Somanetics Corporation F3Q09 (Qtr End 08/31/09) Earnings Call Transcript

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 |  About: Somanetics Corp. (SMTS)
by: SA Transcripts

Somanetics Corporation (SMTS) F3Q09 Earnings Call September 17, 2009 10:00 AM ET

Operator

Good day everyone and welcome to the Somanetics Corporation third quarter 2009 financial results conference call. Today’s call is being recorded and webcast.

With us today from the company are Bruce Barrett, the company President and Chief Executive Officer; Bill Iacona, Chief Financial Officer and Mary Ann Victor, Chief Administrative Officer. At this time for opening remarks I’d like to turn the conference over to your host, Miss Mary Ann Victor. Please go ahead.

Mary Ann Victor

Thank you. Good morning everyone. Thank you for attending our third quarter 2009 investor conference call.

Statements concerning our future business, operating results, expected net revenues, anticipated investments and other guidance are forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. Such statements are based upon management’s expectations as of today, September 17, 2009. You are cautioned not to place undue reliance on these statements. Information contained in these statements is inherently uncertain and actual performance and results may differ materially.

Factors that could cause results to differ materially from any forward-looking statements include economic conditions in general and in the healthcare market, including the recent global economic crisis; market demand for our products; our dependence on the INVOS System and disposable sensors; and on distributors for a substantial portion of our sales; single source suppliers; competition; the management of our growth; our ability to attract and retain key personnel; the potential for product liability claims; government regulation; challenges associated with developing products and obtaining and maintaining regulatory approval; research and development; the lengthy sales cycle for our product; employee turnover; changes in actual or estimated future income; changes in accounting rules; enforceability and cost of enforcement of patents; potential infringements of others patents; the effect of acquisitions and other factors set forth from time to time in our SEC filings.

The company undertakes no obligation to revise or publicly release the results of any revisions in today’s forward-looking statements.

Now I will turn the call over to our President and CEO, Bruce Barrett.

Bruce J. Barrett

Thank you, Mary Ann. Good morning and welcome to our call.

We began our third quarter with the extension of our exclusive distribution agreement with Covidien in Europe, the Middle East and Africa. This extension enables us to move forward developing our INVOS Cerebral/Somatic Oximeter business in these important markets with an excellent partner.

In August we completed our initial hiring and training of personnel in Europe to support Covidien. We now have four people dedicated to the European market, with one person in each of Germany, Italy, France and Spain.

Also during the quarter we continued to make progress establishing the INVOS System in adult cardiovascular surgeries and laying the groundwork to capitalize on our entry into the neonatal ICU. We also experienced early success with adoption of the INVOS System for use during soldier surgeries performed with patients in a seated position, a new market opportunity that I will discuss later. And we initiated the launch of our Vital Sync System that integrates data from various bedside devices.

In August we filed a patent infringement and unfair competition complaint against CAS Medical Systems in the district court for the eastern district of Michigan. The complaint asserts that CAS Medicals’ FORE-SIGHT Cerebral Oximeter System infringes at least three of Somanetics U.S. patents and that CAS Medical has engaged in a pattern of false and misleading statements in advertising and promoting their device.

From a financial perspective, hospitals continue to limit capital spending and slow adoption of new technology to cope with the adverse economic conditions. U.S. invo system hardware revenue of nearly $1.3 million was almost double what we produced in the second quarter and similar to the same period a year ago. Yet we still found it difficult to finalize capital sales projects.

Purchases of hardware by our international distribution partners were down 58% against a very strong comparative quarter, but also reflecting the global nature of the economic crisis. In the U.S. market sensor revenue increased 13% over the same period a year ago. Sequential growth for sensors over the second quarter was similar to the level we’ve experienced in recent years. Disposable sensor purchases by our international distribution partners increased more than 20% over the same period a year ago.

We delivered strong earnings in the quarter, with diluted earnings per share of $0.17. Throughout the year we have slowed expansion of the U.S. sales and education team and generally managed our investments in response to the adverse economic environment.

We have completed beta testing for our new Vital Sync System and in August we completed initial training of our U.S. field sales and education team to initiate promotion of the system. While this is a capital sale that will take time to produce revenue, we are encouraged by early experience in the marketplace. In particular, early customer feedback reinforces our belief that the Vital Sync System will provide us a tool to accelerate research and understanding of the INVOS System, as well as further differentiate our product in the ICU environment.

In the neonatal ICU, customer response to the INVOS System has been very positive and we are encouraged by feedback from our early users as well as our clinical researchers. While the economic environment has greatly slowed early adoption in the neonatal ICU, we continue to work a growing number of new business opportunities as well as pursue further development for the value proposition for the INVOS System in this important market segment.

With regards to the value proposition, we are working to reduce the cost of use by extending the number of days a sensor can be used on a patient. Currently our sensors are labeled for 24 hour use and are difficult to re-adhere once removed. To extend the useful life of a sensor and reduce the cost of monitoring per day, we are validating and preparing a new FDA 510(k) filing to obtain clearance for an off-the-shelf adhesive solution that can be placed between the sensor and the patient that will permit removal and reapplication of the same sensor for several days. Our neonatal customers and advisors have indicated that extending the use of our sensors in this way would largely address the cost of use issue.

