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Volcano Corporation (NASDAQ:VOLC)

Q2 2009 Earnings Call Transcript

August 4, 2009 5:00 pm ET

Executives

John Dahldorf – CFO and Secretary

Scott Huennekens – President and CEO

Analysts

Chris Pasquale – JP Morgan

Rick Wise – Leerink Swann

Jason Mills – Canaccord Adams

Amy Sullivan – Piper Jaffray

Matt Dolan – Roth Capital Partners

Raj Denhoy – Thomas Weisel Partners

Stephen Simpson – Northland Securities

Operator

Good afternoon, and welcome to Volcano Corporation's second quarter 2009 earnings conference call. During the presentation, all participants will be in a listen-only mode. Following the formal comments, we will conduct a question-and-answer session. (Operator instructions) As a reminder, this conference call is being recorded Tuesday, August 4th. A replay of the call will be available through August 11th by dialing 719-457-0820, passcode 7680499, or via the company's website at www.volcanocorp.com.

I would now like to introduce Mr. John Dahldorf, Volcano's Chief Financial Officer. Please go ahead, sir.

John Dahldorf

Thank you. And good afternoon, everyone. With me today is Scott Huennekens, Volcano's President and Chief Executive Officer. Scott will begin today's call with a review of the second quarter's highlights. As Scott will discuss during his comments, we continued to achieve very solid growth in our core IVUS and FM businesses across all key geographies.

In addition, we completed the previously announced Goodman distribution termination agreement in Japan and realized significant progress in our product development and clinical trial initiatives. I will follow Scott with a review of our financial results for the quarter and guidance for 2009, and then we will open the call to your questions.

Before turning the call over to Scott, let me remind you that our prepared remarks contain forward-looking statements as defined under the Private Securities Litigation Reform Act of 1995. These include statements related to the guidance about financial and operational results; growth strategies; product development and clinical trial programs, and anticipated results of related studies; market acceptance in adoption of our product offering and those of our competitors; the functionality, benefits and capabilities of our products; expanded sales programs; our growing direct initiative in Japan; any strategic activities, the impact of global economic and capital equipment environments on our business, as well as forward-looking statements that we may make in response to your questions.

Factors that could cause Volcano's actual results to differ materially from these forward-looking statements are described in our filings with the SEC, including our 10-K for the year ended December 31, 2008 and the 10-Q for the quarter ended March 31, 2009. Volcano cautions you not to place undue reliance on forward-looking statements that speak only as of the date that they are made. Volcano undertakes no obligation to update publicly any forward-looking statements to reflect new information with events or circumstances as of the date that they are made. Scott?

Scott Huennekens

Thank you, John. And good afternoon, everyone. As John indicated, Volcano had an excellent quarter with continued strong console placement activity and market share gains in spite of the economic environment and the potential for disruption related to our direct sales initiative in Japan.

Our continued success in the quarter further validates the value of our growth platform. It includes sales force expansion, technology innovation, and an active product pipeline that is furthering our multi-modality platform, raising competitive barriers to entry and driving our entry into new growth markets. In addition, our Axsun subsidiary is operating to plan and we are starting to see some good progress with our OCT product development efforts, including the technology obtained through that transaction.

While John will discuss our financial results in detail, our revenues of $54 million in the quarter represent a record quarter for Volcano and the 13th consecutive quarter in which we have exceeded Wall Street consensus. Overall, revenues increased 30% year-over-year, including 21% growth or 24% on a constant currency basis in our core IVUS and FM businesses.

As has been the case in recent quarters, we experienced strong growth in global disposable revenues, with revenues from IVUS disposables growing 26% and FM disposables increasing 75% year-over-year. Complementing our growth in disposable revenues was continued strong IVUS console placement activity, as we placed 233 systems and increased 31% over -- versus 178 placements a year ago.

Through the first half of the year, we have placed just under 450 consoles or roughly a 50% increase over the 300 IVUS console placements in the first six months of 2008. I should also note that our programmed upgrade our s5 family of consoles with fractional flow reserve, FFR, or FM capability is essentially completed, meaning that we now have almost 1,300 s5 family of consoles that are both IVUS and FFR pressure capable.

While we are certainly mindful of the capital equipment environment, it continues to be principally a US circumstance. And as you know, approximately half of our medical revenues are generated outside the US, with the US capital system sales accounted for about 10% of our overall revenues. We believe we are continuing to achieve our growth plans for several reasons.

First, we are executing on our sales, market development and technology innovation programs. Second, for those many centers that already have IVUS, there is a replacement cycle that necessitates the need for a new system every seven to eight years, given that the cost of the equipment is below $100,000 per integrated room. Hospitals have continued to replace outdated equipment. Third, the implementation of integrated IVUS/FM at new customers can be done as a retrofit to existing cath labs and is not dependent on construction of a new cath lab.

Fourth, as we have discussed in the past, we have several vehicles for getting IVUS and FM console placements that customers, including leasing, renting and catheter utilization programs. And fifth and the final driver is an emerging yet important trend, the increased adoption of FM over the past several quarters. As centers look for an FM solution, they can essentially get a two-for-one with our integrated s5 consoles that include FFR pressure capability and IVUS.

Another factor providing us some nice tailwind is the improving PCI environment. While the sequential growth rate appears to be slowing a bit, PCI volume is estimated to have grown in the low-single digits in the second quarter year-over-year in the outlook provided by the major stent companies suggests that PCI volume growth will continue. We estimate that IVUS penetration of PCI activity in the US is now beyond 14% and we continue to extend our market share to more than 50% in the US.

Based on our results, we estimate that the IVUS catheter market grew approximately 13% in the quarter, with our results suggesting that Volcano continues to represent more than half of the US coronary and peripheral IVUS catheter market. We continue to believe that despite the current economic environment, the core IVUS and FM markets can continue to grow well beyond their current $400 million size given the enhanced functionality of IVUS and FM technology and the positive results of clinical data, such as that of the FAME study, which continues to resonate with the clinical community and has led to increased FM adoption. In addition, penetration rates for integrated IVUS and FM consoles among cath labs remain relatively low, providing us a significant market opportunity.

