American Medical Systems Holdings, Inc., Q3 2009 Earnings Call Transcript

American Medical Systems Holdings, Inc., (AMMD)

Q3 2009 Earnings Call

November 4, 2009 5:00 pm ET

Executives

Anthony Bihl - Chief Executive Officer

Mark A. Heggestad - Chief Financial Officer

Analysts

Jared Holz – Thomas Weisel Partners

Peter Lawson – Thomas Weisel Partners

Tom Gunderson – Piper Jaffray

Jonathan Block – Suntrust Robinson Humphrey

[Andrew Olson] – Morgan Stanley

James Sidoti – Sidoti and Company

Abigail Darby - J.P. Morgan

Jose Haresco – Brean Murray, Carret & Company

Tom Kouchoukos – Stifel Nicolaus

Brooks West – Craig Hallum

Jayson Bedford – Raymond James

Presentation

Operator

Welcome to the AMS Q3 2009 earnings conference call. All lines have been placed on mute to prevent any background noise. (Operator Instructions). Mr. Bihl, you may begin your conference.

Anthony Bihl

This is Tony Bihl, CEO of American Medical Systems. I am dialing in today from Beijing, China, where we were conducting some business reviews and meeting with physicians here in this important region of the world. Also on the call this afternoon is Mark Heggestad, our Chief Financial Officer, who is in our headquarters in Minneapolis.

Thank you for joining us today on this call to discuss American Medical Systems’ third quarter results. Before continuing, I must preface all comments with the Safe Harbor statement. Some of the statements made today will be forward-looking and are made under the Safe Harbor provision of the Private Securities Litigation Reform Act of 1995. Any such statements are subject to risks and uncertainties that could cause actual results to differ materially from those anticipated. Those risks and uncertainties are referenced in today’s press release and described in our most recent Form 10-K and other recent filings we have made with the Securities and Exchange Commission.

During this call, we will be discussing certain financial measures which differ from the comparable measures prepared in accordance with Generally Accepted Accounting Principles or GAAP. A reconciliation of these non-GAAP financial measures to the related GAAP financial measures can be found in the American Medical Systems’ third quarter 2009 earnings release including in the financial tables which are part of the release. With these statements, we can move forward reviewing the AMS business as covered in our press release issued earlier today.

I’ll begin by summarizing our overall results for the quarter and review the product line performance within each of our businesses. Mark with follow with a review of our financial performance and fourth quarter guidance. We will conclude today’s discussion with a question and answer session.

Turning to our quarterly performance, American Medical Systems reported third quarter revenues of $123.2 million, which exceeded our guidance of $113 million to $119 million. Total third quarter revenues increased 4.9% over the third quarter of 2008 on a reported basis and rose 6.7% on a constant currency basis.

Non-GAAP adjusted earnings per share were $0.27 for the third quarter, an improvement of 50% over the third quarter of 2008, driven by continued improvement in our gross and operating margins as well as reduced interest and amortization expenses. This strong EPS performance exceeded our quarterly guidance of $0.17 to $0.21. We define non-GAAP adjusted EPS to exclude amortization of intangibles and financing costs, and this quarter we’re also excluding two one-time gains.

Our robust cash flow trends continued in the quarter where we generated $37.3 million in cash from operations as a result of a previously mentioned margin improvements as well as solid working capital management. We were also able to take advantage of the sale of assets in the quarter. All these factors allowed us to reduce our debt by $49 million in Q3.

Regarding the asset sale, in early October, we announced the sale of our Ovion assets for $23.6 million. This transaction allowed us to monetize an underutilized asset at very favorable terms and also served to eliminate all existing and potential obligations and liabilities under previous agreements associated with the Ovion Technology.

Let me now detail our 6.7% constant currency worldwide sales growth. Sales growth was very favorable in our erectile restoration and pelvic floor repair product lines while male and female continence line showed improved trends and BPH therapy continued to post an acceleration in growth. I’ll provide details of this revenue performance by business and product line. Please note that all of the growth rates I’ll provide going forward will be stated in terms of constant currency unless stated otherwise.

First our men’s health business posted revenue of $54.7 million and gained 8.7% over the comparable third quarter last year paced by strength in erectile restoration and complemented by modest acceleration in male continence. The erectile restoration product line outpaced the solid growth trend we saw in the first and second quarters with sales growth reaching the low double digits. This increase is the result of several factors; first the FDA approval of our Inhibizone anti-infection claim in July has strengthened our marketing message, indicating that we have the only inflatable penile prosthesis with clinical evidence showing a significant reduction in the rate of revision surgery due to infection.

Second, we continue to focus on our patient education and outreach programs in the US, and third, we benefited from favorable product mix with faster growth in our AMS 700 inflatable line. The growth in our male continence line approached high single digits. We were pleased with the progress our sales team has made in the quarter through tangible initiatives in the areas of physician education and community health blocks. We remain confident that our focused efforts in these two areas will lead to sustainable growth in male continence.

Turning to women’s health, revenues in the third quarter were $40.9 million, an increase of 5.4% over the comparable period last year. Our pelvic floor repair product line accelerated its positive trend posting solid double digit growth. This performance was driven by our new Elevate Anterior and Posterior products. We had high expectations for the Elevate Anterior launch which began late in the first quarter, and we were not disappointed. We also believe we gained some competitor share. This extremely successful launch also demonstrates our ability to expand the market innovative products that serve both patients’ and doctors’ needs.

The female continence line delivered a gain in the mid single digit range, which while not yet back to the levels we know this business can achieve, does suggest stabilization from last quarter. We again booked double digit growth in our MiniArc single incision sling as the Elevate launch helped to boost MiniArc sales though this was slightly offset by a modest decline in Monarch sales.

Her Option sales continue to decline year over year as we focus on profitable probe sales. In fact if you exclude Her Option growth in the women’s health business, it would have grown in double digits in the quarter. We continue to look at all opportunities to optimize the value of this business.

