more consistent data upon which we can build and project a result that we’re increasingly confident in. so we’re moving towards that and there’s a lot of moving pieces in the equation right now that confound that. But it is our objective to provide increasingly specific guidance on street I guess.

Operator

Our next question is from Steven Crowley from Craig-Hallum Capital. Please go ahead.

Steven Crowley – Craig-Hallum Capital Group

Thanks for taking my follow up and I have two follow up questions. I want to make sure they both get through. One relates to the ophthalmology business and your discussion of the lines crossing probably not until 2014. Just to clarify, are you saying that the ophthalmology business that’s been down year over year for the last several quarters is likely to continue to be down year over year over the next couple of quarters because you had a pretty tough Q3 a year ago. That would imply a sequential decrease in the ophthalmology business in Q3. Is that what you’re telling us?

David Hable

So for the balance of the second half of ’13 our objective is to make those lines cross. I said conservatively we want to refer you to anticipating that in 2014. But we’re doing everything to make it happen earlier.

Steven Crowley – Craig-Hallum Capital Group

Okay. And then in terms of the neuro business, we’ve had this distortion in Q2 that relates to yearend inventory rebalancing and maybe some other transient issues. If we look at the normalized growth rate of that business on a go-forward basis, it certainly isn’t going to be the robust 20% plus we had for a while, but can it be 10%ish type growth on a normalized basis given the strength at Codman and what Stryker is doing. How should we think about that going forward?

David Hable

The answer is yes. Our diligence tells us it has that type of potential as expressed by their specific forecast which we have diligence. So we expect that piece of the business to return to a growth mode.

Operator

Our next question is from Joe Munda, from Sidoti & Company.

Joseph Munda – Sidoti & Company, LLC

Thank you for answering my follow up. Dave, I’ve got two quick ones and hopefully get them in here. As far as the surgeon referral network you spoke about, can you give us a little bit more color there and as well as the competitive pressures. How much more can Alcon really discount their offering in your view?

David Hable

Number two I don’t want to guess. That’s an internal analysis for any competitor. On the surgeon referral piece, the idea is to empower individuals that have substantial experience with referring a VersaVIT unit to people in what I described as our network which means people they train with or trained as a trainer in a prestigious teaching institution and we found that the most impactful way that they can – that the adoption of VersaVIT would be accelerated is if it arrives in effect on someone’s doorstep with the blessing of someone they respect from a clinical standpoint. So we’re trying to accelerate the reach of these VersaVIT machines and reduce this time to payoff in terms of disposable volume that’s being impacted by the amount of activity we’re spending these larger accounts. So I will hold off on giving specifics of the program for competitive reasons. But that’s the basic outline what we’re trying to do.

Operator

The next question is from Charles Bellows from White Pine Capital.

Charles Bellows – White Pine Capital

About how many evaluations do you have going now?

David Hable

So I’m holding off on giving that specific number. So I recognize it’s a frustration to not have some of those specifics, but as someone noted, we aspire to give more specific guidance in the future.

Charles Bellows – White Pine Capital

Well, maybe I could ask it this way, Dave. If you look at 23 sales people, do you expect that each of those sales people should be able to generate a couple to three evaluations a year type of thing or more than that?

David Hable

More than that.

Charles Bellows – White Pine Capital

More than that. And then when do you start to recognize revenues? Is it when you get a flow on consumables?

David Hable

In most cases, yeah. So yes. So that has the revenue payoff and what I’ve said earlier is we’ve been surprised by the number of placements versus purchases of the machine which has further deferred revenue ramp. So as opposed to getting the upfront bonus from buying a $30,000 machine, that revenue flow is going to come from the disposables.

Operator

Now I’ll turn it back over to you Dave for any closing remarks.

David Hable

Okay. Thank you everybody for their time and take on board that the company recognizes that this is a challenging quarter. We’re in transition mode. We’re trying to go from this legacy based business to executing a very different sales process and technology configuration for the company and I know it seems frustratingly slow. But I can tell you from having personally observed this process on multiple occasions, it’s very complex. But we remain convinced that the technology is right. It fills an unmet need and is really attuned to the economic pressures that all institutions that deliver healthcare are going to be up against in an increasing rate. So thanks a lot. We’ll talk to you later. Bye bye.

Operator

Thank you ladies and gentlemen. This concludes today’s conference. Thank you for participating. You may all disconnect at this time.

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