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Volcano (NASDAQ:VOLC)

Q3 2013 Earnings Call

November 04, 2013 5:00 pm ET

Executives

John T. Dahldorf - Chief Finance Officer and Principal Accounting Officer

R. Scott Huennekens - Chief Executive Officer, President and Director

Analysts

Christopher T. Pasquale - JP Morgan Chase & Co, Research Division

David H. Roman - Goldman Sachs Group Inc., Research Division

Chris Lewis - Roth Capital Partners, LLC, Research Division

Robert Marcus - Leerink Swann LLC, Research Division

Raj Denhoy - Jefferies LLC, Research Division

Bruce M. Nudell - Crédit Suisse AG, Research Division

Ben Andrew - William Blair & Company L.L.C., Research Division

Michael Rich

Steven M. Lichtman - Oppenheimer & Co. Inc., Research Division

Jason R. Mills - Canaccord Genuity, Research Division

Operator

Good afternoon, and welcome to Volcano Corporation's Third Quarter 2013 Earnings Conference Call. [Operator Instructions] As a reminder, this conference call is being recorded, Monday, November 4. A replay of the call will be available through November 11 by dialing (404) 537-3406, passcode 71109347 or via the company's website at www.volcanocorp.com. I would now like to introduce Mr. John Dahldorf, Volcano's Chief Financial Officer. Please go ahead, sir.

John T. Dahldorf

Thank you, and good afternoon, everyone. With me today is Scott Huennekens, Volcano's President and Chief Executive Officer. Scott will outline key events during the quarter and our outlook around the near- and long-term market environment, and I will follow with a review of our financial result.

Before turning the call over to Scott, let me remind you that today's discussion will contain forward-looking statements that involve risks and uncertainties that could cause our actual results to differ materially from those discussed in today's call. These risks and uncertainties are outlined in today's press release and in our filings with the Securities and Exchange Commission, including our 10-K for 2012 and our 10-Q for the second quarter of 2013. We caution you not to place undue reliance on our forward-looking statements, and we disclaim any obligation to update these statements. Scott?

R. Scott Huennekens

Thank you, John, and good afternoon, everyone. We have quite a bit of information to cover today, including our perspective on the near-term market outlook and how this has impacted our results for the third quarter and outlooks for both the balance of the year and 2014, as well as serving as the basis for a strategic reprioritization initiative we announced today; our continued success within the peripheral imaging market, which is helping to offset the impact of the continued decline in PCI volumes, that is stable PCI volumes in the U.S.; the positive result that came out of last week's TCT conference; and the meaningful progress we've made with new products, including iFR, Verrata, PioneerPlus, Crux and Sync-Rx.

Before speaking to these and other topics, I want to address the strategic initiative we announced today, which is a by-product of the completion of our 5-year strategic plan as well as the challenges and highlights of 2013 and expectations for 2014.

The 2013 challenges have been: The continued decline of stable coronary PCI volumes in the U.S. and the expansion of that decline to Japan. This decline is expected to continue, although at a lower rate; strong negative investor reaction to the $450-plus million capital raised in late 2012; constrained resources for healthcare spending in the U.S., which has put pressure on our ability to grow FFR and IVUS revenues at historic rates; in Japan, a currency foreign exchange headwind of more than 30%, the 10% reduction and IVUS reimbursement in Japan, as well as leadership changes and slower-than-expected FFR adoption in Japan, although year-to-date FFR revenues have grown 78% on a constant-currency basis; limited new product introductions or new clinical data related to our products and continued cyclicality and decline in infrastructure spending that impacted Axsun telecom; and the last is some predictability for timing of revenues at Axsun Medical as an OEM supplier to the OCT ophthalmology market. We believe that some of these challenges are now behind us and/or adequately reflected in our guidance for the balance of 2013 and all of 2014.

Our highlights in 2013 today though have included generating 10% constant currency medical segment revenue growth in a challenging market; continuing to achieve market share gains in FFR and IVUS in all our key geographies; producing FFR disposable revenue growth of 26% on a constant-currency basis; and greater than 30% growth in our U.S. peripheral IVUS business; continuing to lead innovation with the market launches of our core IVUS system Verata FFR wires, iFR adenosine-free FFR and the Crux IVC filter system; achieving major clinical trial success with the ADAPT-DES and ADVISE II studies, both of which were featured prominently with data presentations at last week's TCT; acquiring the PioneerPlus Re-Entry catheter system; and realizing increased operating leverage and expanded manufacturing capability in Costa Rica.