Finally, BPH therapy revenues of $27.7 million rose 4.9% in the third quarter, compared to the same period last year. We are encouraged by the 5.6% growth in the laser therapy product line and note this is the third consecutive quarter of double digit growth in US fiber sales. Although the economy is still impacting this product line as console sales remain down, these positive fiber results suggest that our focus on communicating the clinical benefits of Green Light in treating BPH is gaining traction, particularly in the US where we continue to see success in growing our fiber usage.

Regarding the implementation of changes to the Stark Law earlier this month, we’re encouraged to report that as we expected there’s been little impact to our business, and further we would expect any impact to remain muted going forward.

Let me pause now to review the accomplishments we’ve made in the 4-point plan to improving laser therapy that we first laid out in our quarterly call a year ago. First, we’ve completed our reorganization to separate BPH therapy from our men’s health business and hired an experienced general manager to lead this business. Secondly, we’ve successfully realigned the US salesforce to focus separately on capital equipment and trailing disposables or fiber sales. Third, the implementation of the One AMS concept in order to leverage the AMS franchise is working quite well, and finally we have reached our goal of a 10-percentage point improvement in gross margins by 2010 ahead of schedule.

Regarding our TherMatrx product line, while the business did decline modestly in the third quarter, we saw positive movement in sales partly due to the fact that we took short term advantage of a competitive product recall. On the operation front, as today’s results attest, we continue to drive favorable operating leverage in our business and have achieved margin improvements ahead of schedule. We’re pleased with the progress we’ve made in controlling our expense structure. At the same time, we remain committed to making investments to drive growth where we see opportunities in our market.

To this point, we’ve begun to add selectively to our sales team, with the addition of approximately 20 t0 25 positions beginning in the fourth quarter. In addition, with the recent positive news in our product approval in Japan, the AMS 800, we will ramp up our investment in market development and infrastructure during the quarters in Japan. We believe these investments will allow us to capitalize on opportunities for sustainable growth over the long-term.

Now let me take a moment on comment on healthcare reform and the proposed tax on medical device manufacturers. Because we derive 70% of our revenues from US sales of Class II and III devices, we do stand to be impacted by the proposed device tax, described in the bills currently circulating in the House and Senate. As such, we’ve been very active in educating members of Congress about the potential effects that this tax would have on our innovation and job growth. We will continue to evaluate this situation closely together with the Advanced Medical Technology Association (Advomed) of which I’m a board member. We’re considering a number of strategies to reduce the effect on our business should this device tax be enacted. However, until something more concrete is available, it would be premature to articulate any specifics at this time.

Before I turn the call over to Mark, I’d like to affirm that we remain optimistic about our growth prospects over the remainder of fiscal 2009 and as we look into fiscal 2010. Even though we’re not yet prepared to call the bottom of the global economy, our product lines overall are performing well, with erectile restoration and pelvic floor repair delivering solid growth, the continence lines improving, and laser therapy turning around. Further, our operational discipline is contributing to the high level of cash generation which in turn is driving us to an improved and more nimble financial position, as evidenced by the recent upgrade from Moody’s and improved outlook from Standard and Poor’s credit rating agencies.

I remain confident in our ability to grow especially with our selected investments and sales personnel throughout the world. Bottomline, I’m confident that we’ll deliver on our financial objectives for the year.

At this time, I’ll turn the call over to Mark Heggestad.

Mark Heggestad

As Tony has provided the revenue detail for each of our product lines, I’ll limit my comments on revenue to the impact of foreign currency fluctuations and then provice additional color on the rest of the P&L, the balance sheet, and cash management and finally fourth quarter and 2009 guidance.

The strengthening of the US dollar versus a year ago had an unfavorable impact of $2.1 million when comparing third quarter revenue to the prior year resulting in reported growth of 4.9%. Excluding the unfavorable impact of foreign currency fluctuations, constant currency revenue growth in the third quarter was 6.7%. Third quarter international sales were essentially flat on a constant currency basis. The international business continues to be weighed down by the persistence of the weak economy especially in developing regions of the world which are served by our distributor network. The US on the other hand experienced a strong third quarter especially relative to recent trends delivering a growth of 9.2%.

Moving on to the rest of the P&L, all of our margin trends whether they be gross margins, operating margins, or profitability margins, were again favorable. Our third quarter gross margin percentage reached 82.7%, up 3.9% from the 78.8% a year ago. The strong third quarter gross margin percentage was achieved through a combination of factors including favorable product and geographic mix, improved product reliability and thus lower warranty costs, and cost containment resulting in greater manufacturing efficiencies across the board.

Concerning laser therapy specifically, recall that a year ago we stated our objective to improve the laser therapy gross margin by 10% from 50% at that time to a sustainable 60% over the following 12 to 18 months. With the third quarter laser therapy gross margin of 62.8%, we have now experienced three consecutive of 60% plus gross margin, well ahead of our stated schedule.

While the margin story is clearly positive, bear in mind that some of the improvement is due to product and geographic mix factors, and these are not expected to persist long-term as the capital equipment environment recovers and the international economies improve.

In the third quarter, we again drove significant leverage in our operating expenses. This is evidenced by our third quarter operating income margin of 26.9%, up 5.6% versus the 21.3% margin a year ago. Last year’s third quarter operating margin excludes the IPRD charge we recognized in that quarter. Marketing, selling, and G&A spending of $52.9 million in the third quarter grew 1.9%, compared to $52.0 million in the prior year third quarter. R&D spending of $12.4 million was 10% of revenue, in line with our stated long-term target.

On a year to date basis, our operating income margin is 26.0%, putting us on pace for a record setting year after adjusting prior years for the change in accounting for stock option expense adopted in 2006. Occasionally it is important to reflect on more than just the past quarter. Note that we have limited the growth in the operating expenses of selling, marketing, and G&A for two years now, while spending R&D dollars at a rate of 9% to 10% of revenue over that same time period. We very consciously limited spending and drove efficiencies during the early quarters of this two-year period to assure we right-size the organization and then continued to take a very cautious approach when we entered the current economic downturn.

As Tony noted, we are now at a point where we are ready to make incremental investments in certain selected areas, especially in the areas of selling and selling support as well as geographic expansion. Even with these increased investments, we will continue to leverage the P&L, but at more modest levels nowhere near the 300 to 500 basis points of improvement we had driven over each of the past two years. Accordingly operating margin improvements will be slightly more tempered beginning in the fourth quarter and then carrying through to 2010.