On the value side of the equation, many independent studies are ongoing that we expect to further establish the benefits of use of the INVOS System in the neonatal ICU. Certain of these studies are establishing normal and critical values for oxygen saturation of the brain, kidneys and bowels for patients of various gestational ages. This information allows clinicians to identify patients with abnormal vital organ profusion so they can take corrective action and assess the impact of the therapies. The results of one such study of 100 term and pre-term infants was recently published in the Journal of Neurovascular Research. These data give customers a basic understanding of the values they should expect in normal term and pre-term infants to use as a baseline for understanding when patients fall outside the norm.

Also, Dr. Istvan Seri from L.A. Children’s Hospital, who is a leading expert in hemodynamics and shock in neonates, directed and completed extensive neonatal piglet research in the period. This series of studies assessed the impact of various cardiac drugs routinely used in neonates on brain, bowel and kidney oxygenation and profusion. The results of these experiments seem to conclusively demonstrate the value of the INVOS System in managing cardiac drug use in neonates.

Other studies are evaluating the relationship between INVOS System values and clinical outcomes or pathologies. For example, we are very encouraged by early data evaluating the role of monitoring the regional oxygen saturation of the bowels in pre-term infants at risk of bowel ischemia or neck. Several studies relating to this topic are ongoing, and as these and other results are published we expect to build a stronger argument for use of the INVOS System in the neonatal ICU.

Overall, we are pleased with the progress we are making with our business in a challenging economic environment.

And now Bill is going to review our financial results in more detail for the periods. Bill?

William M. Iacona

Thanks, Bruce.

As we reported this morning, our net revenues for the third quarter were $12.5 million, a 1% increase over the same period of 2008. For the nine months ended August 31, net revenues were $35.5 million, a 5% increase over 2008. U.S. net revenues increased 10% in Q3 to $10.4 million and represented approximately 83% of our total sales for the quarter. For the nine months ended August 31, U.S. net revenues increased 5% to $28.4 million and represented 80% of our total company sales.

For the third quarter, U.S. disposable sensor revenues grew 13% to $9.1 million and our INVOS hardware decreased 2% to approximately $1.3 million. For the first nine months of 2009, U.S. disposable sensor revenues increased 15% to $25.6 million and our INVOS hardware revenues decreased 42% to approximately $2.8 million, reflecting slower hospital capital equipment spending in the U.S. as a result of the current economic climate.

Our international net revenues in Q3 were $2.1 million, a decrease of 28% from $3 million in Q3 ’08, primarily due to reduced purchases of our INVOS System monitor by Covidien in Europe, reflecting slower hospital capital equipment spending in Europe. Year-to-date our international net revenues increased 5% to $7.1 million.

For the quarter ended August 31, we placed 89 INVOS monitors in 53 hospital accounts in the United States. Internationally we sold 87 INVOS monitors. For the nine months ended, we placed 277 INVOS monitors in the U.S. and 360 OUS. As of August 31, 2009 our installed base of INVOS monitors in the U.S. grew to 2,800 monitors in more than 750 hospitals. In the third quarter, our U.S. sensor unit sales increased 10% to 83,540 and year-to-date U.S. sensor units grew 11% to 235,806.

Our combined pediatric and neonatal sensor sales accounted for approximately 35% of total U.S. sensor revenues and 27% of total U.S. sensor units for the quarter and year-to-date 2009. Total company sensor unit sales increased 12% to 132,130 in the third quarter of 2009 and increased 17% to 366,726 for the nine month period.

Gross margin was strong at 88% for the third quarter of 2009 compared to 86% in the same period a year ago, primarily due to an increased percentage of U.S. sales in Q3 of ’09. Year-to-date gross margin percentage was 87% for 2009 and 2008, consistent with our expected gross margin.

During 2009, our operating expenses have increased, primarily as a result of continued investments in sales and marketing and research and development, the establishment of our international BV and related branches in Europe and the hiring of international sales employees. For the three and nine months ended August 31, our operating expenses have increased 20% and 14% respectively compared to 2008, primarily due to items such as trade shows, sales training, recruiting, international sales hires and administrative expenses, as well as investments in R&D headcount and project expenses.

Q3 operating income was $3.2 million compared to $4.2 million a year ago, and year-to-date operating income was $7.6 million compared to $9.1 million in the first nine months of 2008.

Income before income taxes for the quarter was $3.5 million and net income for Q3 was $2.2 million or $0.17 per diluted share. Year-to-date income before income taxes was $8.5 million compared to $11.3 million a year ago and net income for the first nine months of 2009 was $5.3 million compared with $7.1 million in the same period of 2008.

Our balance sheet and operating cash flow continue to remain strong with cash, marketable securities and long-term investments totaling approximately $77.7 million as of August 31. And cash flow from operations for the first nine months of the year were approximately $7.9 million. The company has no borrowings.

I will now turn the call back over to Bruce, who will talk about the business for the remainder of 2009.

Bruce J. Barrett

Thank you, Bill.

At the end of the second quarter we offered guidance for net revenues in the range of $50 to $52 million and operating margin of approximately 20%. To achieve $50 million in revenue we need to deliver the same percentage of our total year sales in the fourth quarter that we’ve achieved in each of the past few years. While economic headwinds may pose a threat, given this history and our new business pipeline we are maintaining our revenue guidance.

With regards to operating margin, we previously offered guidance that operating margin as a percent of sales would come in at about 20% on continuing operations. Through nine months, operating margin is at 21.4% and we remain comfortable with our guidance at the 20% level.