We recently provided preliminary guidance for 2014 revenues that included the following expectations. As reported, revenue growth of 9% to 11% and constant currency growth of 8% to 10% driven by growth in FFR, number one; number two, continued market penetration in peripheral IVUS; number three, expanded distribution in the U.S. and Europe; number four, growth for Axsun Medical ophthalmology business; and number five, new products introduction.

PCI declines of 2.5%, second of all relative to 2014 expectations, PCI declines of 2.5% in the U.S., 2% in Japan and flat PCI volumes at EMEAI, which is Europe, Middle East, Africa and India for us; number three, a projected Japan reimbursement cut of 7.5% on all our disposables beginning April 1 next year; number four , continued innovation leadership with the introduction of the Sync-Rx systems building upon our success in Europe and Japan with the introduction of iFR adenosine-free FFR in the U.S., where we expect regulatory approval and commercial launch in the second half of 2014, as well as the introduction of the ComboWire plus pressure and FloWire; the omni multi-modality FFR system, fast IVUS catheters and systems, the full market release of Crux and the ramp of Axsun's ophthalmology swept source OCT engines; number five, increased focus on capital allocation strategy and discipline; and six, continued increased operating leverage and the transition to 100% disposable manufacturing in Costa Rica by the end of next year.

As I've mentioned, we have now completed our 5-year strategic plan, and per the 2013 challenges I outlined earlier, our markets have changed, and we recognize the need to adapt and change with them to ensure our ongoing success and growth. With the opportunities ahead of us, however, comes the need to make hard choices and relentlessly prioritize our focus, attention, time and investments, including having a disciplined approach to portfolio management that require making reasoned tradeoff decisions.

The initiative we announced today is a reprioritization and reallocation of resources within our distribution, R&D and clinical programs that will enable us to focus on areas of projected strong growth as outlined earlier. This initiative will include changes within our U.S. sales force, to expand and better align it with our new priorities, and it is designed to improve operating predictability and results as we focus our resources on what we believe are higher return priority projects. It will also result in a discontinuation of 3 product development programs where we see limited market, growth and strategic value. The 3 programs are Forward-Looking IVUS, Forward-Looking Intra-Cardiac Echo, and Optical Coherence Tomography for intravascular imaging.

While we are discontinuing our current coronary OCT development efforts, we will move forward and expand our development and commercial efforts on current and future medical applications for OCT direct [ph] and medical. We do not see coronary OCT imaging as an attractive go-forward market. We estimate the total global market at roughly $75 million. And based on our data and external data, we believe the markets in the U.S. have been flat for the past 6 quarters, and there has been only nominal growth in Europe.

Our outlook for the coronary OCT market is based on what we see as a limited market opportunity in coronary imaging, the high cost of development and achieving regulatory approvals and a strong progress we see for Volcano and other IVUS companies in the high-resolution IVUS imaging.

As a result, we are pushing more aggressively with our high-resolution IVUS imaging program around our back technology.

John will address the financial implications of this initiative during his comments while we plan to invest the roughly $12 million in operating expenses associated with these discontinued programs in a higher growth, lower risk revenue generating product and market development opportunities I mentioned a moment ago, and we expect to see meaningful revenue contributions from these areas in 2014.

Turning to the third quarter. We turned in a solid performance with revenue growth on a constant-currency basis of 8%. We continue to win the console market share battle and our IVUS -- our U.S. IVUS disposable revenues grew 7%, reflecting our growing penetration of the peripheral IVUS market. FFR revenues were 16% on a constant-currency basis, putting 34% in Japan, which while very good, was not to our expectations. I'll speak to Japan in more detail shortly.

But in the U.S., unlike in the past where our growth was driven by significant market share gains as well as market growth, more recently, our growth has matched that of the overall market. As a result, we are making changes to our sales and marketing strategies to focus more of our efforts on the building and growth of the FFR market. In the meantime, we continue to achieve market share gains in Europe, where total revenues increased approximately 27% year-over-year. We also saw a continued adoption of our iFR technology in Europe and Japan.

Finally Axsun Medical also had a strong quarter with revenue growth of 18%, even though we had some sizable ophthalmology orders shipped in the second half of 2013 to 2014 as we indicated in our press release last Monday.