We are confident that we can continue to grow revenues from our core businesses at 20% or more annually while achieving improved margin in operating expense leverage, leading the long-term profitability. In the next few minutes, I will update on your key initiatives, including our sales force expansion and market development programs, clinical studies and our product pipeline in Volcano’s involvement in healthcare reform.

As we’ve discussed with you in the past, the expansion of our sales force continues to be important driver of our growth. We ended the quarter with a total of 174 direct sales reps versus 171 last quarter and 152 at the end of 2008. Obviously, much of this growth is a result of our direct sales initiative in Japan, as we ended the quarter with 34 reps versus 25 in the first quarter.

In the past month, we have (inaudible) our direct sales force there to more than 40 and now have more than 80 total personnel in Japan. At the end of the second quarter, we had 110 sales reps in the US and 30 in Europe and rest of the world. In addition, we continued to leverage our strong relationships with industry leaders such as GE, Philips, Abbott, Medtronic and J&J Cordis, as well as our involvement in clinical trials being conducted by a number of the major pharmaceutical companies.

The transition in Japan that we spoke with you about last month continues to go well. Our plan to transition the Goodman accounts to Volcano Japan by the end of this quarter is on schedule, as we now have commitments for more than 160 accounts. Goodman continues to work closely with us. We are also on schedule with our program to convert legacy, IVG, IVUS consoles at customer locations to our s5 family of IVUS consoles.

In addition, we are starting to see increased uptick of disposables and a number of these converted accounts. By year-end, we plan to have more than 50 sales reps in Japan, which is comparable to the sales forces of the leading cardiology companies in Japan and more than 100 total personnel in Japan. As we mentioned in the last month’s call, we believe that FM, which has very little penetration in Japan currently, can be an exciting market opportunity for us and that it will be an area of added focus going forward. In addition, we are continuing to enhance our infrastructure, such as systems and inventory management support.

Turning to the clinical arena, IVUS and FM continued to assume more prominent roles and major medical meetings. At the PCR meeting in Barcelona in May, there was a great deal of interest in FFR and OCT, as well as IVUS. And these technologies were the subject of a number of live cases and clinical presentations. We also sponsored a very well attended symposium at PCR featuring several leading European clinicians that export optimizing DES usage in PCI cases. Members of this panel articulated the importance of optimizing stent placement and the value of IVUS in ensuring (inaudible) acquisition and its ease of use and benefits versus the use of angiography alone.

In addition, there was discussion around how the use of FFR is changing practice pattern and improving patient outcomes and the value of using IVUS VH in the diagnosis of atherosclerosis and vulnerable plaques. And lastly, the culprit-of-the-culprit concept that we’ve discussed with you in the past was also discussed prominently. This approach has been promulgated by our Medical Director, Dr. Pauliina Margolis, and suggested the disease may not be located where the actual blockage occurs in the artery, the underlying premise is that when a lesion ruptures within a vessel, it produces a secondary lesion downstream, a condition that often gets missed with angiography alone.

Other highlights of PCR include the showcasing of our OCT technology at the Volcano booth and a live case utilizing the OCT system and catheter in ThoraxCenter in Rotterdam. We also announced the expansion of participating clinical sites in our OCT program, which is just into the ThoraxCenter, now includes the cardiovascular center in Belgium and the University Hospital in Poland. These centers are using our OCT technology in a wide variety of clinical studies for the acute and stable patient populations in the assessment of lumen and vessel structures. We are trying to continue adding to the list as centers using OCT during the balance of this year.

Finally, at PCR, we announced an exclusive worldwide distribution agreement with Lumen Biomedical for their Xtract thrombus aspiration catheter in the US and Europe. This device has FDA approval and CE Mark for use in the coronary vessels, as well as some peripheral vascular applications and represents a potential market of approximately $70 million a year. This program is aligned with our multi-modality platform strategy and our mission of offering tools that treat the right patient and the right lesion in the right way and ties in nicely with our culprit-of-the-culprit concept.

We also expect to have a very active presence at TCT in San Francisco next month. For Volcano, the highlight of TCT will likely be the presentation of updated data from the PROSPECT trial. You may remember that interim data was presented at last year’s TCT, but we expect that a more statistically significant data set, including three-year follow-up on the entire 700-patient study group will be available for presentation at this year’s meeting.

As a reminder, this is a study we are doing with Abbott Vascular. They use IVUS to explore the risk of atherosclerosis and vulnerable plaque. This was a study of 700 acute coronary syndrome patients. In home [ph], culprit lesion was treated with stenting and all three arteries were investigated with angiography, IVUS and IVUS Virtual Histology to establish a baseline of plaque and lesion characteristics. These patients are subsequently followed for three years. If an event occurred, it was correlated back to the baseline information.

Two major findings from the PROSPECT baseline data were, number one, 52% of patients had thin-capped fibroatheromas called TCFAs, identified by IVUS VH that have been shown in other scientific research to be the main cause of heart attacks; and number two, 43% of patients have lesions within IVUS minimal lumen area of less than 4 millimeter square that were missed by angiography and not treated. These lesions were identified by IVUS and met the generally accepted criteria for stenting.

We expect three-year follow-up results to be announced at TCT, answering important questions such as number one, how often do TCFAs cause events? Number two, in what kinds of patients, diabetic, obese, hypertension, et cetera do TCFAs cause more events? Number three, were the less than 4 millimeter squared lesion areas involved in any event? And number four, were events in the less 4 millimeter squared lesion areas predictable based upon on the plaque types identified by Virtual Histology?

Based on how the data address these and other questions, the medical evidence of utility for the use of IVUS in Virtual Histology can increase dramatically. In addition, other Volcano-related activities at TCT will include live cases and data presentations highlighting our core IVUS and FFR technologies, including the culprit-of-the-culprit concept.