Royalty income in the third quarter was $961,000, compared to $745,000 a year ago. Starting in the fourth quarter, royalty income will be about $500,000 to $600,000 lower per quarter due to the sale of the Ovion technology. Third quarter interest expense of $4.7 million declined $1.5 million or 24% from the third quarter of 2008 when our debt levels were much higher. Our debt repayment during 2008 and year to date in 2009 has reduced our borrowing costs significantly. Amortization of financing costs of $4.4 million primarily represents the non-cash charge pertaining to the new accounting on convertible debt adopted in the first quarter. All prior periods are retroactively restated to reflect the accounting change. This charge will continue to be approximately $4 million in the fourth quarter.

In the third quarter, we booked two large one-time gains related to nonrecurring transactions. The first was a gain of $5.6 million to reflect the exchange of our convertible debt in the third quarter which I will discuss shortly. The second is a net pre-tax gain on the sale of Ovion technology amounting to $17.4 million. These two gains are excluded from our calculations of non-GAAP adjusted net income and non-GAAP adjusted earnings per share. Last year’s third quarter also included a large nonrecurring transaction—a $7.5 million IPRD charge for a milestone payment related to the Biocontrol acquisition. To provide better comparability between years, this charge is also excluded from our calculation of third quarter 2008 non-GAAP adjusted net income and non-GAAP adjusted earnings per share.

The other expense line of $341,000 is primarily driven by losses on foreign currency hedging activity. Given current foreign currency exchange rates, we will recognize losses on hedging contracts of approximately $1.5 million in the fourth quarter.

Our third quarter tax rate excluding the impact of the two large one-time gains was 38.0%, slightly above our guidance of 36.5% due to some discreet tax items recognized in the quarter. We continue to expect the fourth quarter tax rate to be approximately 36.5%.

Excluding the amortization of intangible assets and financing costs as well as the two large one-time gains, third quarter non-GAAP adjusted net income was $20 million, and fully diluted earnings per share was $0.27. This represents a 46% and 50% increase over similarly adjusted net income and EPS of a year ago. With our third quarter revenue exceeding our guidance, coupled with exceptional margin performance, we surpassed the top end of our EPS guidance by $0.06. Recall that we will exclude certain amortization related expenses from our non-GAAP adjusted results due to their non-cash nature and the fact that they limit comparability to other companies. Specifically the non-GAAP adjustments on a pre-tax basis are intangible asset amortization of $3.4 million or $0.03 per share, financing amortization of $4.4 million or $0.035 per share, and the two one-time gains of $23 million in total or $0.18 per share.

A full reconciliation of GAAP to non-GAAP adjusted earnings and earnings per share is included in our earnings press release. On a GAAP basis, net income of $28.6 million and earnings per share of $0.38 increased significantly over net income of $3.5 million or $0.05 per share a year ago.

Turning the focus to the balance sheet and cash management, we again continued very favorable trends established in 2008 and the first half of 2009. We ended the third quarter with a cash and short-term investment balance of $49.5 million, significantly higher than prior year levels despite a substantial debt reduction. Cash generated from operating activities in the third quarter of 2009 was $37.3 million.

In addition, we received incremental cash from the sale of the Ovion Technology while utilizing cash to complete the convertible note exchange, the two of these netting to an incremental source of cash of $11.3 million. This robust cash flow generation enabled us to reduce our debt by $49 million in the third quarter. We have now reduced our debt by $105 million year to date, well ahead of previous expectations. All the debt we paid in the third quarter was applied to our senior secured credit facility, bringing the balance of that debt down to $151 million at quarter end. Given our seasonally lower level of cash generation in the fourth quarter, we expect to reduce debt by an additional $15 million in the remainder of 2009. Accordingly, we now expect our total 2009 debt reduction to be approximately $120 million, an increase from our previous estimate of $95 million.

The net result of all this with respect to our debt load has enabled further improvement in our total leverage to EBITDA ratio to 2.7 times, down from 3.1 times at the end of the second quarter and down substantially from 4.1 times a year ago. I would like to emphasize that we’re very encouraged by the significant improvement particularly over such a relatively short period of time. Importantly this progress has resulted in a total leverage to EBITDA ratio below the lowest level required under the covenants of our senior secured credit facility, now or anytime in the future.

It is equally important to note that we executed an exchange of our convertible debt in the quarter which markedly strengthened our financial position and flexibility. We exchanged $250 million of our 3.25% convertible debt for 4% convertible debt. This transaction resulted in a number of positive developments, including a 3-year deferral of the put date. In addition, the tax implications of this transaction provided significant positive net present value of cash flow over the life of the debt.

Commensurate with the substantial improvement in our financial position, our credit ratings also improved in the quarter. In September, S&P revised our outlook from stable to positive, while Moody’s raised our debt rating one notch to BA3 to B1. These improvements are especially noteworthy in light of the tight credit environment of the past 12 months, and they are a testament to our operational and financial achievements.

I will now turn to the outlook for the fourth quarter and highlight our revised guidance. Based on our positive performance in the third quarter and favorable trends, we’re raising our 2009 revenue guidance to $509 to $515 million from previous guidance of $495 to $510 million. Our non-GAAP adjusted earnings per share guidance is also raised to $1.10 to $1.14 from previous guidance of $1 to $1.10. This revised guidance reflects the strong performance of the third quarter bounce by the investments Tony and I discussed earlier. This equates to fourth quarter revenue guidance of $136 to $142 million and fourth quarter non-GAAP adjusted earnings per share guidance of $0.29 to $0.33.

As previously noted, all non-GAAP adjusted EPS guidance excludes the impact of intangible asset amortization and amortization of financing costs. Intangible asset amortization is expected to be approximately $13.2 million or $0.11 in 2009, and approximately $3.2 million or $0.03 a share in the fourth quarter. Amortization of financing costs is expected to be approximately $16.5 million or $0.14 per share in 2009 and approximately $4 million or 3.4 cents per share in the fourth quarter. All EPS guidance also excludes the impact of large one-time nonrecurring type items.