With respect to our market outlook, as we indicated on our press release a week ago, we are seeing continued declines in the U.S. PCI volumes year-over-year, although we believe we are seeing some signs of stabilization. We expect to end the year with U.S. PCIs down in the low single digits versus 2012. This is clearly impacting our coronary IVUS business in the U.S., while also having implications for our FFR activity. We expect the PCIs in the U.S. will decline -- will continue to decline at about 2.5% as we stated earlier in 2014.

It is in Japan where we have seen the most noticeable change in the environment as PCI activity there, which has been relatively flat for the past number of quarters, dropped in the third quarter, a trend which is continuing into the fourth quarter. As we indicated last week, we are expecting about 2% decline in Japanese PCIs in 2014. While John will discuss this during his comments and guidance, keep in mind the reduction in reimbursement in Japan is for all of our disposables, which are primarily IVUS and FFR. Our estimate of 7.5% represents an average of the previous 3 reductions over the past 6 years. As a reminder, the reimbursement reduction in 2012 was approximately 10% for IVUS and zero for FFR.

As I mentioned, Europe continues to be a bright spot. Although as we've indicated in the past, this is not a continent-wide basis, but primarily in Northern Europe. We are also doing well in our distributed markets, such as Turkey, Russia and the Middle East. Geographies in Southern Europe, such as Italy, Spain and France, remain challenging. Our outlook for Europe through the balance of 2013 and all of 2014 is that PCI volumes will remain flat overall with some modest growth in the Northern European region offset by continued softness in Southern Europe.

Despite the headwinds we faced with respect to this PCI activity, I think it is important to note that the tailwinds we've discussed with you in the past remain in place and are closer to realization. These include the need for documentation, proof of necessity and the drive to cut hospital readmissions and overall costs. As a result, we believe that over the long term, the growth of risk-based delivery of healthcare will drive the adoption of FFR and IVUS in the U.S. In addition, the issue of over-stenting continues to be of importance. In July, a panel of experts convened by the AMA and a joint commission cited elective stenting as 1 of 5 overused treatments that too often provide 0 or negligible benefit to patients and potentially exposes them to risks.

While our IVUS coronary activity remains strong, we are having great success with our programs in the peripheral market, and we continue to believe that the market for IVUS and the peripherals is massively underpenetrated with more than 3.1 million procedures globally, an imaging penetration of less than 3%. We believe that ultimately, the size of the peripheral imaging market will approach that of the coronary imaging market.

Our growth in the peripherals continue to accelerate in the third quarter as revenues from peripheral imaging increased approximately 30% year-over-year, driven by increased penetration in the AAA and venous catheter market. We also benefited from initial sales of the PioneerPlus Re-Entry catheter, which we acquired in August from Medtronic.

PioneerPlus represents leading technology for the treatment of subtotal and total and chronic total occlusions within the peripheral vasculature, potentially eliminating the need for surgery. Our IVUS technology, which we have been providing in combination with the PioneerPlus for many years is used to direct the guide wire past stenotic lesions prior to additional intervention, such as balloon angioplasty or stent placement or atherectomy by providing a cross-sectional ultrasound image of the area of interest. We believe that with our peripheral emphasis and the knowledge of IVUS, we can accelerate the market adoption of this product as we build out a portfolio to address lower extremity PAD, including IVUS for stentizing atherectomy selection and guidance, and FFR to help determine treatment in the leg. We will also seek to establish penetrations of the PioneerPlus in non-U.S. markets where sales have been nominal in the past.

The current clinical success and application of the Pioneer products in conjunction with our Valet Microcatheters also contributed to our thinking around the forward-looking IVUS program. We view current and future versions of these Pioneer and Valet technologies of providing very good solutions that obviate the need for the FLIVUS development program.

The Pioneer transaction furthered our strategy to diversify beyond coronary applications and increase our penetration of the peripheral market and enjoins our product portfolio that includes the Crux IVC filter, Valet Microcatheter, the PV .035 IVUS catheter for use in AAA, and the Eagle Eye IVUS PV .018 and .014 catheters for use in highly stenosed peripheral lesions. The PV .035, which has been available in the U.S. and Europe, is being launched in Japan now, and we expect to record some initial revenues during the current quarter.