As we close out fiscal 2009, we will continue our efforts to develop the INVOS System opportunities in the cardiovascular surgery, pediatric and neonatal ICU market segments. We estimate these markets represent potential annual disposable sensor revenue worldwide of $800 million.

Over time, there are many other markets that we plan to pursue with the INVOS System. For example, today there is developing market interest in addressing the risk of adverse cerebral outcomes associated with shoulder surgeries performed with a patient in the seated position. There have been several reports of severe adverse cerebral outcomes in patients during this procedure. These adverse outcomes are believed to be the result of inadequate cerebral profusion pressure and oxygenation despite apparently adequate mean arterial pressure. This topic has been the subject of articles in the Anesthesia Patient Safety Foundation Newsletter over the past year, and there is an entire session dedicated to this topic at the upcoming American Society of Anesthesiologists annual meeting in October. At that meeting, we will be working to make the link between the risk of adverse cerebral outcomes in these procedures and the potential safety benefit offered by the INVOS System.

Already our sales team reports 16 hospital centers using the INVOS System in shoulder surgeries. This is a logical additional sales call that our people can make while selling the INVOS System in our core target markets and may represent another avenue to contribute to our growth moving forward.

In summary, we believe we are taking proper steps to strengthen our leadership position with the INVOS System. We have a strong balance sheet and financial profile. We have some exciting developing opportunities and we believe we are positioned to deliver a solid finish to the year.

And now, Bill and I would be glad to answer any of your questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) Your first question comes from Gregory Hertz – Citi.

Gregory Hertz – Citi

So just a couple questions, and I appreciate the sensitivity in the matter but hoping to get some viewpoints on the pending patent litigation. I’m just wondering first off do you think that CAS their marketing tactics are serving solely to take share from you or is it just a general slowing of adoption for newer markets outside of cardiac surgery as well.

Bruce J. Barrett

Well I think if we just talk about competition in general, any time you have competition it tends to slow the sales cycle simply because you have customers who are going to consider their options, so the sales cycle obviously gets slowed versus if you’re the only player in the game. There’s some impact on pricing in certain situations. And of course to the extent they’re selling product and we’re not selling in a certain situation, there is also impact on volume. So you know whether it’s CAS or any other person who might be in the market, I mean those are the influences that you have on what you’re trying to get done yourself.

Gregory Hertz – Citi

And then with respect to maybe a loose timeline, assuming CAS files a response by I guess the due date of the 30th of this month, can you provide a loose framework for timing on the next important step such as claims construction?

Bruce J. Barrett

Well I think really the next important step for us would just be when it comes time to meet with the judge probably later in October or November and determine what the process is going to be from a timeline standpoint, I think until then we really won’t know much. Right now I guess I can probably tell you just about everything I can tell you about you know the situation with the litigation which is simply that you know at least our counsel is suggesting to us that they think it’ll take a budget of about $3 million through a trial and that it could last you know depending on how fast the procedure goes sometime between 2010, 2011. And how much of that expense occurs in 2010 versus 2011, you know we’ll start getting some flavor for that I think once we find out what the judge is going to establish as a schedule.

Gregory Hertz – Citi

And is there any view at this point internally that you could share as far as the quantifying the impact of the allegations that you have in the lawsuit as far as you know dollar sales thus far?

Bruce J. Barrett

No.

Gregory Hertz – Citi

And the other question for Bill, I guess. The R&D has obviously it’s remained well below 5% for a while here and just wondering what kind of trajectory should we be looking for and what will drive the R&D higher as a percent of cost if you do in fact expect it to rise?

William M. Iacona

Yes, I think if you look at some of the projects that we have going on here and there’s some obviously that we’ve talked about publicly and others that we have here that we’re working on behind the scenes but we have the contract development agreement that we spoke to in the past with the Shirley Research Corporation out in Massachusetts, as well as continued development as we continue the launch here of our Vital Sync System. In addition to that, there’s other projects that we’re working on in parallel relative to advancements to the Oximeter, the INVOS System as well as advancements to the disposable sensor. So I think as you look forward you can definitely expect that you’ll continue to see increases in our R&D expenses, you know not only through the projects that we’ve just touched on but we’re also continually looking for other opportunities as well for ways to advance our technology as well as our competitive edge.

So you know in terms of percent of revenue you know I know we’ve never really spoken to that too much. It’ll probably increase slightly over time. You know we’ve always said that we don’t think you’re going to see our R&D as a percent of revenue going north of 5% you know too dramatically but in absolute dollars I think you’ll definitely continue to see more and more from the financial statements relative to R&D spend.

Gregory Hertz – Citi

And just one more if I can sneak it in here on Vital Sync. What’s the next step of stage of development there and does it currently allow for the incorporation of the INVOS sensor data at this point?

Bruce J. Barrett

I’ll speak to that, Greg. I guess there’s a few points to make with regards to Vital Sync. The next step for us is that we will be filing a new 510(k) for the addition of derived parameters and custom alarms and alerts shortly. So that would be the next feature step for the technology that exists in a standalone form. As far as being able to directly monitor cerebral oximetry with the Vital Sync, currently we do that through connecting our INVOS System into the Vital Sync such as we do other monitors into the Vital Sync. And that is a project. It’s a project that we slowed the start of this year while we got better educated on you know just the market for the Vital Sync and determining exactly how we wanted to approach it after getting a little bit of experience with the Vital Sync and with the economy being what it was. But that is a project that we’ll be jumping on as we go into 2010 is the combination of the technology so that you don’t need two boxes to achieve that goal.