Thank you for your time, and I will now turn the call back over to Tony.

Anthony Bihl

To conclude, we surpassed our revenue and non-GAAP EPS guidance, and by again managing P&L and balance sheet well, we’ve demonstrated strong execution on expense management evidenced by our year to date record high operating margins and cash flow generation. Importantly, this quarter marks our eighth consecutive quarter of demonstrating consistency in achieving or exceeding expectations. Further our fourth quarter revenue and EPS guidance provides tangible evidence of continued performance. In addition, we received our first product approval in Japan, sold our Ovion Technology, entered into a successful exchange of the majority of our convertible debt, and received important recognition to our credit from two rating agencies.

In short, we feel very good about this quarter’s results and our outlook. Before opening up our call to the Q&A session, in order to allow as many analysts as possible to ask questions, please observe our request that you ask no more than two questions—one leading question and one followup question, and then return to the queue. Thanks very much for your consideration on this. Angelia, would you please provide instructions and open up the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Jared Holz – Thomas Weisel Partners.

Jared Holz – Thomas Weisel Partners

Can you just talk about gross margins? If you back out the laser scope business, you’re looking at a base business that is 88% gross margins. Where can that go? Have you hit a peak there? Could this be a 90% gross margin business? It’s already among the highest in med techs, so where can that base business go?

Mark A. Heggestad

Jared, I agree with you. It is among the highest in med tech right now. I’m certainly not predicting we’re going to continue to go over the 87.6% margin we have in that business right now. With that said, we certainly continue to drive efficiencies in this business. If you take a look at where we’ve made improvements, we’ve made improvements in the laser margin, but we also have made improvements over the past three quarters in the implantable margins as well, not only as a result of mix but as a result of driving efficiencies. As we look forward, we’ll continue to do that, but at this stage in the game, we’re not predicting any sort of significant increases in those margins.

Jared Holz – Thomas Weisel Partners

Looking to 2010, the past one maybe even two years, the growth in your business overall has been just a little bit inconsistent, and that’s not dissimilar from what we’ve seen from other companies, but given that your overall business is pretty much procedure based and shouldn’t have a high degree of sensitivity to economics, where do you see this business kind of going over the longer term, in terms of not maybe a growth rate, but when do you get to the point growth is going to be a little bit more consistent quarter after quarter?

Mark A. Heggestad

I assume when you’re talking about growth, you’re talking about revenue growth as opposed to bottomline growth. At this stage in the game, it has been difficult. Certainly, there has been some volatility in the growth. Part of it is due to the economy. We’ve seen it around the world in terms of how some of the economies have been impacted versus others. At this stage in the game as we look out, we certainly anticipate that with the products we have in our product pipeline combined with as Tony and both referenced the intent to drive geographic expansion, in the long-term we certainly intend to see increased revenue growth; however, as we look out over the shorter term, certainly with the economy and the longer time period it takes for those investments to take hold, we’d anticipate that we’d continue to see revenue somewhere around where we see it right now.

Anthony Bihl

I’d just add to Mark’s comments. We certainly are impacted by external factors, and those will always be there. There will always be some ups and downs in the economy. There’ll always be a new product launch by a competitor or some noise in the market in that way, but I think our focus is about building some stability into our execution. I think that’s the best thing we can do. That is to ensure steady cadence of new products from our existing businesses and then to build some stabilization and some good, strong execution into our salesforce, and I’m feeling very positive about both things. I think we’ve started to get our arms around the laser therapy business, and clearly those results are showing, and I think our businesses in many ways some external factors have affected us, but we’re focused on what we can do internally to deliver reliable results over time, so I feel positive about our ability to do that.

Operator

Your next question comes from the line of Peter Lawson – Thomas Weisel Partners.

Peter Lawson – Thomas Weisel Partners

Tony, I was wondering if you could just talk about pricing and volume across the three major product lines.

Anthony Bihl

I commented earlier on that in our male health business we saw favorable product mix, and that favorable product mix yielded better pricing to basically the existing product, but the higher priced products sold, with the AMS 700 being so strong, in erectile restoration. We find across the board though, let me just say that, pricing has been relatively stable for us, and I think that’s a function of our sales team doing a great job of selling value. That is very much where our focus is. We provide a lot of high value, and so we hold price. We have been fairly reliable in being able to do that, and so we have seen good stable pricing almost across the border. I’ll let Mark comment on any particular product line, but when we see price favorability, it’s typically a shift in mix to higher end products in the product portfolio and so that’s been a good stable environment for us, I think.

Mark Heggestad

The only other thing I would add to that in this quarter particularly we saw very favorable geographic mix as well. As I mentioned US grew 1.92% while the more developing areas of the world that are primarily are distributing markets and therefore have much lower pricing are the areas that we probably were down the most, and so certainly geographic mix had a big impact this quarter as well.

Anthony Bihl

From a volume perspective, volume growth, pelvic floor repair, the launch of Elevate drove real volume for us. There’s no question. Laser therapy, fiber sales is clearly driven by volume. Procedures getting in the hands of physicians and that’s been a clear message in those lines where we have seen fast growth.

Peter Lawson – Thomas Weisel Partners

To follow up on the international side, what are the plans for driving growth in the international markets?

Tony Bihl

We commented briefly about it, but essentially we reorganized during this year 2009 and formed three regions to bring more focus to the fact that there are big opportunities outside the US, where today we generate about 30% of our revenue. So we formed Middle East and Africa as one region, Asia Pacific, Latin America, and Canada as another region outside the US, put general managers in charge of each, and they have been building staff, functioning capabilities. As we enter 2010, we’re adding resource into those areas. I commented earlier that we will make investments in Japan as we now have our first product approval and anticipate two more product approvals coming into 2010, but that will be an opportunity for us to capitalize on, again, one of the other second biggest or so healthcare markets in the world, so it’s a matter of now putting more infrastructure and resource in place, strong training capabilities, stronger marketing capabilities, but those organizations have really started to deliver for us, so we have seen nice growth outside the US, but we think now it’s a matter of building the team, building the infrastructure a bit, and then selectively investing in markets like Japan where we are highly committed and then continuing to drive our businesses in other markets outside the US.