Volcano will also host the (inaudible) symposium entitled Right Patient, Right Lesion, Right Way. That’s 7:00 AM on Wednesday, September 23rd. It will focus on the ability of Volcano’s technology to add value to the cath lab by quickly identifying which patients will benefit most from PCI. Which lesions are, in fact, significant (inaudible) and what tools are available to improve technique and confirm a physician strategy and outcome, all very timely messages given the current healthcare reform environment.

In addition, we will be hosting an investor event on the morning of Thursday, September 24th, that will feature a review of FFR by Dr. Moore Karan [ph] from UC, Irvine and a leading authority on FFR pressure. It will begin at 10:00 AM and will be providing additional details on that event within the next couple of weeks.

A brief update on our other major clinical programs includes enrollment and our assessment of dual anti-platelet therapy with drug-eluting stents or ADAPT study that’s continued on schedule. As of the end of the quarter, more than 4,000 patients have been enrolled, including 800 in the IVUS sub-study, which is expected to include 11,000 total patients and 3,000 patients in the IVUS sub-study. The objective of the sub-study is to determine whether the use of IVUS can aide in the prediction and reduction of stent thrombosis.

In the Bifurcation Lesion Analysis and Stenting or BLAST study, we have enrolled approximately 50 patients at seven centers. The objective of this study is to demonstrate that the use of Volcano IVUS with VH leads to better outcomes versus the use of angiography alone in bifurcation stenting. The trial design calls for the enrollment of approximately 220 patients at approximately 15 centers in the US and Europe.

The Volcano OCT image lesion analysis using intravascular OCT or VLALA [ph] study will enroll 115 patients at five centers, with the objective of validating the safety and efficacy of OCT technology in coronary vessels. Enrollment is expected to begin early next year.

Our SPECIAL, or Study of Prospective Events in Coronary Intermediate Atherosclerotic Lesions, trials is a natural history study of vulnerable plaque comparing Volcano VH IVUS with angiography. The study enrolled 257 patients in Japan suffering from acute coronary syndrome, ACS, with the two primary endpoints being major adverse cardiac events associated with progression of plaque during a 12-month period and a progression of plaque as measured by angiography and VH IVUS functionality 12 months after intervention. The 12-month follow-up is expected to be completed by the end of this year.

Finally, data from our 3,000-patient VH registry that demonstrated the value of our grayscale and VH IVUS technology has now been reported in more than 60 publications and abstracts. Looking ahead, we expect to be involved in new FM studies next year that can build upon the outcomes demonstrated in the FAME study, and we will be launching an AMI VH registry that we believe will provide further clarity on when to or not stent [ph] patients suffering from acute MCI.

The proposed reimbursement rates from CMS for DRG’s, under which our products are most commonly used, were finalized at the end of last week and will take effect in October here in the US. They reflect the total increase of 1.6% for the market basket and IVUS and FFR codes have not changed materially.

With respect to our product pipeline, we expect to introduce several enhancements to our IVUS and FM disposable offerings over the six to nine months. These include our next generation phased array IVUS catheter, our new FFR pressure guidewire, enhanced software user interface for the s5 integrated multi-modality imaging platform.

I’ve touched on our OCT development program and the incorporation of the technology we acquired through Axsun earlier. We expect our initial OCT offering to be launched in the US and Europe before the end of next year, with the introduction in Japan coming about a year later. Overall, the Axsun business is performing on plan, and we are continuing to explore additional opportunities for that technology in other medical applications, such as imaging and analytical devices for peripheral, vascular, neural, pulmonary, ophthalmology, cancer detection and blood glucose monitoring, among others.

Our image-guided therapy products that combine IVUS and a balloon on the same catheter have demonstrated positive outcomes from our animal studies in the second quarter. We are on track for first in man use at the end of this year and expect to be first to market with this technology with a global commercial launch in the first half of 2010. We believe the worldwide semi-compliant balloon market is approximately $500 million.

The early results with our Forward-Looking IVUS program have been very promising. Although we have encountered in an issue with an outsourced component that we believe will result in a slight pushback in our timeline for the product of approximately three months. We now expected the first use in man for the diagnostic device or preview, as we referred to it, will occur in the first half of 2010, with the market introduction expected in the second half of 2010.

The timeline for our (inaudible), the product with RF capabilities, provided therapeutic solution all in one package is for commercial approval in the US and Europe in the second half of 2011 and a full year later in Japan. We continue to be actively engaged in healthcare reform debate around comparative effectiveness. As we discussed in our last call, we believe that our technologies can be important players in this regard, as they help clinicians treat the right patient at the right time and with the right message to lower costs, maximize resource utilization and achieve optimal outcomes.

This includes, for example, our FM technology, which we believe with wider adoption could create upwards of $1 billion in annual savings to the global healthcare system, while saving lives and significantly improving patient outcomes a supported by the FAME, New England Journal of Medicine published article.

In closing, Volcano is off to a great start in 2009 as evidenced by our ability to grow revenues in excess of 20%, realized market share expansion, continue our strong IVUS console placement activity and achieve success with our long-term growth initiatives, such as our direct sales effort, Japan, product pipeline and clinical programs. We are executing on these strategies that will further position Volcano as a leading therapy guidance and optimization of global company that is addressing large market opportunities.

We continue to expand our sales and market development efforts and make improvements to the technology, all of which are enabling us to achieve growth significantly beyond the growth of the market. We are encouraged by the continued success of our console placement effort as we believe we are now realizing an excess of 70% total IVUS console placements. And while we are cognizant of the economic environment, we believe that the factors we’ve discussed today are helping us to mitigate its impact in the US. We are realizing our long-term goals while setting the stage for an exciting 2010, including planned profitability.

Thank you for joining us today and I’ll now turn the call over to John.