Operator

Your next question comes from Gregory Brash - Sidoti & Company.

Gregory Brash - Sidoti & Company

You maintain your revenue guidance here. Just curious you know what gives you confidence you’ll see that $2 to $4 million sequential gain in revenue here in the fourth quarter? Are you seeing any improvement in hospital spending? You know it looks like your INVOS sales improved pretty nicely sequentially.

Bruce J. Barrett

Yes, I mean I guess it’s a couple of things. One is we just look logically. You know we’ve always seemed to have had a pretty strong fourth quarter. If you look at each of the last two years we’ve done 29% I think is the number, I looked at it a few days ago but I think that’s what it was, of our total revenue for a year were done in the fourth quarter. And 29% of our revenue this year would be $14.5 million in the fourth quarter which would put us at the $50 million mark for the year. So you know there’s just one little sanity test.

Then we look at our projects and we actually happen to have our regional sales managers in together this week and went through all the capital projects and where we stand with having closed new sensor business and what’s on the plate for the fourth quarter. There’s no doubt that with you know the slowness of people acquiring capital this year that there’s a larger pool of opportunities. You know I think the risk is that you know whereas we think we have a large pool relative to what we’ve had over the last couple of quarters that looks like it’s ready to close, you know the risk is that the hospital has just never released the capital. But we are getting some indications at least from certain centers that money is freeing up some and that they expect that they will you know be getting at least to the top items on their list, which we are in certain of these centers, before the year’s out.

You know we still have a lot of hospitals who just say you know some of its state dependent, but as to what the individual state’s economy is, but you know we have a lot of hospitals who still just say we don’t have capital. And you know as far as next year you know we’re not sure what to expect yet. Obviously our comps are going to be a little bit easier to deal with next year after the year we’ve had this year with capital, but at the same time our understanding is that hospitals expect to reduce their capital spending in 2010 again or at least their budgets. So we’ll just have to wait and see and take it quarter by quarter.

But we feel good about the business that we’ve got on the plate in terms of our opportunities for this quarter. We just have to see if we can bring some of it home.

Gregory Brash - Sidoti & Company

Can you touch a little bit on the shoulder surgery opportunity and what prompted you to go after that market? What’s the pricing like or the potential market size? Is it just wearing the sensor for a couple of hours during surgery?

Bruce J. Barrett

Yes. The procedure itself is basically a shoulder surgery that they perform in the seated position, which they call the beach chair position so they call it a beach chair procedure. What they find is that once you sit patients up their blood pressure may not really be reflective of what’s going on in the brain in terms of pressure and profusion. And what really prompted this is last year the Anesthesia Patient Safety Foundation which is you know an important group within the American Society of Anesthesiologists who’s particularly focused on patient safety during anesthesia, they put out a newsletter that talked about reports of severe adverse cerebral outcomes during this procedure. Because really obviously people going in to get their shoulder done, they don’t expect to walk out with a stroke or you know have a fatality during the procedure. I mean you think you’re going in for something simple.

From our standpoint yes, the investment is the same as the investment in the sensors for any other procedure. Its two sensors on the head, so it’s a $200, $250 investment in disposables. They’ll use it for the two hour procedure and then most likely that’s all they’re going to use it for because they’re really interested in it during the period they have the patient seated. And then these patients get woke up fairly quickly after the procedure and it should go uneventfully. We’ve always looked at procedures like this as you know it’s a very low incidence so less likely that people are going to make an investment of our nature to do the monitoring. However, with the attention that this procedure is getting, the problem that you have is this procedure’s often done on healthy younger individuals and it’s not the sort of individual that you want to find yourself having had a stroke with.

So there appears to be, due to all the attention that this procedure is getting, some degree of interest in people making the investment just from a safety standpoint in the technology. In fact just as an anecdote I know one of our region managers reported that they were at a regional anesthesia trade show this past weekend, and that the majority of the leads they actually took at the show were related to people just coming up and saying they wanted to see our product for this beach chair procedure. There was another article dedicated to this in the Anesthesia Patient Safety Foundation newsletter talking about what might cause this to occur. And it’s obvious that we need to make the link between the occurrence of this sort of event, now that people are very aware of the possibility, and the ability of the INVOS System to alert you if you had inadequate cerebral profusion pressure and oxygenation.

So you know we’ve got some business. Like I said we’ve got about 16 accounts that are using it. There seems to be a heightened interest. We’re going to promote this as one of the applications for the technology at the upcoming American Society of Anesthesiologists. It’s a straightforward call for our people to make on accounts that they’re already calling on. It’s just a little different customer in certain instances. And we’ll see if we can’t make some hay with it.

Our understanding is it may be worldwide an $80 million opportunity in sensors. We think there’s about 200,000 procedures in the U.S. so maybe if there’s another couple hundred thousand outside the U.S. So I guess in total that probably answers your question.

Gregory Brash - Sidoti & Company

Are you selling the monitors to this market?

Bruce J. Barrett

Currently we try to sell the monitors into any market we can. I can’t say that we have enough experience yet to see if we’re going to be successful selling them into this market or not. We see it as potentially some low hanging fruit that we should take advantage of and in this capital market whether or not we’ll have success selling the hardware versus loaning it, getting the projects done, moving on and taking our sensor sales, I don’t think we have enough experience yet.