We are the only company offering a phased array catheter for peripheral indications and believe its depth of penetration, ease-of-use, plug and play, and imaging diameter capabilities provide us a strong competitive advantage. Our peripheral-only sales force is gaining increased traction in the market, and the peripheral-related training that we provided our sales -- our overall sales force earlier this year has started to reap benefits. Today we believe our peripheral imaging market share globally exceeds 75%. Our primary focus in this area includes FFA, EVAR and TEVAR, AV access and vein compression, an underlying cause of DVTs and Venous Reflux Disease.

We're also seeing increased clinical interest in the use of imaging and physiology for the diagnosis and treatment of PAD. We exhibited at the recent VIVA conference, where there were several live cases involving the use of IVUS, and we'll be showcasing our Crux and PioneerPlus devices at next week's Peripheral Focused V meeting. [ph]

We saw a number of U.S. TCT last week, and I want to make just a couple of -- take a couple of minutes to touch on some highlights from that meeting.

First of all, we received very positive feedback from clinicians for our new offers, including iFR, the Verrata everyday pressure wire, Crux IVC filter and the Sync-Rx system. Second there were 2 important data presentations at TCT, beginning with 2-year outcomes from the use of IVUS and the ADAPT-DES study, the largest prospective registry of IVUS use today. The results from ADAPT-DES suggest that the use of IVUS with angiography versus angiography alone for stent placement was associated with reductions in certain serious patient events, including stent thrombosis, myocardial infarction and target lesion revascularization. The incidence of stent thrombosis was reduced 53%, MI was reduced 38%, and the incidence of major cardiac events such as stent thrombosis, cardiac death and MI was reduced by 34%. Also importantly, IVUS guidance changed the procedure 74% of the time. These findings are important to Volcano for 2 reasons: First they support our strategy of functional PCI providing precision-guided therapy solutions to address the economic and clinical trends I touched on earlier to improve outcome and reduce unnecessary procedures as a pathway for growth; second they validate our approach, increasing our focus on the use of IVUS in more complex coronary cases.

The second study highlighted at TCT was ADVISE II, a prospective study involving more than 800 patients across more than 40 global centers investigating the utility of our IVUS iFR technology and accepting the severity of coronary stenosis. The data presented as a late-breaking clinical trial at TCT replicated earlier findings, showing that the hybrid iFR/FFR approach correctly matched an FFR-only approach in 94.2% of coronary stenoses and successfully avoided the use of adenosine in 65-plus percent of patients. ADVISE II is the first prospective study which seeks scientifically rigorous methodology to investigate the diagnostic utility of iFR in a real-world population. Given that a key factor, inhibiting the use of FFR as a need for adenosine in patients who may have an adverse reaction, we believe the outcomes from this study are very important at helping to build long-term penetration for physiology. Furthermore these outcomes mitigate any confusion around the performance of iFR technology that use a different algorithm.

The data from this study is the basis for our pending 510-K submission, and we believe that we will receive FDA approval for iFR and be able to initiate commercial sales in the U.S. in the second half of 2014. In the meantime, adoption of iFR in Europe -- excuse me, iFR in Japan and Europe continues to meet or exceed our expectations as it is now in more than 100 centers. I should also note that we are in the process of initiating enrollment in 2 important iFR studies. The first is a defined diagnostic study, which is designed to demonstrate that the most efficient, cost-effective pathway for high-risk patients is to go directly through a diagnostic angiogram with FFR versus the current standard of care pathways with noninvasive tests. We believe that the outcomes will demonstrate the superiority of iFR guidance and enable clinicians to avoid unnecessary stenting and bypass procedures in both the diagnostic lab setting and cath lab.

The second study is DEFINE flair [ph], and it will assess the safety and efficacy of decision making on coronary revascularization based on the iFR measurements compared with those of FFR.

TCT also marked the official launch of the Verrata FFR wire for which we now have approval in the U.S. and Europe. It's our fifth new wire in 5 years. Verrata is designed to prevent kinking and ensure a more reliable connection, and provide frontline workflow to run therapeutic devices. Our initial first demand [ph] cases have had positive outcomes, and we look forward to rolling out this product during the balance of the year and into 2014. We also believe we are on track for its approval in Japan in early 2014.

I mentioned a favorable reaction to our Crux IVC filter, and we are in -- we are now in a limited market release for the device. We are encouraged by the early market response to Crux, although we don't expect it be a meaningful contributor to revenues for another couple of quarters.

