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Cyberonics Inc. (NASDAQ:CYBX)

F1Q10 (Qtr End 07/24/09) Earnings Call

August 20, 2009 9:00 am ET

Executives

Dan Moore - President & CEO

Greg Browne - Vice President, Finance & CFO

David Wise - General Counsel

Analysts

Tom Gunderson - Piper Jaffray

Keay Nakae - Collins Stewart

Bill Plovanic - Canaccord Adams

Anthony Petrone - Maxim Group

Margaret Lovatt - Suntrust Robinson Humphrey

Operator

At this time, I would like to welcome everyone to the Cyberonics first quarter fiscal 2010 results conference call. (Operator Instructions). Thank you.

Mr. Dan Moore, you may begin the conference.

Dan Moore

Thank you, Regina, and let me add my good morning as well and thank you for all for attending this call. I'll be joined this morning by our CFO, Greg Browne and we'll begin with David Wise our General Counsel, reading the Safe Harbor statement.

David Wise

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

Forward-looking statements in this presentation include statements concerning achieving consistent annual unit growth of 10% to 20% per year. Fiscal 2010 guidance for net sales, gross margin, income from operations, capital expenditures, equity compensation, depression expenses, R&D expenses, recognizing the value of our deferred tax asset and future reported tax expense, achieving an operating margin of 25% by fiscal 2011, growing our epilepsy sales including growth at Europe, Latin America and Asia.

Demipulse generator market penetration, conducting and completing clinical and R&D projects, including projects related to new generators leads and other hardware, new stimulation parameters, seizure detection and recording and responsive stimulation, securing regulatory approval in Japan, doubling our R&D investment epilepsy in fiscal year 2010 and maintaining leadership in the medical devices for epilepsy.

Our actual results may differ materially for a detailed discussion of the factors that may cause our actual results to differ. Please refer to our most recent filings with the SEC, including our Form 10-K for the fiscal year at April 24, 2009.

Dan Moore

Thank you, David. For those of you who are following on slides, I'm on slide 3. I just want to give an overview of the task that we expect to cover today. First I'll cover the highlights of Q1, our first quarter of our fiscal year '10 and provide the overview. I'll specifically focus on sales before turning it over to, Greg Browne who will focus on our financials.

Our financial turnaround is largely complete after two years. We will begin to focus more on the future and from a strategic standpoint, discuss our customer focus, our international growth and expansion, and begin discussing more about our new product pipeline. We'll also provide our fiscal year 2010 guidance before we move to Q&A.

The highlights for the quarter from a financial standpoint, once again, we saw strong double-digit sales growth of 14% in our first quarter. Our quarterly operating margin stayed at 17%. We also once again made good progress in reducing our debt. We're now in a position where our cash is at $56 million exceeding our debt level of $47 million.

In the area of epilepsy, our core business, in Q1 our US net sales were up in the strong double-digits again at 19%. International units grew by 15%. Q1, 2010 represented the first quarter of our full launch of the new Demipulse product and our conversion rate now stands at 56%. And once again, despite the economy and reimbursement headwinds, we continue to grow our average selling prices in the US.

In the area of depression as previously announced, we were successful in discussing with the FDA, an idea to reduce our patient's requirement for the D-21 study from 460 patients to 330, allowing for earlier completion of that trial. Since the last patient was enrolled in February of 2009, we expect the 12-month follow up to be complete in March of 2010.

I'm moving on to slide 6, looking specifically at our quarterly net sales. James Reinstein and his global team have done once again an outstanding job of continuing to grow our sales. Our revenues for the quarter totaled $38.5 million, consistent with Q4 of last year growing by 14%.

In the US again consistent with last quarter, over $30 million in epilepsy sales, representing 19% growth over the same quarter last year. International, $7.2 million a 5% increase. Overall, we had sales in the US of $31 million, again consistent with last quarter and significantly stronger than one year ago, and international $7.2 million. Our international epilepsy net sales were up despite significant currency impact.

On slide 7, we are focusing on our most important product line in our most important market, that being US epilepsy generator units. And if you look over the two-year period, you will see consistent same quarter year-over-year growth, quarter-by-quarter and in Q1 we sold 1,665 units.

Moving to slide 8, you will see steady worldwide epilepsy unit growth in Q1 2010, versus Q1, 2009, for example that 1,665 units in the US represented 8% growth over the same quarter last year and international, we had impressive double-digit growth of 15% with 615 units. Overall our epilepsy business reached our goal or close to our goal of almost double-digits of 9.8%.

Equally important, we've had a lot of success over the last couple of years with our average selling prices and Q1 was no exception, where we saw 13% growth over the same quarter last year. If you remember, going back to January of this year, which would represent late Q3 '09 on a chart on page 9 or slide 9, we had a change in US reimbursement. Many expected price pressure and yet, we've had two full quarters of continued ASP increases.

Some were expected accounts to stop performing VNS procedures, but I'm happy to report that the number of accounts ordering continues to increase. In Q3 of last year, we sold to 425 accounts in the US, in Q4 436 accounts, and in Q1 of this year, 443 accounts. It is a good testament through the overall value proposition of VNS therapy for patients whose drugs have failed them.

I'm going to turn it over at this point to Greg Browne, who will discuss in more detail the financials from Q1.