Operator

The next question comes from the line of Tom Gunderson with Piper Jaffray.

Tom Gunderson – Piper Jaffray

I will continue with the foreign theme here. I understand that the weaker economies and especially with distributors didn’t do well in the summer quarter. Did you have growth in your direct markets overseas Mark?

Mark Heggestad

It was a mixed bag quite honestly, but we did have some strong growth in some of the developing markets, and again it was the distributors primarily that were down and then a few of our direct markets as well.

Tom Gunderson – Piper Jaffray

But overall would you say the direct markets on a constant currency were up?

Mark Heggestad

Yes, absolutely.

Tom Gunderson – Piper Jaffray

Tony, great optics on calling in from China. I think the other Advomed members should do their conference calls from China as well and see if that sends a better message than Congress is getting right now. Can you tell us what the trip to China is about or are you looking at manufacturing or are you looking at opening up new markets, both?

Tony Bihl

First of all, I would like to take credit for being so strategic, and I just happened to be trying to plan a trip to this part of the world, and it turned out that the technology allows me to be here to make this call, so we found a way to make this work. No optics should be taken from it. Important part of my role is to get out to where the physicians are and to get out to these new markets, and I committed to be in this market early on when I came with AMS. In Beijing, we’ll be going to visit Japan, and we’ll be going to Korea, three markets that just happened in this trip to be able to have some interesting things going on. We’re focusing very much on our business operation and how they are developing, and we’re focusing on our distributor relationships and how they are developing, and I’m meeting with a lot of physicians, and I hope to get educated about the needs of this market, so don’t think anything more from it than that, other than clearly this is an important area of the world for us, and my role calls me to get out and visit these places.

Operator

The next question comes from the line of Jonathan Block with Suntrust Robinson Humphrey.

Jonathan Block – Suntrust Robinson Humphrey

First question, actually also international, Tony you mentioned the product approvals in Japan. The next question, do you also expect reimbursement to come on board in 2010, and when we think about that from an investment standpoint, should Japan be dilutive or accretive I guess on the bottomline next year?

Tony Bihl

First of all, the approval we got was for the AMS 800, and we are now diligently working toward reimbursement. There is a big open question there in terms of the process for reimbursement. We’ll go through a review late this year in December with the review committee who will look at whether our product should be removed from a category called AMT which essentially limits the way it’s reimbursed. If it’s removed from that, we’ll submit for reimbursement, and we’ll see something hopefully during 2010, if not reimbursement could be delayed beyond 2010 for AMS 800, so we’re putting in all effort all we can do to make that happen and otherwise we’ll continue to sell the AMS 800 in the market for those patients who pay for it directly, and we have seen some volume there. In terms of Japan accretive or dilutive in 2010, we’ll build the infrastructure in 2010, and so it will be likely dilutive in 2010 on that net basis. Mark, would you comment on that?

Mark Heggestad

Certainly, it will have some dilutive impact. As we build that market out, the revenue is not going to increase at the level or make any investment in that market.

Jonathan Block – Suntrust Robinson Humphrey

If you can just pass along what you have been hearing maybe from your sales reps on competition in male incontinence. Like you said the growth certainly picked up from what you experienced last quarter. What are you hearing from the reps in terms of docs trialing, what are they experiencing, where is that competitor trying to go, is it limited just to the sling market or are they trying to go after sphincter market as well?

Tony Bihl

Clearly the positioning of that product has been that it’s a one solution for all problems, and so it’s going at our market for both artificial urinary sphincter as well as the AdVance Sling. Consistent with what said in the last call, and I think there has been some more data, in fact some of you folks have published it, but consistent with what we said last call, our sales teams tell us that the impact has been clearly there. There are physicians trialing the sling, and the indications are that they are not concerned about that from our salespeople, so I always take that as a positive message, and I think that they have had some challenges and some problems with product, and I don’t want to comment on that. I don’t have the details behind that, but we stand very confident in the AdVance Sling, very confident in the artificial urinary sphincter. Our focus on community health talks and particularly on training physicians and making sure the physicians who did AdVance once before now still feel comfortable with the procedure, we’ve done a lot of work in this area. Our sales team has executed very well to focus on what we have in our product portfolio and worry less about the competition, so I think that will net positive for us in the end.

Operator

The next question comes from the line of Andrew Olson with Morgan Stanley.

Andrew Olson – Morgan Stanley

I had a couple of questions on margins. With regard to the gross margins, it was pretty strong in the quarter. You called out a couple of components of that. Can you talk a little bit more about what those were and to the extent that it’s driven by mix and capital spending, what your outlook is there over the next 12 or 18 months on to the extent that we should think about gross margins as being sustainable if you’re not expecting any particular change in the capital environment?

Mark Heggestad

So when you take a look at our gross margins and the improvements we have seen over in the third quarter which are pretty consistent with the previous couple of quarters, I’ll break it down. There are really three things that have been relative equally driving that. One is the improvement in the laser scope business itself in terms of the quality of that product, and as a result of that, we have significantly less warranty cost, service cost, etc., and we have gone from a mean time to failure on that product when we first picked it up of probably around 5 or 6 weeks to a mean time to failure that’s in excess of 18 months right now which is really above standard for a capital product of that type, so that team has done a great job of taking a lot of cost out related to that.

The second component relates to just cost efficiencies in general across the board, both in the laser business as well as in our implantable business, and again our organization has done a very good job of driving efficiencies through the cost structure, and so if you take a look at both of those two, obviously those are sustainable as we go forward. The third component is the one that’s a little bit more difficult to understand what it means on a go forward basis. Again, we have had both very favorable product mix, and we have had very favorable geographic mix, and there’s no doubt about it that when the capital environment picks up and when our distributor markets pick up, and I really can’t predict when that will happen, but when they do pick up, it will have somewhat of a negative impact on our gross margins, and I would expect that we could have pressure of as much as 1 or 2 percentage points on those gross margins if they come back very strong and very robust.