Gregory Brash - Sidoti & Company

Did you hire any sales reps in the quarter? And has the new 510 (k) for the neonatal sensors has that been filed?

Bruce J. Barrett

I’m sorry. What was the second question? The 510 (k) on?

Gregory Brash - Sidoti & Company

The new indication for the neonatal sensors, the longer wearing?

Bruce J. Barrett

On the second question we are in the process of finishing the validation and it’s really not a new sensor, it’s really just getting appropriate labeling for the off the shelf adhesive to be used as a device that attaches our device to a patient. It’s currently labeled as a wound dressing so we just need to get the labeling proper for the adhesive for what we want to use it for, which is to attach our device. We’re going to be filing that 510 (k) next month when all the testing comes back that we’ve been doing related to that. So we would hope by January, February that we’re off and running with this as a solution. In the meantime we know quite a few customers are talking amongst themselves and have already discovered that they can do this and they’re doing it anyway. But we would like to be able to actively promote it on label as a way of addressing the cost of use.

On the sales force I guess the easiest way to answer the question is right now we stand with nine positions that we would like to fill but we have not filled but we’re actively recruiting for. Two of those are sales territories and seven of those are clinical education specialists, and they’re sort of scattered throughout the country as we try to increase our labor pool to help us with the incremental labor that’s required to run evaluations in the neonatal ICU.

Operator

Your next question comes from Jonathan Block - Suntrust Robinson Humphrey.

Jonathan Block - Suntrust Robinson Humphrey

I guess first one, it’s sort of a follow up on the sales and marketing, maybe it’s a little more simplistic. Can you remind me what the plans were in fiscal year ’09 in terms of the number of reps that you wanted to bring on when you gave initial guidance and then where you are today?

Bruce J. Barrett

Yes. I think when we gave initial guidance that the numbers were going to be that we’d end up with five regions, obviously each with a region manager. That we had installed a new position which we called the clinical development manager which is more of a clinical specialist who’s responsible for the ongoing education and training of the other clinical resources within the region, so five of those, one per region. And then there would be 29 sales representatives. And we still use one I think manufacturer’s rep in one area of the country who’s been very successful, so essentially 30 territories. And then we were trying to have an approximately equal number of clinical managers. So those were the numbers.

And basically we’re setting, still targeting those numbers, but we’re setting with two territories that we’re in the process of filling and seven of the clinical manager positions.

Jonathan Block - Suntrust Robinson Humphrey

So maybe I’ll follow up offline but just to be clear, to me your original plans you would essentially bring on like seven to nine bodies in the fourth quarter. Is that correct?

Bruce J. Barrett

Yes. If we ended up with exactly what we started out as our plan we would fill nine positions.

Jonathan Block - Suntrust Robinson Humphrey

So I guess you know just as a follow up to that, why so back end weighted? I mean you just described an $800 million sensor market that you do $50 million in rev, so you know you’re 6, 7% penetrated. You’ve got the dominant market share. Why haven’t you gotten more aggressive and you know go out there and hire what I’m guessing are a lot of talented bodies out there in this environment?

Bruce J. Barrett

I think its multi-factorial. You know one is is that a couple of openings are related to turnover and when you’ve got a seven person organization out there in the field as we have, you’re going to have always a couple, three I guess or so that you’re in the process of filling due to turnover. A couple of them have just been very hard to find the type of person that we’re looking for. We actually instituted a new procedure for testing to identify people who have the right characteristics for success, especially interested in these clinical managers’s role, and it’s created a little lengthier process for us for hiring people just because we’re being a little bit more demanding. I think we better understand what it is we’re looking for and we’re being more selective in filling those positions.

And then the third thing is, even though I agree with what you’re saying in this economy I think you can throw as many resources as you want at us but I don’t know that it necessarily means you’re going to sell that much more. And certainly as the economy pendulum starts swinging back I think there’s a better argument for that that you need to be throwing a lot more of the sales and marketing resource at it and capitalize on it for all the reasons you just said. But you know for example I don’t think it mattered if we had twice as many people selling capital this year, you’re just not going to get the money released. So we are somewhat measured in the way we’re approaching the business from that standpoint.

Jonathan Block - Suntrust Robinson Humphrey

I know you’re not giving specific FY ’10 guidance, but I just want to make sure I’m thinking about this correctly. You know you announced last time the Covidien deal. I think Bruce you mentioned its $2.5 million in price sort of beginning [feb], so maybe for your fiscal year ’10 it sort of means closer to $2 million if you would. That just drops or does that drop straight to the bottom line? I mean where I’m coming from is the $2 million should be $0.10 in EPS alone next year. Is that correct?

Bruce J. Barrett

Yes. I think there’s a couple things I think as it relates to Europe at least in terms of the way we look at it. We just brought on investments that are about $1 million in Europe and so maybe we’ve had a half year of that spend this year. So you’ve probably got $0.5 million in incremental investment in Europe next year just with the headcount and expenses related to maintaining the BV and the branches that we’re into. You’ll get about nine months of the $2.5 million in price is what we’re expecting. And then I think the question next year in Europe is just going to be, and I think it’s going to be true in Japan, too, the question is going to be on the hardware side. And my expectation next year is that we’re probably going to see that the ripple effect of the economic conditions are going to have an impact in Europe more as we move into next year, maybe more so than they did this year.

At least that’s what the feedback is that we’re getting from our partners. So you may see a little softness in the hardware side. But all in all, yes I think that’s kind of some color on what we’re expecting out of Europe next year, at least at this point.