Greg Browne

I'm going to comment on the financial results for the first quarter, including income statement, balance sheet and cash flow, as well as, make comments on guidance particularly with respect to tax. Talking or turning to slide 11, comparing our income statement for the first quarter to the first quarter of the previous year.

Obviously, I'm pleased to report $6.5 million in income from operations or 16.9% of net sales. As Dan mentioned earlier, this operating income represents a strong start for the year in contributions from all parts of the organization. It compares with $2.8 million in the comparable period of the prior year and the operating leverage is demonstrated by the fact that on sales increased to 14.1%.

We were able to increase income from operations by over 130%. The reported number is also very close to the $6.7 million reported in the fourth quarter of fiscal year '09, which to remind everybody was the highest quarterly operating income ever recorded by the company.

We remained focused on our 2011 goal of an operating margin of 25%. The sales increased to 14% represented solid topline growth with US and international sales organizations, both making good contributions.

Our international sales performance of $7.2 million comprised 19% of total revenue, with foreign currency movements contributing a decrease of approximately $900,000 to the Q1 fiscal year '10 number, when compared with the first quarter of last fiscal year.

These currency movements overshadowed the ASP improvements that have already been achieved in Europe and other regions. For example, in the U.K. market, we have achieved the average selling price increases of almost 8% over the last 12 months.

Demipulse penetration has now reached 51% internationally. International distributor sales accounted for 30% of international unit sales in the quarter, higher than the 25% in the first quarter of last year, but lower than the 36% we saw in the fourth quarter.

Our gross margin was somewhat higher at 86.1% in the first quarter of last year, although consistent with recent trends. Higher unit sale volumes, higher prices and a continued strong performance by the production team have all combined to maintain this number. And we continue to expect our gross margin to be around 86% in the current fiscal year.

Total operating expenses at $26.6 million were higher by about $500,000 than last year and comparable with our recently completed fourth quarter. We continue to expect that R&D activity relating to epilepsy will increase in coming quarters, consistent with our strategic focus and priorities.

Some of the partnerships and licenses entered into will contribute to this increase. Our R&D activity related to epilepsy has increased each quarter over the last year and this trajectory is likely to continue.

Overall spending on depression has declined to approximately $600,000 this quarter from the $1.1 million in the fourth quarter and almost $2 million in the first quarter of last year. With the completion of D-21 study now expected in March of 2010, we expect this quarterly expenditure of around $600,000 for this study and the registry to continue for the remainder of the fiscal year.

Our tax expense primarily reflects alternate minimum tax as discussed on the last call and I have more to say on this later. We reported fully diluted earnings per share of $0.23 a share for the quarter.

I should point out that the number of shares included for the purposes of EPS calculations increased by around 700,000 in the current period, due to an accounting standard change. We have chosen as allowed, not to make this change retrospectively.

My comments on slide 12 included in the quarter our equity compensation expense of $2.2 million. This number is expected to be approximately 10% lower for the whole fiscal year 2010, when compared to fiscal year '09 and significantly lower again in fiscal year '11.

When we compare our direct research and development expenditure on epilepsy in the most recent quarter, with that of the first quarter of fiscal year '09, we have an increase of over a million. This almost exactly corresponds with the decrease in depression expenditure, and as stated earlier, this trend is consistent with our priorities.

Just a reminder that the research and development line in our income statement comprises not only research and development activity related to epilepsy, but also clinical compliance and regulatory expenses.

Selling, general and administrative expenses of $21.6 million represented 56% of revenue, down from 64% in the first quarter of last fiscal year, while research and development was 13% of revenue and resulting in an operating margin of 16.9%. The first quarter gain on the early extinguishment debt, net of tax effect and amortization of deferred issuance costs, was $1.5 million.

Now [I'll return] to the remaining slides and comment on the balance sheet and cash flow. Our balance sheet reflected on slide 13 continues to improve and includes ongoing increases, positive stockholders equity, which now totals approximately $35 million. Debt to $46.7 million at July 24 represents a total reduction of over $85 million in the last 18 months.

Our cash of $57.3 million including, $1 million of restricted cash exceeded debt outstanding by over $10 million. The ongoing improvements to our relative debt position alongside the continued improvements to our income statement, before the company considerable financial flexibility.

Turning to slide 14 and 15, our operating cash flow for the quarter of $4 million was not quite as strong as in recent quarters, as a result of both planned increases and inventory, as well as, higher receivables, both in the US and internationally. Our overall day sales outstanding increased to 60 days from the 53 days at the end of fiscal year '09.

As a reminder, this number was 55 days at the end of fiscal year '08. This increase is due to several factors, including general economic conditions in the US and internationally, longer credit terms relating to new distributor agreements entered into in the previous fiscal year. We intend to pay particular attention to this area over the next quarter.

Capital expenditure totaled $700,000 for the first quarter compared with depreciation and amortization expense of 500,000. Our expectation for fiscal year '10 continues to be that capital expenditure will be significantly higher than last year, approximately $8 million, due primarily to upgrades to both our manufacturing equipment and IT infrastructure and software.

Turning to guidance for a minute. So, we have reiterated our annual earnings guidance of operating income of $24 to $27 million. With respect to tax guidance, again to repeat what I said on the last call, our continued expectation is that cash taxes will be approximately equal to 4% of pre-tax income in the current fiscal year and that is likely that this would also be the case in fiscal year '11.