Andrew Olson – Morgan Stanley

And the other thing, you had called out some additional investments you’re making in the next year. Can you help us frame what the magnitude of those investments would be?

Mark Heggestad

Without getting into actual dollars, I think the key is as I mentioned in the commentary, you have been seeing 300 to 500 basis points of improvements in our operating margin here consistently for two years in a row, and as I mentioned without getting into any sort of guidance, you won’t continue to see those kinds of improvements as we go into 2010, but you will continue to see improvement, but it could be at a very much lower level, especially in 2010 as we begin to make a number of these investments from a geographic expansion and a sales support standpoint.

Operator

The next question comes from the line of James Sidoti – Sidoti and Company.

James Sidoti – Sidoti and Company

The first question is on currency. What was the impact in the quarter on revenue?

Tony Bihl

$2.1 million negative, Jim.

James Sidoti – Sidoti and Company

And with the divestiture of the Ovion Technology, how does that impact your royalty line going forward?

Tony Bihl

We previously had a royalty agreement with Ovion, and as a result of that, we were netting about $500,000 to $600,000 of royalty income per quarter. When we sold the technology to Ovion, we also sold along with that our right to collect any more royalty revenues as a result of that. If you look historically in our quarters over the last year or so, there would have been about $400,000 to $600,000 of royalty income each quarter related to that, and we’ll no longer have that going forward.

James Sidoti – Sidoti and Company

On the last quarter, you indicated there was some trialing going on on the meshes and that was swelling some of the growth both the male and the female side of the businesses. Has that continued in this quarter, or do you have any update on that?

Tony Bihl

The trialing was primarily on male incontinence, and it was a competitive sling offering that’s in the market place today. That remains out there, and physicians continue to do trialing on it, as I mentioned earlier. I think there had been some challenges to the results, and I don’t want go into any deep comment on that, but it’s still going on out there, but I think my comment earlier was that from a sales perspective, our team still feels very comfortable and very confident in our ability to drive the AdVance business, so I think net-net, we’re still comfortable with our position, but that trialing did slow down. Certainly it did slow down some of the growth. I think we have to acknowledge that. On the female side, it’s been more a case of competitive challenge, and we feel like we moved the needle back in our direction in the third quarter with the launch of Elevate, where we believe that concomitant procedures helped to move some of the continence back to AMS.

Operator

Your next question comes from the line of Abigail Darby - J.P. Morgan.

Abigail Darby - J.P. Morgan

Going back to the men’s continence division, outside of the competitive dynamics you mentioned previously and then the international expansion opportunity, could you talk a little bit more about the underlying fundamentals of that market in the US—a macro view of market growth trends in that business both in 2009 and how’s that looking for 2010?

Anthony Bihl

Two components of it—the treatment for more severe incontinence, the artificial urinary sphincter continues to drive along and grow, and in fact it frequently hits in the double digit growth for us, and so we think that’s a very stable business worldwide. It’s the earliest and most powerful product in the marketplace for male incontinence, and clearly what we’ve done is to focus that product on more severe incontinence or where sphincter damage exists. And so we feel very comfortable with our ability to continue to drive that business, and we found that we’ve been able to sustain that very well over time. The AdVance sling is addressing the more moderate incontinence, and we believe it provides a solution to a man who maybe didn’t want to go so far as a sphincter, but may be perhaps could get some relief of the incontinence. We saw tremendous growth early on when the product was launched, and we suspect that some of that there really wasn’t any solution for men prior to the AdVance sling and that was viewed by most people as a great solution. We did have InVance, but AdVance offered a whole new opportunity for men with mild incontinence. We think that perhaps there was a little bit of pent-up demand and physicians did do a lot of the procedures, and perhaps some of the slowing that we saw was because we not only just needed to drive procedures, we needed to drive patient flow again very simply to educate men that there was a solution. And so what we have been focusing on is we believe that there are many men out there coping with incontinence. That’s an underlying fundamental belief that we have, and data supports that, and so we believe our role has got to be to continue to drive patient awareness so that those patients go to their physicians and ask about alternatives. When they do, AdVance is the product of choice.

Abigail Darby - J.P. Morgan

One quick question on the BPH fiber utilization trends—you’ve had positive growth in the past couple of quarters. Can you comment on whether you think that’s reflective of underlying procedure pull-through or fiber utilization or if that’s in some part due to an inventory buildup, and also kind of related to that, do you have any comments on the recent final PSS for the prostate surgery and also the hospital outpatient reimbursement for prostate surgery as well and how that may impact that division.

Anthony Bihl

Let me start with the revenue growth we’ve seen in this business. Certainly, fiber utilization has been, and I think we described it in our commentary, very clearly we continue to have success in showing physicians the net favorable clinical outcome for patients to use a Green Light laser, and that has had a lot of staying power for us in the marketplace. As you know, we added a lot of salespeople in the early part of 2009. We had 15 salespeople, but we focused a total of 40 people in the US on educating physicians and helping with fiber utilization, and we see that paying off. So we don’t believe that we’re seeing inventory buildup. We see that we’re seeing true utilization of the procedure by more and more physicians in the marketplace, and that’s been a very positive sign. We’ve seen the same kind of favorable feedback from our mobile providers who are providing much of this capability to physicians in the US. So I think the underlying activity of that business of three quarter in a row of double digit fiber growth gives us a sense that we’ve got the formula on this right now, and we’ve got to continue to execute everyday, but Green Light is a terrific procedure, and physicians are offering it more and more for their patients.

The reimbursements that have been recently communicated—the final CMS reimbursement—is that what the question was about?

Abigail Darby - J.P. Morgan

Yes, that’s correct.

Anthony Bihl

Generally speaking, it was positive for AMS. I think as it relates specifically to Green Light, outpatient hospital procedure sees a 4% increase in reimbursement, and ambulatory surgery center Green Light sees a 9% increase in reimbursement. The physician component on both of those stays about flat year over year as it does for many of our procedures at AMS. They’re either flat to up anywhere from 0-7%. So overall, reimbursements for our products on an outpatient basis, hospital component is up in the range of 3-10%. In the ASC, the ambulatory surgey center, the facility component is up anywhere from 8% to as high as actually 24% with things like our MiniArc and Monarch and 20% with Elevate. So we think it’s a strong message for us.