Jonathan Block - Suntrust Robinson Humphrey

You know cardiovascular seems to have settled in there nicely, it was bouncing around but now it’s you know added 11% unit growth for the quarter, so sort of that 10 to 12% range. I’m still scratching my head on PICU NICU, you know correct me if I’m wrong but I have unit growth of 6% so you’re looking at sensors that have gone from the mid-50’s growth rate in ’08 down to 3% last quarter and now 6% this quarter? I realize what you said about the sensor growth but I guess my question is you know if you get what you’re looking for in terms of the label, does it actually take another step back before forward? Because now you’re going to have these customers that are going to take what was a 24 hour sensor using it for, I don’t know, 72 hours? And then once they see all the utility that accompanies it, the adoption increases? Can you maybe walk me through that?

Bruce J. Barrett

Sure. Yes, the growth in the U.S. on units for pediatric neonate was 80% in the quarter. You know that was up from I think 3.6% last quarter, but still not anywhere near what we wanted. And the kind of numbers you were quoting for 2008 is exactly why we sort of found ourselves in the position we’re in with this particular market this year. We would have never guessed that we would have found ourselves in a single digit sort of growth situation as we got into this, with the enthusiasm that’s in the market.

As we walk through the launch of an ability to extend the days per use of the sensor, I’m sure there will be individual situations where customers change it in 24 hours and now they’re going to use it for several days or they make it work for two or three days and now they’re going to make it work for four or five. But I think that is going to be such the exception because the people who are using this in any sort of volume right now have already come up with their own, homemade solution for how they’re going to make it work more than one day at a time. Because to use it one day at a time at the price that you know we’re trying to command is just onerous.

So basically you don’t have a lot of customers using it according to the labeling, one day at a time. And the labeling itself even doesn’t require that you change the sensor in 24 hours, it just recommends that you look underneath the sensor. The problem is it’s just not that easy to get it to stick again after you take it off that first time. So I don’t think you’re going to see a large amount of that. You may see a little bit. I think where the real bang is going to come is that you know people aren’t going to see this as something that’s too expensive to use whenever they can say you know if I put this on and I can use it for five days and it costs you know you’re talking $30 a day to monitor a critically ill neonate, you know that’s not so bad.

And I don’t just say that not knowing. You know we’ve talked to many of our current users who have expressed concern about the cost and they’ve said you know what, that would address our issue from a cost side. You know still for us to broadly use it, we probably need some more data, too. But you know at least from a cost standpoint we won’t be locking these things in a closet and have to beg for them to put them on a patient because they cost so much.

Jonathan Block - Suntrust Robinson Humphrey

So essentially it doesn’t change the way that someone currently practices. You’re just hoping that it brings on the incremental guy who is on the sidelines because of cost.

Bruce J. Barrett

Yes. I’m sure there’s a small percent of people it’ll affect. But for the most part we think it’s an upper.

Jonathan Block - Suntrust Robinson Humphrey

Bill, I always have to bother you on the housekeeping side. Just for the U.S. INVOS, when you say the hardware revenue, the 89 units going to about $1.2 million you know I need a big realized ASP to get there. So does that now include just a little bit from Vital as well?

William M. Iacona

Actually it does not. For the quarter of those 89 you can assume we sold just about half of them, so we did have a nice realized ASP on that. But there is no revenue in the second quarter at all related to Vital Sync. I’m sorry, third quarter.

Jonathan Block - Suntrust Robinson Humphrey

Just going forward how are you going to break that out? Is that going to be another line item?

William M. Iacona

Yes. We will. Sure. As we broaden the launch of the technology here in the fourth quarter and have revenues associated with Vital Sync, I’m sure we’ll be speaking to that.

Operator

Your next question comes from Charley Jones - Barrington Research.

Charley Jones - Barrington Research

Bill, first, could you just repeat how many total sensor units you sold in the quarter please? And then I guess you know while you’re looking for that, Bruce I was hoping you could tell us a little bit more about how you’re expecting them to use the neonatal sensor. Are you expecting hospitals to look under the sensor following you know a change in the labeling or you know leave it on for a couple of days without looking? And I guess implied in that question is, if there is an issue with the adhesive you know how do you resolve that? Do they just not look under the sensor?

Bruce J. Barrett

With regard to the first part of the question, it’s prudent in these neonates to always look beneath the sensor on an occasional basis. We suggest at least daily. So you know yes, they’ll still do that. I mean the issue with neonates versus adults is they have extremely sensitive and tender skin and so you know there’s always issues with adhesives in general on neonates and the risk of skin damage. So there will always be the need to make sure that you don’t have something that’s occurring beneath the sensor that you didn’t realize for long periods of time. So you want to make sure that you take it off, take a look. You know they move the patients, they do MRI’s on occasion, CT scans. I mean there’s things that they have to do that they want to take sensors off for, too. So this just allows them to take it off, take a look, do what they need to do, put the sensor back on and be able to do that for some period of time.

Charley Jones - Barrington Research

I guess I thought you were saying that they have difficulty keeping the sensor on after they’ve removed it and you want them to be able to use it for about three days.

Bruce J. Barrett

No, I did say that, and that’s the case now if you don’t use this off the shelf barrier that you put on the skin and then apply our sensor over it. If you just apply our sensor with the adhesive that is on our sensor and you take it off after 24 hours to look beneath the sensor, some people are having difficulty getting the sensor to reapply and stick reliably for a longer period of time again.