However as I mentioned on the last call due to the consistent and steady improvement in earnings and assuming we continue to achieve our sales and earnings objectives this fiscal year, is likely that Cyberonics will need to recognize the value of its deferred tax asset, either in whole or in part fiscal year 10. This recognition would likely result in a significant one-time gain and subsequent reporting of income tax expense at higher levels.

I'm now going to turn back to, Dan for an update on our epilepsy strategic focus.

Dan Moore

Thanks, Greg. Couple of years ago, we made a decision to focus on devices for epilepsy because it was our feeling that this was a large market and it was also largely under penetrated. We are very happy with that decision and as you can see, since then there have been nine quarters of success, partially validating that decision.

I say partially because, we know we have a lot of work to do in the future to continue to capitalize on that market opportunity. That market opportunity doesn't stop at VNS. It also doesn't stop in the US. As we've shown, we can grow in international. We can also grow we believe through product development in areas where we bring epilepsy devices to patients with epilepsy in ways that will treat them beyond the basic VNS product lines.

If we look at VNS alone, we know that there are 400,000 patients in the US that can benefit from VNS and yet, when we look at the broader epilepsy market, in the US alone there's 2.7 million patients or more impacted by epilepsy.

Moving to slide 17 and getting into some of the details of our epilepsy strategic focus. First, our goals, as you would expect those goals are around growing sales, increasing profitability and developing epilepsy devices. First, we expect to continue to build upon our epilepsy medical device leadership.

Second, we expect consistent annual unit growth of 10% to 20% and as mentioned earlier, we're at the lower end of that now with 9.8% global growth over the prior year. We also expect operating margins as Greg has mentioned to get to the point where we're achieving 25% operating margins in fiscal year 2011.

Let's break down that epilepsy strategic focus into three areas. It all begins with a customer and that's where I will begin on slide 18. Customer focus, first, in this last quarter we had six key opinion leadership summits, where we brought together 71 people, 71 epilepsy thought leaders into six small groups, giving them an opportunity and us an opportunity.

For them, they had the opportunity to meet with senior management including me, our head of clinical and R&D, where we discussed not only the past and the present, but most important the future. We talked about our progress and our direction and most important and of most interest to them our commitment to epilepsy.

Second, we were able to have physician-to-physician discussions to discuss the gaps that exist for patients with epilepsy not only with VNS but other things as well. We reviewed our clinical's to-date and shared our direction with them. Most relevant to them, we looked at our R&D programs and showed them a lot about our direction and where we were going and equally important to us gained our input.

I have to say that we got a lot of excellent feedback along the way, and they are very enthusiastic about the work that we are accomplishing. We have two more of these types of meetings scheduled with neurosurgeons during the rest of this calendar year.

Second area, customer focus. Last year, we held 10 advance topic symposia and that this year has evolved into VNS Educational Symposia, the difference being the Advanced Topic Symposia were more general discussions about epilepsy, whereas the VNS Educational Symposium are more specific to VNS.

Last year, we had 10 physician programs, with 144 attendees and two nurse programs with 104 attendees. This year we have 17 programs in total aimed at physicians and nine for nurses. Bottom line, it’s a lot of opportunity to discuss the treatment gaps and appropriate use of VNS in patients with epilepsy.

Another area of customer focus on slide 19. Our VIP visits to Houston, where we will bring in an epileptologist sometimes with his or her neurosurgeon and his or her nurse practitioner. This gives us an opportunity to them to come and see the work that we are accomplishing here and for us to spend a day with them gaining a better understanding of their practice and soliciting their input on our projects and our direction overall.

In fiscal year 2009, we hosted 13 physicians. In fiscal year 2010 in the first quarter alone, we've had nine physicians. Our epilepsy fellows program, we believe the fellows in this business like many other medical device businesses, the fellows represent the future.

It's important that they learn about VNS as an adjunct to treatment to drugs. At last year's AES, we sponsored 27 fellows to come to the meeting and attend an evening session that was led by a physician thought leader, where we discussed alternatives to drug therapy.

In fiscal year 2010, this year's AES, we are targeting again to bring 30 fellows to that meeting. In addition to that we've already had 24 fellows registered for the Kiffin Penry Neuromodulation Course that will again discuss alternatives to pharmacological approaches to epilepsy.

Additionally, senior management field activity. James, Milton and I are regularly in the field visiting physicians in key accounts. Those accounts are accounts that are either performing a lot of VNS now or have the potential based on their patient populations to treat more patients with VNS. We share our approach to this market with them and again gained their valuable feedback.

As mentioned last time, we have new marketing and clinical materials in the field today. The clinical selling tool that makes the case for VNS, the clinical article reference guide, the physician brochure and the patient video, all of those materials over the last quarter have been well received.

We also mentioned last quarter that we had changed the sales incentive plan. That plan focuses on not only achieving a growth plan, but growth that includes new patients. Bottom line is we are focused on helping patients understand the benefits of using VNS in their difficult to treat patients, nearly one third of the parities that they regularly see.

Let's move to slide 20 and talk about international and our growth and expansion there. We have significantly strengthened our organization over the last year with approximately 50% of our international personnel having been hired in the last 12 months.

In Q1, all regions showed growth. Just to give you an update on some of our key markets. China, we now have three hospitals that are implanting regularly. We have training scheduled for two more. We've entered Russia and completed the first implants to support our registration process there and a very important market, Japan.