John Dahldorf

Thank you, Scott. Record revenue for the second quarter of 2009 were $55 million, a 34% increase over revenues of $41.5 million in the same period a year ago. Our results for the second quarter of 2009 include revenues of $3.9 million from Axsun Technologies, which we acquired at the end of 2008. Excluding Axsun, our organic revenue growth was 21% year-over-year and 24% on a constant currency basis. Our revenues for the second quarter include an unfavorable FX impact of approximately $1.2 million versus the prior year.

For the first six months of 2009, our revenues were $103 million, an increase of 32% year-over-year and organically we grew 22% or 25% on a constant currency basis as the unfavorable FX impact in the first six months of 2009 of approximately 2.5 million versus a year ago.

The breakout of revenues for the second quarter included consolidated sales of IVUS systems, a related equipment of 9.3 million versus 10.5 million a year ago. In the US, IVUS system revenues were $6.1 million, essentially flat with revenues of $6 million a year ago. In Japan, they were 151,000 versus 1.4 million a year ago. And in Europe they were 2.2 million compared to 2.4 million a year ago.

As Scott mentioned, our console placement efforts in the quarter were quite successful, as we placed 233 IVUS consoles versus 178 consoles in the second quarter a year ago. Excluding the 55 consoles placed in Japan in the second quarter this ear, and the 31 placed in Japan a year ago, we experienced a 21% increase in console placements year-over-year.

I should also note that roughly 70% of the non-Japan console placements were cash sales and 60% were integrated consoles. Through the first half of 2009, we have placed 443 IVUS consoles versus 299 in the same period a year ago. Given the concerns about the potential impact of the capital equipment environment on our activities, we are pleased with our continued success in this regard. In total, we now have more than 4,400 IVUS and FM consoles placed worldwide.

The expansion of our disposable business continues to drive our growth, resulting from our growing installed base, increased utilization and market share gains. On a consolidated basis, IVUS disposable revenues were $31.8 million, which represents a record quarter for this business and a 26% increase over $25.2 million a year ago. In the US, IVUS disposable revenues were $15 million, a 15% increase over $13 million a year ago.

In Japan, they were $11 million versus $7 million last year. Two factors impacted our year-over-year growth in Japan. The first was the change in Goodman’s ordering process last year that had a negative impact on our disposable revenues and in the second quarter of this year, we saw a dramatic growth in direct sales versus a year ago driven by new accounts not associated with the Goodman transition.

In Europe, IVUS disposable revenues were $5 million versus $4.4 million a year ago, an increase of 13%. I should point out that on a unit base, growth in Europe was 27% year-over-year, but the revenues were impacted by currency exchange rates and geographic mix as was the case in the first quarter. An important growth factor over the past several quarters has been our FM business, and that continued during the second quarter. As a reminder, with the addition of the FFR functionality for s5 console, our FM revenues now consist almost entirely of disposables.

Total FM revenues in the quarter were $7.2 million versus $4.4 million a year ago, or an increase of 65%. In the US, FM revenues nearly doubled to $4 million from the $2.1 million a year ago. In Japan, they were $405,000 versus $201,000 last year, and in Europe, they were $2.5 million versus $1.8 million a year ago, an increase of 35%.

As we discussed in both our conference call last month and during Scott’s comments today, we believe that Japan represents a significant opportunity for FM and it will be a focus of our direct sales efforts in the market going forward. Other revenues on a consolidated basis were $2.1 million versus $1.4 million a year ago.

Gross margin in the quarter was 58% versus 62% a year ago and 58% in the most recent quarter. The most notable factors impacting gross margin in the quarter versus a year ago were the low margin Axsun revenues and favorable FX. Operating expenses in the quarter were $37.4 million. This compares with $40.1 million a year ago and $34.9 million in the prior quarter.

As a reminder, we had $12.2 million in in-process research and development expenses related to the Novelis acquisition in the second quarter a year ago. Major contributors to the increase in operating expenses included costs related to our going direct initiative in Japan and sales force expansion in Europe. Other elements included legal expenses related to the LightLab's litigation, Axsun expenses that we did not have a year ago and increased R&D spending for product development and clinical trial programs.

On a GAAP basis, we reported a loss of $5.3 million or $0.11 per share versus a loss of $13.5 million or $0.29 per share in the same period a year ago. Excluding stock-based compensation expense of $2.9 million, Volcano reported a net loss of $2.4 million or $0.05 per share in the second quarter of 2009. Excluding the aforementioned $12.2 million of in-process R&D charges and stock-based compensation expense of $2.4 million, Volcano reported net income of $1.2 million or $0.02 per diluted share in the second quarter of 2008.

Weighted average basic shares at the end of the second quarter of 2009 were 48.3 million versus 47.2 million a year ago. We ended the second quarter of 2009 with approximately $140 million in cash, cash equivalents and short-term available for sale investments versus $149.9 million at the end of fiscal 2008 and approximately $144 million at the end of the prior quarter.

Our use of cash during the quarter reflects capital expenditures primarily on the placement of consoles and increased working capital. We are reaffirming guidance for revenues of $218 million to $223 million, an increase of 27% to 30% over revenues of 2008. We also continue to expect the gross margins for the year will be in the range of 59% to 60%, including the additional depreciation of approximately $775,000 through the balance of the year related to the Goodman transition. These costs notwithstanding, we continue to benefit from our manufacturing cost reduction initiatives.

We continue to expect operating expenses will be in the range of 67% to 69% of revenues, including stock-based compensation expense of approximately $12 million, intangible amortization of approximately $4.2 million and approximately $3.5 million in Goodman commissions.

As we have indicated previously, our outlook for operating expenses reflect increased spending in Japan, expansion of our sales and marketing programs in other geographies, G&A to support the growth of our business and legal expenses associated with the LightLab's litigation. In addition, we expect a modest increase in R&D spending to fund product development programs, clinical trials and regulatory activities.