Operator

Your next question comes from the line of Jose Haresco – Brean Murray, Carret & Company.

Jose Haresco – Brean Murray, Carret & Company

I wanted to reach back a little bit into women’s health. Tony, I think you mentioned although you’ve seen improvement in the women’s health business, there is likely to be greater improvement. Could you walk us through it in a little bit more detail? What kind of improvements are you expecting to see or would you like to see in that business as we go forward? Is it sales, is it more headcount, is it more clinical data?

Tony Bihl

Clearly the launch of Elevate, we repeated it many times, but from the solid growth we saw in this quarter and previous quarters, it’s everything we thought it would be, and we think that there are a lot opportunities still ahead in Elevate. It really provides a solution to pelvic floor repair that physicians just really see a difference here, and so we think that has a fair amount of running room just in itself as we launch it around the world. From a standpoint of headcount, yes, I think as we described adding 20 to 25 salespeople here at the launch in the fourth quarter, part of that is to build some robustness in certain areas, particularly outside the US where our focus on women’s health is insufficient to get access to all the physicians we need, and so we just believe, for example, in Canada, the number of reps we have covering Canada for women’s health is not sufficient to capture all the opportunity, so we have given ourselves confidence that we can execute and now we’re going to add reps to those markets where we know we can get some growth, so I think that’s still there for women’s health. MiniArc double digit growth reinforces for us that we’ve got the right single incision sling and that strong execution will continue to grow that business, and Monarch is a very strong stable business. It’s down slightly in the quarter, but I think that we can probably stabilize that again. We want to continue to look at that, but I think the net-net of is add some more resource but also the new product that’s in the market still has a lot of room to run.

Jose Haresco – Brean Murray, Carret & Co

On the CapEx side of the business as it relates to BPH, how should we think about the gating factors in that business because even though we talked about CapEx, some CapEx sales across med tech are limited by credit, others are limited by purchasing budgets, given the nature of the BPH business, which of those things do you think if at all are kind of the gating factors for that business to come back?

Tony Bihl

The fiber side of that business is reporting very strong growth, and so we think that that formula we understand and that’s going to be continued driver. If you think about the razorblade business, you want to have an appropriate number of lasers in the marketplace and then you want to reinforce their utilization with the physicians who see these as the best solution for their patients. We’ve got the back half of that figured out very well. We’ve got a nice installed base of Green Light out in the marketplace. The fact is there is something like 845 HPS systems and another 800 PV systems still in the market today, so we’ve got a nice install base of instrumentation to drive this business, but we aren’t selling so much capital, and that’s primarily because of conservatism in the hospitals right now in terms of releasing capital budgets, and so for us we believe that some of that will come back as money frees up, some of that will come back as we move to new markets, and clearly as time goes on, some opportunities come as you look at new products being launching the marketplace, so we look at the economy piece as certainly a temporary hit to that part of the business, that growth part of the business, but we see that there are a number of other moving pieces that will have positive impact over time. I don’t know that it will turn around early in 2010. Again, we think the economy overhang might still be a little out there, but we’re still optimistic about where it will go in the long term.

Operator

The next question comes from the line of Tom Kouchoukos with Stifel Nicolaus.

Tom Kouchoukos – Stifel Nicolaus

I wanted to start on just the international versus US growth and looking at this quarter versus last. It almost seems like it flip-flopped. You had great growth in the US this quarter, and last quarter, international was stronger, and I guess I’m just curious to see how much of a factor seasonality played or did you just start to see the deterioration in the OUS economy hitting your sales this quarter?

Tony Bihl

I think the latter in terms of how it applies to Europe. First of all, distributors was a big challenge for us in the European and Middle East market, and that was probably one of the biggest overhangs for us, but I think also the European economy has been maybe a little bit harder hit than some other parts of the world, and some of that we did begin to feel. That said, I think we and our team on the ground in Europe feel fairly confident that we can figure out how to get our growth mode back again, and so we talked earlier to a previous question about how effectively we drive our women’s health business. We think there are opportunities in Europe to do a better job in that area. So there are some things we can do from an execution perspective, and Tom, in times like this, that’s what you focus on. The economy will come and go, but you focus on execution. We’re working closely with distributors. We have taken a conservative position with distributors in terms of cash management, and we think that’s the prudent thing to do. We’ll continue to watch that closely, and as those markets begin to strengthen a little bit, you’ll see us busy back in those markets again.

Tom Kouchoukos – Stifel Nicolaus

The second one is following up on an earlier question in terms of just market dynamics. Looking at the female incontinence business, there’s been a little bit of mixed messages out there market-wide between one of your larger competitors and then there is a smaller player in this space. One’s had great growth, the other one is still pointing towards the FDA letter as being something that’s slowed growth of the whole market down, but given that you guys are showing solid growth, and one of your larger competitors has had very nice growth as well, do you think there’s been a rebound in the market as a whole, or where do you think stress incontinence procedure volumes are trending right now?

Tony Bihl

I think my sense of it or our sense of it is yes. As we said in previous quarters, there was some impact on us, some competitor takeaways. To us that meant that the market was still there, but we just weren’t getting it and other people were getting it, and I think what we saw in Q3 was we believe we moved the needle back our direction a little bit, and we thought it would happen that way. Again, that’s about execution, that’s about having the appropriate coverage in the women’s health area and it’s also about getting Elevate launched. We continue to train physicians in incontinence at a very strong rate, and so it tells me that the market is robust and the opportunity is robust. So we’re still very favorable about it.

Tom Kouchoukos – Stifel Nicolaus

Do you have a guestimate of what rate it’s growing at as a whole?

Anthony Bihl

No, I don’t. We typically say that these markets are big markets. They’re growing probably in the single digit areas, but I think the issue with that is it’s a function of how many people are not being treated, and so what we believe is it’s not simply a factor of the aging population and the number of new incontinent patients. It’s more a factor of how do you reach those who don’t realize that there’s a better solution. I kind of think market growth is a little bit overrated as a measure sometimes in these markets because it’s not a fully penetrated market.