We've made solid progress with our partner Nihon Kohden. Nihon Kohden being a major company with epilepsy ties via their EEG equipment. We have submitted as we told you in the past our product registration. We received questions and those responses to those questions have been submitted in the last quarter.

We have our quality system audit scheduled for September 1st, and our clinical audit will be scheduled after the quality system audit is complete. We need to get our regulatory approval in Japan and then that would be followed by the approval for reimbursement. Important area, new product development, slide 21, as you would expect we have active programs for generators, leads, other hardware and software, including new treatment parameters.

But, we spent a lot of time focused on seizure recording, seizure detection and responsive stimulation. Our approaches are multiple. With the revenue base that we have, we can support multiple approaches to solving this very difficult area seizure detection and seizure prediction.

We are using both, the cardiac signal approach and EEG. We expect to development systems that will consist of external devices, implanted devices and combination devices, as well. As Greg mentioned, we have consistently allocated more dollars to R&D during the past two years and this year, we expect our investment in epilepsy R&D to double.

Milton and his team are growing in number and capability, as they work internally and equally important, work with external partners to assemble the very best programs for seizure detection globally. We are confident that they are doing all the right things to ensure our device leadership and growth.

And equally important those epilepsy top leaders that we've brought together have confirmed that we are on the right path, based on what we've heard from them, throughout those six meetings, the key opinion leader visits and our interactions in the field.

And as Greg mentioned, on the final slide for guidance, despite a soft economy and other concerns that some have, we are reiterating our guidance on the topline of a $157 million to a $161 million and expect income from operations to be $24 million to $27 million. We've had nine successful quarters over the last two years.

We believe and our physicians believe, we have the right opportunity by going after an under penetrated epilepsy market, beyond VNS. We believe we've been assembling the right team, starting with the sales force, supported by marketing, sales management, international. A sales support team, customer service, finance, legal, HR, a development team, that's creating the future for us, as we talk with R&D, regulatory and clinical.

Bottom line is we have a formula that you've seen many times in your life. It's a formula for success where you put the right team on the right opportunity. And we believe we will continue to succeed for all of our customers, physicians and most important, their patients and bring a nice return to our shareholders.

Thanks for your continued interest and support. I want to use this opportunity to once again thank this team for the turnaround in the everyday activities that they have been bringing for to ensure that we have success in treating patients with epilepsy. Turn it over for Q&A.

Question-and-Answer Session

Operator

(Operator Instructions). Our first question comes from the line of Tom Gunderson with Piper Jaffray.

Tom Gunderson - Piper Jaffray

Dan, in the past conference calls, you've detailed the US generator unit sales as you did this one, but also the US lead sales, so that we could make some estimate of what replacement versus new generator sales were. Can you give us those numbers for this quarter?

Dan Moore

Tom, I will. Let me start there with I think, what we are all after and that's new patients. As we've mentioned, we want to expand our therapy to new patients. And our Q1 data and we look at this many ways, our Q1 data suggests that we implanted between nine and ten new patients in the US every calendar day during Q1. Well, still a majority of our VNS procedures, this number is not growing to our satisfaction.

Now, when we made the strategic decision to return our company to focus on epilepsy, that decision was partially based on the VNS market opportunity including significant new patient potential to compliment that growing replacement cycle. As you've all seen that growing replacement cycle has materialized, but the new patient growth has not yet happened, even though we implant a lot of new patients every day.

We also recognize that we have to drive new patient growth, but that's a long-term process. I just went through all the important growth initiatives that we have underway in the area of customer focus and international expansion and product development. And we bottom line believe that we got the right plans in place to achieve that meaningful patient growth.

I also just for a perceptive, before I get right into that lead number that I think you want, let's not lose sight of the impact of that robust replacement cycle. We were estimating based on the Model 100 reimplants at 70% replacement rate when patient's batteries fail. At those key opinion leaders meetings, more recent data suggested that more than 90% of those physicians reported that their replacement rate exceed 80%.

So, we know we have a strong replacement trend, coupled with those improving ASPs that you've seen. It's well given us, good growth in the US and just for perspective again, if you go back two years, Q1 two years ago, we did $21 million in epilepsy sales in the US.

This most recent quarter we did almost $31 million, a 47% increase. Those US units grew from 1379 to 1665 approximately 21% during that same period, so, not a bad outcome. We have no reason to believe that replacements will decrease and we remain optimistic about our continued success.

I will go to the leads number because I know you want that number, but we believe leads is not a perfect way to measure new patients and we've said that in the past and we have more recent data that suggest that there is more replacement of leads over the last couple of years and we are learning more about that as well.

But if you want to use the purchase of a lead as an indicator, you have to remember that doesn't necessarily reflect the use of a lead, but our epilepsy leads in the US were up slightly by approximately 2% Q1 of this year versus Q1 of last year. Our goal bottom line is to not only grow new replacements, grow ASPs, but we know we need to grow new patients and we believe we've got the right program to do that.

Tom Gunderson - Piper Jaffray

Thanks for that. And then you mentioned a lot on doctor, physician, customer, if you will, contact and I'll bundle my last question into that framework, and that would be in your discussions both in Houston when you bring them in and in the field when you go out to see them, Could you talk about, A, how the docs are seeing the economy and the treatment of epilepsy in this tough economy and whether the patients restrictions on personal consumption are affecting that?