On a GAAP basis, we continue to expect to report a net loss of $0.38 to $0.43 per share. Excluding stock-based compensation expense of approximately $12 million and Goodman commissions of approximately $3.5 million, we now expect to report a loss of $0.06 to $0.11 per share on a non-GAAP basis.

I might also add our expectations for 2009 reflect lower interest income and unfavorable currency exchange rate versus fiscal 2008. We expect the weighted average shares outstanding at year-end 2009 will be approximately 48.7 million basic shares and 50 million shares on a diluted basis.

Between now and our next scheduled conference call, we are appearing at the Canaccord Adams and Thomas Weisel Healthcare conferences next week and in early September respectively. In addition, as Scott mentioned, we will be holding an investor event at the TCT on the morning of September 24th, which we will be providing additional details over the next couple of weeks.

Thanks again for joining us today, and we’ll now open the call to your questions.

Question-and-Answer Session

Operator

(Operator instructions) Your first question will come from Mike Weinstein with JP Morgan.

Chris Pasquale – JP Morgan

Hi, guys, Chris Pasquale here for Mike.

Scott Huennekens

Hi, Chris.

Chris Pasquale – JP Morgan

John, just to start off with -- it looks like really the only significant change to guidance relative to what we talked about in July was the non-GAAP EPS. Can you just talk about what’s changed there going from $0.03 to $0.08 to a loss of $0.06 to $0.11?

John Dahldorf

Yes, there is two things. The first is, we’ve reduced our forecast for stock compensation expense by about $1 million. And as we are defining the non-GAAP measure for the Goodman transition, we are only including the commission fees of about $3.5 million. And when we spoke to earlier, we had also included the approximately $800,000 that we had in there for the depreciation cost for the consoles that we acquired. So if you take the $1 million of change of stock compensation and $800,000 of the depreciation for the Goodman consoles divided by the $48.7 million, that’s basically your $0.03 difference.

Chris Pasquale – JP Morgan

Okay, that makes sense. The second question, I know you guys don’t guide on a quarterly basis. But can you talk a little bit about the revenue seasonality we should expect in the back half of the year with the Goodman inventory drawdown in the third quarter and then the fourth quarter when you really start to see the full benefits of going direct for the first time?

John Dahldorf

Yes, yes. And Chris, I think as we’ve kind of talked in the past, if you go back and look at the last couple of years, historically we’ve been kind of 24.5% or so of the total year revenue in -- for the third quarter. And for this year, I expect the impact on our revenues kind of from that normal rate will be approximately $1 million to about $1.3 million. And so I expect the revenues in the third quarter to kind of be in the 24% of total year revenues.

Chris Pasquale – JP Morgan

Okay, perfect. And then one last one. Scott, you guys obviously had a lot going on in your pipeline in terms of new product categories, but you also mentioned the new products that you are going to be introducing in your core businesses over the next couple of quarters. Can you just spend a minute talking about the significance of those launches and what benefits they offer versus your existing product lines?

Scott Huennekens

From a competitive standpoint, we don’t want to go into that much detail, Chris, but in general, the things we work on or the things that improve, the image quality of the products and their deliverability. So we expect in our new base rate product and our new rotational product, they will both improve on those two parameters going forward. Similarly, our new pressure wire will also improve on the signal itself and its accuracy as well as the deliverability of the wire.

Chris Pasquale – JP Morgan

Okay, great. Thanks, guys.

Operator

Your next question will come from Rick Wise with Leerink Swann.

Rick Wise – Leerink Swann

Good afternoon, everybody. Let me come back to the gross margin again. Two factors, John, you were citing dragging the gross margins to Axsun and currency. Can you just break down the impact of each or some sort of order of magnitude in the quarter? And maybe just remind me -- maybe I’ve forgotten, do Axsun -- does Axsun drag on gross margins get better or less of a drag over time and why? Thank you.

John Dahldorf

Yes. Depending on which one you want to go first, the Axsun drag on margins is equivalent to about 280 to 300 basis points, and the FX is another maybe 75 to 100 basis points. So if you add those together, we really would have margins in the kind of the 63% range. Axsun’s margins on a revenue today kind of are in the 25% to 27% range. And they are influenced the greatest by the amount of volume that you put through the plant. We have a pretty large amount of fixed overhead in the plant. So to the extent that the business grows in the future, I think that you would see a pretty material change in the margins related to the Axsun products.

Rick Wise – Leerink Swann

And is that change likely going to take two, three or four or five years? Or do you think we could see a significant change over the next two to four quarters or how do we think about that?

Scott Huennekens

Rick, this is Scott. The way I would think about it is we don’t see Axsun growing at the rate of the other businesses. So that percentage of the business will have less and less effect on the gross margins going forward. But they will be just like our other business, a couple hundred basis point improvements in their gross margins over time. But as we’ve talked about since we bought them, it’s fundamentally a different business model than a medical device company, lower gross margins but much lower selling and marketing costs where we have a direct sales force, the numbers we went through today of well over 200. They have two people selling their products to a handful of larger customers -- or couple handfuls of larger customers.

John Dahldorf

So their operating income percentages could get to the same numbers as ours as we grow, but not (inaudible) because we are one company, but the business units can have similar operating income margins as they grow. And I think that’s the way you kind of have to think of it as that as we go forward, they can be 15% to 20% operating income businesses.

Rick Wise – Leerink Swann

Okay, couple other ones. The FFR upgrades are done a little faster than I had expected, which is excellent. How do we think about the sales and margin impact now going forward?

John Dahldorf

Well, I think that the program costs us in excess of $1 million. So obviously we won’t have that in our cost of sales going forward. And I think that what those upgrades provide us is just giving our customers in a much broader base the capability to run FFR. So --

Rick Wise – Leerink Swann

So the absence of expense, but it’s a behavioral effect also about the console and driving market share is what you’re saying?

John Dahldorf

Correct.