Operator

Your next question comes from the line of Brooks West – Craig Hallum.

Brooks West – Craig Hallum

Tony, I wanted to ask a pipeline question. Can you talk about looking out over the next year or two, what you see coming out of the pipeline in terms of product iterations or new products, and then when might you be comfortable enough with the balance sheet and cash flows that you’re putting up to start looking at some potential acquisitions?

Anthony Bihl

First of all, Brooks, as you know we continue to invest nicely in R&D, and we’ve moved that number to spending something around 10% of our sales in this area, and it really is a combination of cadence of new products that are refinements or improvements of existing products, and then it’s also developing some new technology areas. We’ve talked about those, Topaz and Continuum, Excessa for example. From a product cadence perspective, I hope you appreciate from a competitive perspective I don’t want to talk too much about what we’re doing next because we just think that’s not the wise thing to do, but I think that we look at in each of the areas of our business looking at ways to bring a new and improved version of our existing product to the marketplace, and I think you’ll see us do that as we jump into 2010 here. We’ve got a lot of momentum behind some of the new products that are out there in the market. We did launch a 3.5 cuff for our AUS, and we’re in the early evaluation of it in the marketplace before we do a full commercial launch, and I think you should expect to see the same kind of things from us in each of the other areas of our product line, and I can go through each one of them and go through programs, but I’d rather not do that, but with this R&D spend, you’d expect to see a cadence of products coming there, and then again, out behind it is, where are the drivers of growth beyond the existing products, and that’s where we think the Topazes of the world will come after that.

Brooks West – Craig Hallum

Just following up on that question on the M&A potential, any update on that, and then I’ve got one more question.

Tony Bihl

From an M&A perspective, I think we have been very focused on generating cash and paying down debt. We have been making great progress on that, and we still need to make more progress on that, so we are not yet out of the woods from perspective of where we think we want to be, but we have positioned ourselves. Mark talked about it. The exchange of our convert bought us some time on that side of the balance sheet in terms of when we might have the first put on that debt, and at the rate we’re paying things down, it’s probably going to be not so far in the future that AMS can talk about looking out there and to see what’s available, so I don’t want to speculate about what date it is, but I think that we’re moving in the direction we want to move, giving ourselves financial flexibilities so we can have those discussions, and I think as we talk in coming quarters, we’ll give more visibility to that.

Brooks West – Craig Hallum Capital

Tony, realizing that this is a macro question it may be a bit difficult answer, but trying to get a sense of on the overall EMS business, the impact of the economy on depressing procedure volumes, potentially pushing out procedure volumes, and while not asking you to time a rebound in the economy but trying to get a sense of from a topline growth rate, what does a new AMS look like in a healthy economy from a topline growth perspective?

Tony Bihl

I’m going to let Mark comment as well. I think the growth numbers we’ve given in the past of what you should think about this business is still where we stand on that, and our growth this year is below those levels, so I think we’ve answered that question in the past to say we got a laser business that probably ought to be in mid to higher single digits and an implantable business that ought to be in the low double digits, and we think that combination is where we are today with this portfolio, so I don’t think we see a change in direction. This whole issue of procedures, whether they put off or not, is confounded by double digit growth in erectile restoration this quarter. We always thought that was a procedure that was the most vulnerable for deferral, and the fact is we continue to grow, and so there are some markets where we have seen some softness, and perhaps that has been a function of economic factors, but I think the growth rates we’ve published and communicating the past are probably the right ones for this business in this portfolio that we see steady state. Mark, any addition there?

Mark Heggestad

I agree with that.

Operator

The next question comes from the line of Jayson Bedford with Raymond James.

Jayson Bedford – Raymond James

Just looking at the Green Light business and I guess more specifically the category BPH hospital-based treatment, do you think you’re seeing growth in the market or is it a function of you guys just stealing some share, and I guess I’m just trying to get some sense of market growth there.

Tony Bihl

I think it’s probably a combination. We’ve focused clearly on TURP conversion, and the way we’ve done that is to go to existing doctors and demonstrate to Green Light to those doctors. We’ve also focused on getting Green Light into residency programs and where physicians are being trained to make sure that they use Green Light early on in their career and learn Green Light at least equal to what they learn TURP, so that they understand the two procedures. I think we’ve been able to do market penetration more deeply probably as a combination of those two things—a little bit of pull away from TURP and a little bit of pull away from competition. I have to believe that the impact of expanded salesforce in the US and some of what I was seeing reported by our competitors tells me that we’ve gotten a little bit of share, and that’s a little bit difficult sometimes to derive from the reporting, but I think anecdotally we’ve believe we’ve done that successfully, so it’s probably a combination of those factors.

Jayson Bedford – Raymond James

I am not sure, again on the Green Light business, if you quantified the year over year decline in capital equipment. Is it fair to say it was down double digits?

Mark Heggestad

It was, Jayson.

Jayson Bedford – Raymond James

You gave us a little detail on the 845 HPS boxes out there, the 800 PV boxes. I guess the focus of the 14 or 15 reps that you have dedicated to the capital piece, is the goal there to kind of upsell those PV folks to HPS or are they really trying to penetrate and get new urologists on board?

Anthony Bihl

The upgrade of PV to HPS happened early on in the launch of HPS. Some of these PVs are in parts of the world where they’re probably going to stick with PV for now, so clearly in our major markets I think we’re finding less and less of the case where we’re doing PV conversions to HPS. Those days are kind of gone, and we’ve accomplished a lot of those, and now it’s going to new facilities and getting them to convert to Green Light and then acquire HPS. That is where I would say is the bulk of our revenues are coming from today.

Operator

There are no further questions at this time.

Anthony Bihl

Again, we’re pleased with the quarter. Thank you very much for participating today, for joining us on the call, and for your continued interest in American Medical Systems, and we look forward to talking to you again at the end of next quarter.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use prohibited. 

THE INFORMATION CONTAINED HER IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY’S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY’S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY’S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS. 

If you have any additional questions about our online transcripts, please contact us at:

[e-mail] you.