Second how the docs are viewing new drug introductions, for instance, lacosamide in the algorithm of how they position VNS, and then thirdly, you mentioned when you go out in the field you talked to not only to your big guys but your big potential guys. What do you see, Dan, as main barriers to those big potential guys of coming in and actualizing that potential?

Dan Moore

I'll try to take them in the order you did them, and if I miss some, come back to me, but the three topics. First of all, in the area of economy and insurance and consumption, we don't spend a lot of time there, but I wouldn't sit here and say that it doesn't impact our business. I think what’s important is that we are seeing that double digit growth. We are seeing unit growth, but I think it was Kaiser who estimates that for every 1% of on employment, 1.1 million people in the US lose their insurance.

So I don't want to sit here and say that doesn't impact us, but it's not a major part of our discussion with physicians. These are patients who have been on a lot of drugs and they don't have a lot of opportunities and we need to remember that from our perspective and some work that was done actually again by Kaiser suggest that this is an economically viable and favorable procedure in those types of patients.

Number two, as far as drug introductions. Interestingly, in one of those key opinion leader meetings, we have some physician-to-physician discussions and one of those physicians was talking about his career over the last 30 years, and he gave three different points in time and where when he came into the business, there were three drugs or whatever the number was.

But throughout the last 30 years, despite the fact that there had been more and more drugs introduced and more drugs available, the percent of patients who remain refractory, whose drugs have failed them, stays at 30% or above. So in the past we've seen new drug introductions.

We are seeing a new drug introduction now, and in the future we expect to see new drug introductions, but the bottom line is that 30% or more of patients, still their drugs fail them and they need something else, and we believe that neuromodulation is a good solution for those patients. I think Tom in your survey it looks like that 30% or higher number was supported.

The potential future for those accounts who are not implanting as much VNS we think they should or not implanting VNS as well. What we'll bring them on board I think its combination of at least three things. One is the repetition, bringing the data back to them. There are over 1000 sources of data out there that we can bring to physicians to talk to them about the benefit of VNS for their patients who are refractory, again over 30% of their patients. Number two, as they always say and they like more data.

And number three, this whole new product development thing I think every time you launch a new product, you are giving physicians a reason to try that therapy again. So as we go into seizure detection, seizure prediction and we improve the efficacy, I think we will bring more accounts on who either previously used and [saw] or aren't using as much VNS as we believe they should. Did I hit all three Tom?

Tom Gunderson - Piper Jaffray

You hit all three. Thanks. I'll get back in queue.

Operator

Our next question comes from the line of Keay Nakae with Collins Stewart.

Keay Nakae - Collins Stewart

Dan, with respect to Japan, you mentioned the timetable for some of the upcoming milestones, but with respect to the clinical data, can you give us a sense of what the risk is that either what you have is not sufficient or this has to be to do additional clinical work to get the approval?

Dan Moore

If you are specifically referencing the risk in Japan, is that your question?

Keay Nakae - Collins Stewart

Yes, obviously.

Dan Moore

Yes, I think with every day that goes by that risk becomes lower. But there is still a small risk as they are going through the submission that they might want to see more data. But, they've had one round of the data sent back questions and there wasn't a request for clinical study. It doesn't mean they couldn't come back and ask for it. But we're not expecting it at this point.

Keay Nakae - Collins Stewart

What's your expectation for once approved, how long it would take to get reimbursement on board in Japan?

Dan Moore

I think in generally its two to three months, but, that's a general number as well.

Keay Nakae - Collins Stewart

Switching gears to some future items, one with respect to depression, when we come around to March next year or Q2 next year when you are able to talk about the results from the dosing study. How you proceed from there or first of all is it dependent on one of the three dosing arms showing a clear separation?

And two, you've done a lot of work before in trying to determine what type of randomized control study would be necessary to bring reimbursement on board. So, how should we think about the timing of how you might proceed down that path?

Dan Moore

First, is it dependent on the outcome of that study? Obviously, we would want to see a positive outcome or some trending in those three dosing groups. But we need to remember that in any trial where a product has been approved, there is a crossover period. So, in the protocol, you are only allowed to lead at a low dose for so long, before ethically, the IRB have it set up and the protocol is set up to cross patients over.

So, we would want to see the right trends in those lines, between low, medium and high dose. But, further we've got to think about there may not be a dosing, there may be a minimum dose that you need. But above that, you might see an impact on two out of three lines, but not necessarily the third line. So bottom line is obviously, we'd like to see a positive trending in those lines.

And then, what do we do from there; I think is the second part of your question. Is that right?

Keay Nakae - Collins Stewart

Yes.

Dan Moore

I think we've obviously had that goal of getting our operating income to 25% and we are very enthusiastic about how we can do in epilepsy. I think we would be in a position where we have more data and more certainty around depression and we would also have a couple of large players who are also thinking that there's neuromodulation play for patients with depression.

So, I think we would be in a better position to go out and potentially, find a partner for it than we were a year ago with all the uncertainty and the expense of a D-21, a registry that are largely behind us now. But I'm still thinking that there's another trial that would be needed there.

Keay Nakae - Collins Stewart

So, going forward with that study is dependent on being able to spin that off as you were thinking about previously?

Dan Moore

Decision is not yet been made.