Charley Jones - Barrington Research

What is your expectation for annual operating expense spend for international you know going forward? I mean, what kind of run rate should we expect for international?

Bruce J. Barrett

I’ll grab that one. I mean we’ve got the full headcount over there and we’ve got certain administrative costs associated with that. We have one headcount in Canada who runs all of international. As far as Europe there’s a couple more headcount we would like to add. We don’t have the UK covered. We would like to put another person in Italy because the manager for Europe is in Italy and that would free him up to really do the overall European management role. Those two headcount we’re going to wait and just make sure that we’re getting the production out of what we’ve hired.

Our greatest concern with hiring is you know people in Europe in support of Covidien is the same concern that any small company would experience and we’ve seen happen many times. Which is when the manufacturer puts in their own people, the distributor tends to start relying on them too much and not selling enough on their own. So we want to make sure that our people are productive in the right way.

We did have a meeting with Covidien for a couple of days in August. It was a very positive meeting. I think the leadership’s clearly on board with helping us make our people productive and moving forward as a coordinated effort. So we feel good about that. But before we make incremental investments of a couple more headcount over there, we’re going to make sure the ones we’ve got are up and running and being productive.

We also would like to add a headcount in the Pacific Asia area to manage our relationships there and to go after some markets that we frankly just haven’t spent any time on yet. So you know you might have $1 million in expense, $1 million to $1.25 million in expense that we’ve already committed to and maybe another three quarters of $1 million or so that we would like to commit to as we move forward.

Charley Jones - Barrington Research

And Bill on the units?

William M. Iacona

Yes. So in the third quarter U.S. units were 83,540 and those were up 10%.

Charley Jones - Barrington Research

And what was the worldwide?

William M. Iacona

132,130.

Charley Jones - Barrington Research

Bruce, you know I know you can’t know for sure due to the SCS controlling the process, but could you discuss whether you expect data to be presented this January?

Bruce J. Barrett

I don’t expect data to be presented this January. We do have some information on the process. There was a query that was made of the database by a clinician who’s very interested in you know in ultimately presenting and publishing results when there’s something statistically significant to present. The query that he made, the response from the SCS was that the data is not sufficient yet in terms of numbers to be statistically significant. So they’re not going to present anything that’s not statistically significant. So enrollment continues. We don’t know exactly how many patients are going to be required. There’s other queries that will be made of the database to see if there’s other questions that could be asked that weren’t asked by this clinician this time around that might be able to shed some light on a statistical result.

But given that and given the fact that the deadline I think for the SCS was probably mid-August if I recall, that’s usually when it is, to present in January and that deadline’s passed, unless someone’s done something that’s not someone that we’re communicating with, there won’t be anything presented in January.

Charley Jones - Barrington Research

Do you guys expect to do any clinical studies over the next year for shoulder, diabetes or cardiovascular?

Bruce J. Barrett

There are going to be ongoing studies. You know we’re not currently planning to make a major investment in a large study, you know like a prospective randomized multicenter trial. We’ve gone around and around about that with the cardiovascular market. And we’ll go around and around about it again this planning process. I’m sure that will be another thing on the table that we ask ourselves, is that something that we want to commit our resources to do. There’s a variety of reasons why we’ve chosen not to to date, one of which is just it’s extremely difficult to coordinate a study like that when everyone has different protocols for doing cardiac surgery and it’s very difficult to get compliance in an OR setting for this sort of a device for an intervention study.

The shoulders there is actually a couple of studies that are ongoing or planned, but the incidence of severe adverse outcomes in shoulder surgery is so low that I don’t think you could ever do like a multicenter trial that shows that you reduced the incidents of stroke for example. The incidence is like .002% or something like that. So you’re never going to get that kind of data. But what you can get and we’re already really getting is you can get case reports and you can get some quantification of the frequency of patients undergoing shoulder surgery, of de-saturations that would be considered significant de-sats. But as far as saying that we’ll ever have a study that shows you reduced stroke in shoulder surgeries the incidence is just too low to ever prove.

Operator

Your last question comes from Anthony Petrone - Maxim Group.

Anthony Petrone - Maxim Group

A couple with guidance. We’ll start there. You’ve answered most of my questions there. I just have a question on mix as we head into the fourth quarter. Go back to 4Q of last year, from the [equipment] quarter so we have a tough comp coming up. It seems that there’s a little bit more visibility in terms of cap equipment, sensors are certainly strong here so as you look into the next 90 days how does that mix kind of look when you make this assumption for guidance of almost $14.5, $15 million?

Bruce J. Barrett

Yes. I’m trying to picture it in my mind exactly what we’re really expecting on the capital side. I mean we did about $1.3 million in the U.S. this quarter. You know we did $2.7 or $2.8 last year in the fourth quarter in the U.S., which would be a number that would be on the high end of where we might end up I think this year. You know we’re looking for something more in the $2 sort of range to get ourselves where we want to be. Internationally I think you might actually see a little bit of reduction in capital versus last year. I think we had a strong capital finish last year.

And then sensors, you know I’m still anxious to see another quarter on this adult sensor. I think it was Jonathan who mentioned that you know we settled back down after growing about 15% in adult sensor units in the second quarter, that we were back in the 10 to 12% range. You know we sure are closing quite a few accounts and we’ve closed a couple of large accounts recently that can actually impact our numbers. So I’m anxious to see fourth quarter because from the activity I think we would do a little bit better on adult sensors. And I think we’re going to see some uptick on the pediatric neonatal sensor side. So it’s a combination of things. I don’t think we’re expecting you know any kind of stellar result in any one category that’s going to be required to get us up there. It’s a little bit of everything.