In closing, I want to welcome Dan Wolterman to our Board of Directors. Dan has joined the Board during the third quarter. He's President and CEO of the Memorial Hermann Healthcare Systems in Houston. He has more than 30 years of industry experience and will provide us valuable insight into the issues our customers are facing today and will face in the future. We appreciate your continued interest in the company. Volcano continues to be the technology leader that will drive innovation in our functional PCI strategy to achieve better clinical and economic outcomes for our customers and the patients they serve. We believe the changes in strategic priorities we announced today will help us realize the value residing in the company by enabling us to compete more effectively in our growth market.

We are ending 2013 with strong momentum in our pipeline with the commercialization of Crux, iFR, Verrata and Sync and expansion of our iFR offering in Europe and Japan. In addition, we have a more-focused strategy for our sales marketing, R&D, clinical and new product development and capital allocation programs. We look forward to updating you on our progress.

Before turning the call over to John, as some of you may be aware, 1 of our shareholders filed a 13D today. We do not intend to address that filing on today's call or take questions about it. We obviously have seen the 13D and appreciate and take very seriously the perspectives of our shareholders. We intend to address the 13D at an appropriate time in the future. John?

R. Scott Huennekens

Thank you, Scott. Revenues for the third quarter of 2013 were $95.8 million on reported basis versus $93.7 million in the third quarter a year ago. I should note that our revenues for the quarter included a modest contribution from sales of the Pioneer device.

Foreign currency exchange rates had a negative impact of approximately $5.4 million in the quarter. Revenues for the first 9 months of 2013 were $290.4 million versus $279.4 million a year ago. Foreign currency exchange rates had a negative impact of approximately $15.1 million.

Cycle second revenues, primarily systems FFR and IVUS disposables, which include Pioneer and Axsun Medical, increased 3% on a reported basis and 9% on a constant-currency basis in the quarter. Axsun Medical revenues were $3 million versus $2.5 million a year ago, while our revenues from Axsun Industrial were $2.1 million versus $3 million a year ago.

Consolidated sales of multi-modalic systems and related equipment in the quarter were $11 million versus $9.7 million a year ago. Total console placements in the quarter were 234 versus 198 a year ago, including 91 in the U.S. versus 83 last year. In Japan, we had 37 placements versus 35 a year ago, while in Europe, we had 81 placements versus 51 last year. We placed 25 consoles in rest of the world versus 29 a year ago. Excluding our legacy IVG systems, we now have approximately 6,800 consoles placed worldwide, versus approximately 5,900 consoles placed a year ago.

A couple of notes regarding our top line results. IVUS disposable revenues in the U.S. increased 7% in the quarter driven by a roughly 30% growth in peripheral imaging revenues. On a constant-currency basis, FFR revenues in the quarter increased 21% in Europe and 34% in Japan year-over-year. For the first 9 months of 2013, FFR revenues in Japan increased 78%, and 26% worldwide on a constant-currency basis.

Gross margins for the quarter were 65.1% versus 64.5% in the third quarter a year ago. Gross margins versus a year ago were impacted favorably by product mix, offset by unfavorable FX, low-margin system placements, softness in our FFR business in Japan and duplicate capacity costs.

As we have indicated to you in the past, gross margins have been running favorable to our expectations the last several quarters. However we expect gross margin pressure in the fourth quarter of 2013 and through most of 2014 as we start to rationalize our duplicate capacity in Rancho Cordova.

Operating expenses in the third quarter were $68.8 million versus $54.4 million a year ago. Year-over-year SG&A increased by approximately $4.8 million due primarily to increased sales force headcount and expenses associated with our new peripheral imaging marketing programs, expenses associated with the move of our corporate headquarters, implementation of a new ERP system and the medical device tax.

R&D expenses increased by approximately $3.6 million year-over-year, reflecting costs associated with our Sync-Rx and Crux program, as well as increased clinical activity. We would expect spending for R&D to increase in the fourth quarter due to the timing of some of our product development and clinical trial programs.

Regarding other expense categories, we've recorded acquisition-related charges of $1.3 million related to the Crux and Pioneer transactions. I also want to highlight the interest expense line, where we recorded an expense of $6.8 million, of which approximately $2 million is a cash expense. This compares with recorded interest expense of $1.8 million a year ago.

In addition, the reprioritization program that Scott discussed resulted in one-time noncash charges of $4.6 million related to the impairment of intangible assets.