Keay Nakae - Collins Stewart

Just moving back to epilepsy in seizure detection and prediction, how far off are you in terms of having some embodiment of that to bring to market?

Dan Moore

We have not yet put out those dates and we don't plan to at this point. The only thing we've said is that, our objective is to have new products on the market, before the first IP expires in the US in July of 2011.

Operator

Our next question comes from the line of Bill Plovanic with Canaccord Adams.

Bill Plovanic - Canaccord Adams

On the Japan question, if no more data is needed and this kind of goes through the regular process without any hitches, is this like an early fiscal year '11 launch in Japan?

Dan Moore

It could be, but again, it's a binary event. When they are ready to say yes, from a regulatory standpoint they say. I would hope that by early fiscal year 2011 where we've got regulatory approval and perhaps reimbursement approval, as well. But we don't know that and I think we've all watched device companies struggle to get approvals in Japan. It's not a fast process, even when you're fast tracked.

Bill Plovanic - Canaccord Adams

For the new products, detection what have you, so the objective again you just stated was before July 2011. So that would also be a fiscal year '11 launch, correct?

Dan Moore

I want to be careful because, we are just fully launching Demipulse now that generator. We are launching two leads now. I think what we are after and building Milton and a team and bringing in not only the internal technology and the capabilities and the external is creating a product development cycles where we are bringing out incremental improvements. If you look at the device market, again a learning that we had with our key opinion leaders. They are not used to receiving devices and seeing incremental improvement.

So bringing out another generator that has some additional capabilities, I don't want to sit here and say that by July 2011, we will have a seizure prediction product that does everything. What we're saying is, we're lining up to bring out a series of products over the next several years, just like good device companies do, where we add capabilities to our existing products and continue to expand the capabilities of those products.

So, we've talked in the past about recording seizure activity, electronic seizure diaries, we've talked about detection, prediction, all of those things we want to incorporate into our devices over time. But, as I don't want to send the impression that by July of 2011 we will have the product that does everything that a physician can imagine.

David Wise

Bill, just as a reminder, July 2011 is actually now fiscal year '12. So I think it might be a little early to start including that in the models for next year.

Bill Plovanic - Canaccord Adams

Then on Demipulse Dan when you launch that your thoughts were a two tiered strategy, it's now over 56% of US units. What historically Cyberonics when they launched a new generator it become a 100% within months, obviously you are taking a different strategy. What do you expect the final penetration rate of the Demipulse to be in the next 12 months?

Dan Moore

We've said in the last call that we expect to be by the end of this year in the 55 to 60 range and that's about where we are. Every account it's been available now for a quarter, so I don't know that it will stop at 60, it may go beyond that. But the idea is the one you go to first are most likely the ones to take it.

And as you go over to more accounts it becomes harder and harder for those accounts to accept the new product, given the differentiation in price for example. So we've said 55% to 60% by the end of the year and we are sticking with that. But, it could go higher.

Bill Plovanic - Canaccord Adams

Then have you launched a new lead as well, with the premium price?

Dan Moore

Yes. In the last couple of years we've been in limited commercial release of two leads, both bringing more durability to the lead products. And those two products are out there in limited commercial launch, now the Perennia and the Perennia Flex.

Bill Plovanic - Canaccord Adams

Where are those single launch? What type of penetration and what type of premiums on those?

Greg Browne

Well maybe I could answer that one, Bill, but the premium on those is around 25% over the existing leads, and that itself dried our lead ASP up to over $4,500 in the US market in the last quarter, but the penetration is still relatively small. It's, I believe about 20%.

Bill Plovanic - Canaccord Adams

So, opportunity there, and then my last two questions were one you had other income of $493,000. What was that?

Greg Browne

That was reflecting some foreign exchange changes during the quarter. We saw some rapid movements in the dollar, in fact that declined against where we were at the end of the fiscal year. It's been on the roller coaster, and so that's reflective of those foreign exchange changes.

Bill Plovanic - Canaccord Adams

I think you mentioned you are going to have, at some point take a fully tax rate. What tax rate would you expect to take, when do you think that will happen?

Greg Browne

Bill, it's a little bit early to tell. We have just to reiterate, we have approximately $240 million of tax losses in the US, and as we go through this fiscal year, we will have reached the point where it becomes reasonable to assume we'll be able to absorb at least some of those on an ongoing basis, a realistic number.

So I guess the tricky part of this is, we are working with our tax advisors to calculate what the ongoing tax rate from that point is still some work ahead of us, so on the next call I will be able to give a bit more color about that.

Bill Plovanic - Canaccord Adams

I don't understand to get to the $0.23, Greg, if I take the 7.9 million divided by 27.7 million shares, I'm not getting that. Is there another calculation I need to be making?

Greg Browne

There is and it looks a little confusing on this quarter because in the first quarter of last year we were not buying back convertible note. So essentially, most of the gain on the purchase of the convertible notes is removed from the net income prior to calculating diluted earnings per share.

Bill Plovanic - Canaccord Adams

How much of that would be removed, all of it?

Greg Browne

Well, it was just short of $1.5 million.

Operator

Our next question comes from Anthony Petrone with Maxim Group.

Anthony Petrone - Maxim Group

A couple on, Dan, you mentioned the number of new accounts that you had sold into or let me take a step back, the number of accounts you sold into the quarter, so I think the number was 430 plus accounts, maybe a little bit north of that. Just trying to drill into that number a bit and see is that is net new physicians or what is the mix between new and existing physicians within that number?