Just the fact that fourth quarter [inaudible]. Census is usually a little bit better in the fourth quarter.

Anthony Petrone - Maxim Group

If you can, Bruce, can you elaborate a little bit on some of those accounts you mentioned and closing a couple of large accounts. Was that equipment up front this quarter that hit or are we going to see a follow through in census from those deals close in this quarter, perhaps in the current quarter we’re in now?

Bruce J. Barrett

Actually the largest account that we closed in cardiac, and we don’t mention account names for the most part, but the largest account that we closed will do about 1,200 sensors a quarter. And we only saw I think a couple hundred of those last quarter, because it was closed at the very end. And the capital associated with that is expected to occur in the spring of next year because they didn’t have the capital this year, but they are intending to pay for the capital.

Anthony Petrone - Maxim Group

That brings me to my next question and I guess as it relates to guidance somewhat here. You mentioned hospitals looking into 2010 and cap equipment may be tough. What percentage of the hospitals that you’re dealing with are relying on their own budgets? And what percentage of these hospitals are depending on state budgets? I mean how much of a factor do you believe that would be moving into next year?

Bruce J. Barrett

I can’t say that I have a percentage to offer up. I just know that when you look at states like California and Michigan, you know we have the good fortune of living in the state of Michigan but their economy is obviously the worst in the country.

Anthony Petrone - Maxim Group

But the Tigers may make.

Bruce J. Barrett

Yes, the Tigers are good. Finding capital seems to be even tougher than in certain of the other states. Whether that’s a state budget issue or just general economy and people not going in for procedures, so revenue in the hospitals are down and all these other factors. It’s hard to say. But there does seem to be some state related or region related capital influence. It may not be state budgets, though, that are driving it.

Anthony Petrone - Maxim Group

And then lastly in guidance, Vital Sync, is anything in there for the fourth quarter? I know you have three in the field right now and there’s still a little bit to go in terms of approval. So are we seeing very little in the fourth quarter from Vital?

Bruce J. Barrett

Yes, we’re assuming very little. You know if we can get $100,000, $200,000 out of it I would be satisfied. Its more just implementing the process. I mean we know it’s a capital cycle so to sell anything in the fourth quarter is basically expecting that people have a few capital dollars that we can shake loose because they want it really quickly. Otherwise it’s going to be something they’re going to have to budget for. And frankly since most of the activity will be as we move into 2010 I would think people who are really budgeting for it are going to be budgeting for 2011. But we did sell our first one to one of the three beta sites as we started off this quarter. So we’re at least on the board. And you know we’re excited what the potential is, especially strategically.

I mean you know this was really, just to be clear, we think it’s another revenue stream over time but you know we’re realistic about what kind of revenue stream that might be in this capital environment. But strategically we think this thing really is going to set us apart in the ICU and make it to where we have a really sustainable competitive advantage there to the extent that we can be successful getting people on board with these types of features.

Anthony Petrone - Maxim Group

Two more here, if I could sneak these in. One would be on you mentioned slowing down the investment in sales and marketing. I’m wondering what the capacity of sales is to meet the level of big business activity if indeed we move out of this malaise in capital spending. So do you feel if we kind of get into the middle part of next year, will the company look to hire ahead of that? Or how are you gauging that change in the marketplace? And will you be in a situation where perhaps you’ll be playing catch up if indeed you don’t have the amount of feet on the street that you would in a better environment?

Bruce J. Barrett

Yes, and I guess the answer to that is we’re always ready. You know we’ve got the balance sheet and we’ve got the margins that if we think investing is going to drive the top line that it’s worthwhile doing. So certainly as the economy improves or unrelated to the economy the things that we’re doing start having a noticeable impact on our ability to move product, then we’re going to add. And the investment that we would add to would certainly be the field selling resource.

Now in lieu of that you know our intention is we have R&D increases in spending that we expect that Bill alluded to earlier that you know will be of at least some pace faster probably than sales are growing, even though you know we’re not going to double or triple R&D. And you know we just have general growth in our business that we’re going to have to support. But we’re big believers in you feed the hot hand. Its just in this economic circumstance its hard to find the hot hand that you just want to throw a lot of resources at.

Anthony Petrone - Maxim Group

And last on CAS Medical patent infringement, I know you’re probably not at liberty to speak much here, but they recently filed for a labeling extension and received it late August. Is that changing? It seems like it was more of a reactionary event. I’m sure they had it in the works for quite some time. Does that change the approach here in terms of the infringement? I know there’s some details that’s probably a longer answer than for the call and we could do this offline if need be.

Bruce J. Barrett

Oh no. I think I can easily answer that because I don’t think their labeling changes have anything to do with you know the patent situation. So no, that doesn’t change anything.

Operator

And this does conclude the question-and-answer session. And for closing remarks, I’ll turn the conference back over to Bruce Barrett.

Bruce J. Barrett

Thank you and thank you all for joining us again this quarter. We have no closing remarks, so we look forward to talking to you again at the end of our year. And at that point we’ll provide you our guidance for 2010. Thank you.

Operator

This does conclude today’s conference. Thank you for your participation.

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