Scott Huennekens

Rick, I would also add just as a general concept, FM sales, we project over the next few years, will grow faster than our IVUS sales. FM has a slightly lower gross margin than IVUS does. So as it becomes a bigger percentage of total, it’s a little bit of headwind on our gross margin line. But we haven’t had the focus over the last four years on driving the cost down because it was a small part of our business when focused on the IVUS side from a cost reduction. So you may recall from the beginning, (inaudible) catheter costs well over $230 now, well under -- approaching less than $150. The same opportunities, we believe, exist and we will take advantage of with our FM wires over the next couple of years. So we would expect our FM margins to expand as volumes get bigger and we tackle the cost side and that will reduce that headwind.

Rick Wise – Leerink Swann

Great. Just one last one. Just sort of bigger picture, as you pointed out, the US console revenues were basically flat versus a year ago, but sequentially up over $1 million from the first quarter. Just out of curiosity, is this as expected? Is it worse than you thought? Is it better than you thought? And just does it give us any picture window into where we are relative to the complicated US spending environment? Thanks.

Scott Huennekens

Yes, thanks for the question. It’s pretty much right on what we expected. At the beginning of the year, we said that we have built into our guidance number an expectation relative to the US capital market. That has borne out pretty much exactly what we expected. So as I think we said last time, is that we are not seeing that we are losing deals. The deals are going away. They are getting moved to the right from a time standpoint. So we feel like when things free up, there is going to be this pent-up demand. And whether that starts to happen in the fourth quarter this year or the third quarter this year or starts to happen in 2010, we feel like we are very well positioned to be the beneficiary since we are winning 75% to 80% of US capital deals.

Rick Wise – Leerink Swann

Thanks again.

Operator

We’ll hear from Jason Mills with Canaccord Adams.

Jason Mills – Canaccord Adams

Hi, Scott and John.

Scott Huennekens

Hi, Jason.

John Dahldorf

Hi, Jason.

Jason Mills – Canaccord Adams

Thanks for taking the question. I want to go back to gross margin. There is a lot of moving parts there, John, and you mentioned a lot of them. I’m just -- (inaudible) being around the bush a little bit, how do we kind of look at gross margins going forward into 2010, given that the volumes on the disposable side obviously will outpace those on the capital equipment side, offset by Axsun and others that are in the model now? You exited 2008 before Axsun. I believe you are sort of running in the below-60s. Axsun brought that down, but again you’re still ramping disposals. How should we think about that? I know you haven’t given 2010 guidance, but should we think about that in the low-60s or maybe a little bit of a color trajectory or something?

John Dahldorf

Yes. So, Jason, I expect that we will be exiting the year with margins at the top of our range. The average for the year will be in the range of 59% to 60%, but I believe the fourth quarter will be a little bit over 60%. And then I think that as we kind of roll into 2010 and you get the full year impact of the conversion in Japan to go in direct as well as some of the cost reduction programs that we are very excited about that we have in place and are putting in place. I think that you should see margin improvement next year of at least 200 basis points of over the average that we have for his year.

Jason Mills – Canaccord Adams

Great, that’s helpful. Thanks for that. Scott, you mentioned at the tail-end of your closing remarks, you plan to show profitability in 2010. Good gross margin color there from, John. What else drives profitability in 2010 for you?

Scott Huennekens

Yes. As we talked about as a company for our out-years, we feel comfortable we can grow the top line at 20% or greater that we can continue to drive the gross margin expansion that John mentioned, and then we will then leverage the operating expenses where they will not grow at the same rate as revenue. And so you get that leverage that falls through in the income statement. And then absent some of these other one-time events, whether it’s from acquisitions, amortization of intangibles from the EndoSonics acquisition finishing up, things like that, all lead us to profitability on a full year basis in 2010, we believe.

Jason Mills – Canaccord Adams

Right. And just to push you a little bit more on that, Scott, 2010 starting [ph] up to be obviously a very eventful year in a lot of areas. It’s tricky to figure out what could be contributed from the new products, from action growth perhaps. I wanted to ask another question about PROSPECT and perhaps (inaudible) effects not in your core IVUS business. With all of that being said, the expense infrastructure in the back half of this year gets a little bit heavier. I’m wondering how quickly you see that operating expense leverage as you enter 2010 juxtaposed with, you know, now you haven’t given guidance for 2010 on the top line, especially as it relates to Japan and what’s going on there with your direct sales effort as well as these new products, specifically image-guided therapy that’s launching. As a sort of a (inaudible) question, I’m just trying to get a sense for how we should think about the operating expense leverage without really -- without any guidance on the top line?

Scott Huennekens

Yes. So a little more color I guess would be that if you look at just the base business -- and Chris asked the question about the new products -- so new phased array catheter, new rotational catheter, improved software program, new wire, growth of the base markets, especially on the FM side, continued IVUS growth, those things coupled with going direct in Japan, introducing IGT, image-guided therapy in Japan, and then very little other new revenue from OCT or forward-looking IVUS or in the impact products next year gets us to revenue growth, we believe, in excess of 20%, without getting too much detail on guidance or anything. And so when you look at kind of the time [ph], we are going to see leverage from all of that starting in the fourth quarter this year, but we started getting a full effect of Japan direct in the fourth quarter. And that will carry through to next year, although given some of the seasonality of how revenues you see [ph] more historically in our business, the profitability of the business will grow over the year. So we are not telling we’d be profitable in every quarter next year, but be profitable for the year next year.

Jason Mills – Canaccord Adams

Great, that’s helpful. One last question with respect to PROSPECT, sounds like TCT will be eventful on that front as well. I understand it is not a specific correlation with your core IVUS business, but I’m wondering what your thoughts are -- the outcomes in those four or five areas that you mentioned are generally positive. Do you expect that to be a contributing factor to uptake especially in the United States with respect to your core IVUS business?