Dan Moore

I don't have that number. I think what's most important for us is that we've got the right therapeutic consultants out there who are assessing their territories and the opportunities within their territories. We are not encouraging them to go find new accounts.

If they believe that there's a new account or a new physician where they should go, they go there. If they believe that they should stay within the accounts they are in and just go deeper in that account with either more physicians or try to penetrate the existing physicians they have and get them to do more cases, they are paid to make though decisions everyday.

So the only reason for bringing up that number, I think was there was some concern over impact of reimbursement and accounts choosing to not do this procedure. And if anything, we've seen a slight increase even though we are not out encouraging people to go, our people being our reps to go wide.

Anthony Petrone - Maxim Group

I guess follow-up to that would be the penetration into these existing accounts. Have you seen that number increase overall? Are you seeing the physicians really going ahead and using this on six out of ten patients, whereas maybe years ago it was only two or three out of 10?

Dan Moore

I don't have numbers to support that yet. I would guess there are some physicians who have increased their prescribing of VNS and there are others who are not anywhere near where we think they should be.

Anthony Petrone - Maxim Group

You mentioned also I guess moving on to price, price was a driver in the quarter. I guess, 13% growth in the quarter from price, but DSOs extended here a bit. Is there any change I guess to the outlook on how you approach the market in terms of price and credit extensions here?

I know you mentioned that one distributor has new terms. Is that something that you'll be moving into other distributors and to other accounts? And how are you going to approach price and credit extensions going forward here? Is it going to change significantly?

Dan Moore

Let me deal with that one. Let me break it into two parts. First of all from a price standpoint, we are not approaching the price in the market any differently on an ongoing basis than we have done over the last two years. As you know, when the management team was in place here, Cyberonics had not taken a price increase for over three years. We took a price increase in January '08.

We took a small price increase at the beginning of this calendar year, and it would be adding [attention] to continue with that approach to the market. With respect to the receivables, I think it's really a surprise that given the economic conditions in this country and I've to say that we haven’t seen our receivables increase prior to this point.

With respect to international, we entered into a number of new distribution agreements in the last fiscal year. Certainly more than one distributor was granted new terms at that time and obviously an increase in those receivables was as expected as a result. We did see a tick up in the US receivables this quarter, and we'll continue to monitor that on an ongoing basis, but it won't affect our approach from a pricing standpoint.

Anthony Petrone - Maxim Group

I see and then moving down, I guess the P&L, Greg couple of questions on expenses. What kind of expense do you expect from, you've mentioned a number of additional educational programs planned through the end of the year and then you have somewhat of an offset from the TRD Post-Approval study. So where should we expect G&A for the end of the year? Is there much change there?

Greg Browne

The G&A expense line will pick up through the year, not so much from the marketing programs, but really more from their international activities and bear in mind that a number of our international expenses are the euro or pound denominated. And so, the way the currency moves will also have an impact there.

I think the biggest change you will see, as we go through this year is likely to be on the R&D line, which is I said encompasses R&D and epilepsy, the clinical work on depression that remains as well as, some quality in compliance and regulatory expenditures. So, we do expect that number to increase through the balance of the fiscal year.

Operator

Our next question comes from Sean Lavin with Lazard.

Unidentified Analyst

This is [Patrick] in for Sean. Looks that you had a good quarter OUS. I was wondering if you might be able to give a little more granular information, break out the leads in some of the pricing because, I know currency has been moving around a lot there in the last quarter?

Greg Browne

In terms of the pricing internationally when compared to Q1 of last year we saw a reduction as you expect. We mentioned we had negative currency, where with currency headwinds this quarter compared to Q1 of last year, and that drove down the generator ASP internationally by 5.5% and the leads by almost 10%. But with that roller coaster in the dollar compared to the fourth quarter of fiscal year '09, we're actually up by 5.5% on the leads. So the actual ASP international on generators was $9801 and on lead it was $2239.

Let me add a little commentary there because as a key pillar for this company strategy was to expand internationally and that remains. We are not overall concerned about the mix of what happens when you do that. We want to expand our penetration in Europe. We're building businesses in Latin America made up of a variety of countries. We are doing the same in Asia, and the Middle East.

So as we bring new countries on, what's most important is that we are putting the right people there who can go into the market and do the right things to build VNS and then other epilepsy device businesses in those markets, and over time the currencies they go up and down and you guys have all been through this as well. So our primary focus is really building strong businesses in those countries and not worrying so much about currency fluctuations. Sometimes they work for us, sometimes against us.

Unidentified Analyst

Last question I've got is on lead pricing. I guess with the new leads in the mix, where do you expect it to settle out and will that have an impact on OUS lead pricing?

Greg Browne

Well it will and let me answer that as two questions. We do expect that the lead pricing will continue to increase on the assumption that the two new leads Dan mentioned increase their penetration of the market as we go forward, we'll be increasing our launch cadence if you like on the most recent one of those.

So we should expect that price to move higher slowly in the US, outside the US, of course, the introduction of the leads will be somewhat slower because of the varying regulatory approvals required in different markets. And as Dan alluded to we have not only currency fluctuations, but as well as distribution mix changes where we serve direct in Europe and through distributors in other markets.