Scott Huennekens

Absolutely. I don’t know the results. I’m not allowed to know the results. Those get announced at TCT. But we have -- the nice thing about PROSPECT is that we have multiple shots on goal as an IVUS company. And really this is looking at two sides of a coin. The one side is the positive predictive value, not to get too technical, but the idea of PROSPECT was, to begin with, was let’s took at these red (inaudible) thin-cap fibroatheromas and find out if therein 50% of the patients to 1% of the time the patient has a heart attack within the three years or 15 or 12 or 50% of the time. That’s the positive predictive value. So -- and if we can start predict, predicting anywhere from 8% to 15%, positive predictive value of heart attacks within three years on a specific lesion, that’s game-changing, because we know we have low event rates with drug-eluting stents and we can start to treat things with some of the state [ph].

Now you got to do additional studies to prove the benefits and everything, but I think they would start using it. The negative predictive value for me is even a bigger opportunity. And that is that if, for example, you take all these lesions that have less than 4 millimeters squared MLAs and the event rates are nearly zero or very, very low, then you find that all the green ones on our VH technology or green and yellow never have events. That’s basically saying you shouldn’t treat them. And that’s the same results validated with a VH technology. And that then starts to say, in every single multi-vessel disease case, you should be using IVUS or FM to determine should you put that second or third stent in, because we believe at Volcano, it’s all about the right patient, the right lesion and the right away. And same would say today that we are over-treating. We’re putting in three stents and it should have been two. And whether you used an IVUS VH criteria or an FFR criteria with pressure, to figure out which one, if you do it right, you’re going to save $1,500 a patient.

If there is a million -- you know, those kinds of patients are the 3 million PCIs worldwide. That’s a very big opportunity to change PCI. And on the one hand, so the PCI can do a better job even than medical therapy, because you’re treating the right patients or better than CABG on the other end of the syndrome because you’re treating the right patients and the right lesions. So prostate therapy opportunity to be game-changing, assume back in September for the results, the initial results. And it will take more studies after that, but this was a big study that’s multi-center, and if things are positive, it’s something that -- that will be -- something that will be published in major journals and have a lot of power.

Jason Mills – Canaccord Adams

Clearly we shouldn’t expect any guidance from the stent players to be in that room that day. Thanks, guys.

Operator

From Piper Jaffray we will hear from Amy Sullivan.

Amy Sullivan – Piper Jaffray

Hi, guys. A lot of my questions has already been asked. But a couple others, you gave us some good update on the status of your worldwide sales force as of today. Just wondering if you can give us some sense of your expectations or further expansion of the next six to 12 months or so?

Scott Huennekens

Before I answer that -- I’ll have John answer it. I just wanted to address Jason’s parting comment there. I do think that this can be very positive for stenting companies. You’ve got a number of procedures that are going to CABG. You have a number of PCIs that are at risk where the patients are getting treated with medical therapy. And this is an opportunity to bring both of those populations of patients back into the PCI mix. And so the middle bucket that they are using today and maybe not optimizing, they may lose a little bit out [ph], but the buckets on each of the other ends can get much fuller. So I would say, Abbott and other people, or Abbott specifically is involved in the study. There is a strong interest in how PROSPECT can help them grow their business. So John, sales force?

John Dahldorf

Yes. Without cooing [ph] exact headcount, which we really don’t have for -- as we’ve kind of rolled in 2010, but I think in the US, we will probably in the 112 to 115 range. In Japan, as Scott mentioned earlier in his comments, we will have probably in excess of 50 between Europe and rest of the world. We will probably have in excess of 32 to 33 reps. As we roll into 2010, again, just kind of echoing Scott’s comments, we don’t expect the sales force headcount to grow in any of our geographies as fast as it’s grown over the last couple of years since we believe that will have plenty of capacity within the existing sales force, with some selected as we’ve seen -- as we see return on investment opportunities in different sections of those particular geographies. But again, we don’t expect the growth in the sales force to be in excess of the growth in revenue like we’ve seen over the last couple of years.

Amy Sullivan – Piper Jaffray

Got it, thank you. And then secondly, you mentioned the progress on converting the legacy IVG units in Japan, just kind of wondering how quickly u see that -- see completing that process of something that has dropped up by year-end or --?

Scott Huennekens

Yes, we -- because of the way that the whole transition now is working out, we don’t feel like we have to kind of convert all of them immediately. And so we’ve kind of laid out our plan to kind of do it over the next six to nine months. And then the decision of how to deploy some of those older IVGs would be based on the condition they are in and the opportunity that we may have in some lower volume of concept. We haven’t had any presence in -- with neither Fakuda nor Goodman over the last six or seven years that we’ve been associated with the business.

Amy Sullivan – Piper Jaffray

Okay. Thank you for taking the questions.

Operator

From Roth Capital we will hear from Matt Dolan.

Matt Dolan – Roth Capital Partners

Hi, guys, good afternoon.

Scott Huennekens

Hi, Matt.

Matt Dolan – Roth Capital Partners

Looking again at the placements despite what seems to be as tough capital environment here definitely outpacing first half of ’08, and it looks like the US continues to come even with a lot of outright sales. So can you talk to us a little about facility penetration? Are you seeing a lot of new facilities opening up here for IVUS or these repeat placements? And the second part of this is, how should we think about placements going forward? It looks like 2009, you could see more units coming in. Is that something long-term that starts to level off?

John Dahldorf

Yes. Again, I think that Scott kind of, again, said it in his earlier comments, everything that we kind of see playing out as far as the capital equipment is concerned is really kind of holding. We are gaining -- we are getting new accounts. We are -- we do see customers buying consoles in replacement kind of a cycle. And so I would say that we haven’t seen a dramatic shift in any particular customer type versus what we’ve experienced in the past. And so we consider that very, very positive news. And again, as we kind of got into the year, at the end of 2008, we had a very, very strong growth, especially as the market really in the US kind of seized on the fact that you now had a true multi-modality kind of a console. And so we believe that we have some pretty tough comps coming up, especially in the fourth quarter. So we’re still holding to the fact that we believe that will be flat as far as console placements are concerned in 2009 versus 2008, although we are running ahead of pace right now versus 2008.