So, we will be looking to increase our pricing for the new leads in every market that we enter, which has been our consistent policy with respect to the Demipulse as well.

Dan Moore

It's about 9 o'clock central, so if we can take one or two more questions and then we're going to move on.

Operator

Our next question comes from Margaret Lovatt with Suntrust Robinson Humphrey.

Margaret Lovatt - Suntrust Robinson Humphrey

This is Maggie in, for John. I just got a couple of questions for you. Congratulations, on the quarter first. Greg thanks for the color on the DSOs. Another question on the balance sheet, it looks like deferred revenue slightly ticked down, Is there anything to that and?

Greg Browne

No. What's happening there is that reflects the license fee that we received with respect to our audacity and some related indications that it was deal done in December '07. And as a reminder, we are recognizing that revenue over six and a half years and so, as we do so, that deferred license revenue will fit down next quarter.

Margaret Lovatt - Suntrust Robinson Humphrey

Then just my second question, I was wondering if you could provide a little bit more color just on why your strategy is to go deeper into current accounts rather than wider. It just seems like getting more physicians to prescribe VNS is a pretty fast way to get to increase new patient growth?

Dan Moore

I think its sum of both. I don't want to represent as deep only. Again, I think the important thing is that we've hired the right people who can decide in a particular geography, in a particular account, whether they go deeper or to go wide and that can even vary within that geography, and that's a global phenomenon as well.

Operator

Our next question comes from Keay Nakae with Collins Stewart.

Keay Nakae - Collins Stewart

I just had a follow up question related to your replacement sales. Given the caveat that there is variability between one patient to the next, is there a mark difference in the longevity of the 101 versus the 102 in terms of the battery life?

Dan Moore

Keay, yes there is based on the experience that we've had to-date, as well as the specifications on the battery. What we've said in the past that on the 101 model the indicated life or range, if you like of battery life is between five and 11 years with an average somewhere in the middle there and on the 102 device, we indicated the range is between three and eight years and we should expect the life of around four to five years on that.

Operator

The question comes from Bill Plovanic with Canaccord Adams.

Bill Plovanic - Canaccord Adams

Thanks for taking the follow-up. Dan, I was wondering if you could help us internationally. You are doing very well there and it looks like that's going to be a good driver for you. Can you give us some color on maybe what the distribution channel looks like today versus 12 months ago?

How many more countries you are involved in, any sort of metrics that can give us a feeling of what type of investment you have made there and timing on when it's paying off, what have you? Thanks.

Greg Browne

Let me take that. Over the last 12 to 15 months now, James has put in place Regional Managers in the Middle East, in the Far East and in Latin America. We are now in the process of supplementing those area managers if you like Regional Managers with some clinical support and other activity. We are hosting regional training sessions and so on for the distributors.

In Europe, as Dan mentioned we've changed a number of sales people. We have added sales people in several markets including Spain and soon to be in Switzerland. We added in the Benelux countries. We have significantly I would say increased our distribution activity in Eastern Europe and other parts of Europe.

So, I think what you are seeing is a significant investment in people in those markets and what that means in practice is that, for example, in Latin America having a person on the ground, we have much greater attention being given to the distributors in those markets on a regular basis, as oppose to the more ad hoc sales that was being made in the past.

We've seen a good growth in our Latin American market and I don't have exact number of countries in Latin America. Now we sell to 41 countries overall last quarter. In the Middle East for example, we had one master distributor a year and a half ago.

Now we have at least seven to 10 different distributors in each market, which again means that the customers in those markets are getting far more attention individually. I think it's an important growth driver for us as Dan mentioned. We continue to see improvements in all regions and growth in all regions and I truly believe that will continue over the fourth coming years.

Dan Moore

Yes, let me just add a little bit to that, because I think it's very important to understand that the transition that was made. Like many US smaller companies, more or less a start up, you have your domestic business and then you try to create something in international and then go often to the best they can do that largely becomes, take the US products and throw them overseas and it’s a distribution model.

What we changed from the beginning when we came in, we start talking about not only the growth that they were achieving, but we expected profitability and we could run these businesses profitable in every country and if we couldn't, there was no reason to be there.

So, part of the change in the 50% of the people over the last year has been to get the right people in, people who come in and expect not only growth, but expect to contribute profitability, and those people go out and hire distributors and hire people who are a different breed. They are not the distributors that are really just distribution channels, movers, logistics, a product, these are the distributors that we go out and find.

We expect them to develop a market and develop it right. And that I think built the foundation for like some of the larger companies have done where 40% to 50% of your business becomes international and that's what we expect, and that's probably be more important than what’s happened in any particular country.

Bill Plovanic - Canaccord Adams

Okay, great, thanks for that. I appreciate it.

Dan Moore

With that I know we are over time here, and I really appreciate everyone's support. It's been a great nine quarters. We have no reason to believe that we can't continue to bring success to this business. We will continue to grow the business.

We will continue to do a lot of the things that you are not seeing that are behind the scenes that we have full confidence in and more important, the epilepsy thought leaders are convinced that we are on the right path and more of them are lining with us not only for the present but for the future. So I appreciate everyone's support and we'll talk to you again in the quarter.

Operator

This concludes today's conference. Thank you for participating. You may now disconnect.

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Source: Cyberonics Inc. F1Q10 (Qtr End 07/24/09) Earnings Call Transcript
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