Matt Dolan – Roth Capital Partners

Okay. And the second part was, do you feel a lot of the new facilities opening up to IVUS or do you see more repeat business for your planning on second or third console?

Scott Huennekens

Yes, this is Scott. John said it’s kind of business as usual. And I don’t have the exact numbers right in front of me, but we’ve got weekly customers who continue to convert their labs where they bought integrated last year and they have to roll around, now they are adding two more. You have a business that we’ve taken -- or are taking from Boston. We have people who are replacing their FM equipment and then they are building IVUS into it. And then we have people who are new to IVUS in the sense that they had one roll-around system and they weren’t using it much. Everybody has IVUS, Matt. But they are looking at it in a more meaningful way once it gets integrated especially with FM.

Matt Dolan – Roth Capital Partners

Okay, great, that’s helpful. On the FFR side, you continue to see a nice tail end [ph] at TCT last year. Now, with the upgrades, you would see kind of a similar pattern now that it’s more readily available than your customer base?

Scott Huennekens

Yes. (inaudible) our sales and marketing people, they have put as much weight in integration as they would into the TCT data relative to usage, especially as it relates to the US. Europe would spend more, the data driving the increase.

Matt Dolan – Roth Capital Partners

Okay. And then finally, you have a number of initiatives ongoing in terms of the pipeline and data et cetera, but historically we’ve seen a pretty steady stream of acquisitions. Can you just give us kind of your thoughts, how you are looking at your pipeline as it stands today relative to any acquisition plans or how you’re facing the M&A environment?

Scott Huennekens

Yes, we feel like we have an excellent pipeline and don’t really have any need from an M&A standpoint. That’s not to say that there might not be some smaller tuck-in opportunity. We said our strategy is grow our IVUS and FM business 20%; number two, move into these new markets, IGT, OCT, FLIVUS, you know the list. In FLIVUS, there may be an opportunity to add XYZ product (inaudible) to have a total solution for CTOs, or with OCT, you can see thrombus. And so that’s part of the reason we got the lumen catheter to put together (inaudible) total AMI solution. IGT will fit in that AMI solution bucket. So as we move forward, there may be opportunities to leverage FLIVUS, CTO, OCT, image-guided therapy with some kind of small tuck-in that helped us or (inaudible) market delivers the technology. So whether it’s, say, OCT for -- there are so many different applications for that varies from [ph] skin cancer detection to ophthalmology applications that there were some business opportunity that made a lot of sense, but was probably a smaller acquisition. It would be something we would look out in the next year, but nothing big or significant we don’t believe [ph].

Matt Dolan – Roth Capital Partners

Sure, okay. Staying within your kind of pipeline, great. All right. Thanks, guys.

Scott Huennekens

Thanks, Matt.

Operator

We’ll hear from Raj Denhoy with Thomas Weisel Partners.

Raj Denhoy – Thomas Weisel Partners

Hi, good afternoon.

Scott Huennekens

Hi, Raj.

Raj Denhoy – Thomas Weisel Partners

I wonder if I could -- a little bit about Japan. I think you mentioned you had some early success there opening some new accounts. And I’m curious maybe you could just talk a little about how you find that market in the early days of being there direct, and really your expectations for being able to continue penetrating accounts as your move to (inaudible) next?

Scott Huennekens

Yes, it’s -- as you know, we kind of started to build out that and add to our direct sales force late last year. And as we built that direct sales force, they were really going and calling on accounts that neither Goodman nor Fakuda were calling on. And these are the accounts that we’ve been able to grow to the point of they contributed approximately $2 million of revenue in this past quarter versus virtually nothing in the same quarter a year ago. So, as we build out the sales force, as we kind of start to shoulder the Goodman accounts that come over, we believe that we will also have extra selling capacity to go out and increase our market share by opening new accounts or increasing our penetration or share within the existing accounts that we have today.

Raj Denhoy – Thomas Weisel Partners

All right, great. So if we look out over the course of next year and this year as well, I mean, your -- I think Japan is about 24% of your revenue right now. It sounds like it’s going to be probably the fastest growing market if you’re going forward just given all the changes going on there. I mean, what’s your expectation for Japan could be as a percentage of your revenue in 2010?

Scott Huennekens

I’d really like to talk about that when I talk about 2010. With all the geographies, I don’t think it would be fair to just talk about Japan as a percentage versus the rest. But I think that if you think about Japan this year as a $50 million business, I think that we’ve talked about since the investor day that we will get an additional $10 million or $11 million of contribution from going direct and then we believe that we can increase our market share at consistent amount as well.

Raj Denhoy – Thomas Weisel Partners

Okay. I guess we’ll leave that till next time. And just one last one, I apologize if you’ve already given this, I joined a little bit late. R&D in the quarter was running just under $10 million, and I know it’s probably buried in your guidance here, but is that sort of a number we should think about as kind of a good run rate number on a quarterly basis here guys?

John Dahldorf

Yes, it is.

Raj Denhoy – Thomas Weisel Partners

Okay. Great, thanks.

Operator

Your final question will come from Stephen Simpson with Northland Securities.

Stephen Simpson – Northland Securities

Thanks. Just a quick question, guys, on cash flow. If you could give us operating cash flow and CapEx for the quarter?

John Dahldorf

Year-to-date operating cash flow is about $3.1 million and capital expenditure is about $12.2 million.

Stephen Simpson – Northland Securities

Thank you.

Operator

And there are no further questions in the queue.

Scott Huennekens

Okay. Thank you very much. We are very excited about our first half results. And when we [ph] come in the second half of the year, look forward to you. Hope we see a number of you at our investor day and TCT in San Francisco.

John Dahldorf

All right. Thank you very much.

Operator

Ladies and gentlemen, that does conclude today’s presentation. We thank everyone for your participation.

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Source: Volcano Corporation Q2 2009 Earnings Call Transcript
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