In terms of the income taxes, we've recorded a tax benefit of $4.4 million versus a tax expense of $2.1 million a year ago. For the third quarter of 2013, we've reported a net loss on a GAAP basis of $8.5 million or $0.15 per share versus net income of $2 million or $0.04 per diluted share in the third quarter a year ago. Both basic weighted average and diluted shares were $54.7 million during the quarter.

Excluding acquisition-related items, amortization of intangibles and noncash interest expense on the convertible notes, net of tax, we've reported a non-GAAP net loss of $0.08 per share.

With respect to guidance for 2013, we are reconfirming our updated guidance for reported revenues of $391 million to $395 million based on current foreign currency exchange rates with revenues on a constant-currency basis of $411 million to $415 million. Medical segment revenues are expected to increase approximately 9% to 10% on a constant-currency basis.

For all other items on a reported basis, as indicated in today's press release, we now expect gross margins will be in the range of 64% to 65%, and operating expenses, including the restructuring expenses, will be 71% to 72% of revenues. We expect to record a restructuring charge of up to $15 million in the fourth quarter, with up to $7 million to $7.5 million of that being cash charges. For the year, we will record approximately $3 million related to the medical device tax, approximately $5 million related to acquisition accounting for Sync-Rx, Crux and Pioneer acquisitions and $3.7 million of amortization of intangibles. As a reminder, interest expense will be approximately $27 million for the year, of which approximately $19 million is noncash.

On a GAAP basis, we expect a net loss of $0.56 to $0.58 per share. We expect our annual tax benefit to consist of our annual effective tax rate of approximately 38.5% plus the $1 million benefit related to the 2012 R&D tax credit that was recorded in the first quarter. On a non-GAAP basis, we expect a net loss of $0.25 to $0.27 per share. And as a reminder, non-GAAP results exclude acquisition-related items, amortization of intangibles and noncash interest expense, and assume an effective tax rate of 38% for the GAAP to non-GAAP adjustments. We expect weighted average basic shares in 2013 will be approximately $54.6 million. I also want to reiterate that approximately 30% of our revenues are in Japanese yen and 14% are in euros. And as for every dollar impact of foreign currency at the revenue line, approximately 90% drops down to the gross margin line and 55% to the operating margin line.

Also today, we are reconfirming the guidance for preliminary 2014 revenues provided in our press release of October 28. Based on our current outlook for the macro environment and the foreign currency exchange rates, we expect to generate revenue growth on a reported basis of 9% to 11% or 8% to 10% on a constant-currency basis. Our assumptions for revenue in 2014 include growth in our Base business of 6% to 8%, and about 200 basis points of revenue contribution from new products, such as Crux, Pioneer and Sync-Rx. This outlook reflects several factors, including the expectation that PCIs will be down approximately 2.5% in the U.S., 2% in Japan and flat in Europe.

In addition, as Scott mentioned, we are anticipating a reimbursement reduction of approximately 7.5% for all of our disposable products in Japan beginning in the second quarter of the year. We will provide more detailed guidance for 2014 during our fourth quarter conference call in February.

I also want to take a moment and address our capital allocation strategy as we've had questions from a number of you on this subject. We want to assure you that the company has a disciplined capital allocation process in place to drive shareholder value, and that we are conscious of the key risks of M&A, those being overpayment, dilution and integration. We understand the need to invest our cash such as that our returns are greater than our weighted average cost of capital, and we have a process in place to ensure this.

These opportunities could include investments and programs to support the growth of our own existing products or those in our pipeline, new product development, M&A or share repurchase programs. You can assess our lack of significant M&A activity since our convertible offering last year as a validation of our disciplined capital allocation approach. As Scott mentioned earlier, our markets have changed, and we have prioritized our strategic initiatives. This also applies to our capital allocation strategy. Our Board, Scott and I continue to routinely challenge our strategy assumptions and metrics in this area that may result in different decisions with respect to investments in new product development, M&A or share repurchase programs. We will apprise you of developments in this area as warranted.

In closing, before our next planned conference call, we will be appearing at the Canaccord Adams Medtech Forum on Thursday, November 14; the Piper Jaffray HealthCare Conference on Tuesday, December 3, and the JPMorgan Health Care Conference on Wednesday, January 14.

Thank you again for joining us today, and we'll now open the call to your questions. In the interest of time, we'd ask that you limit yourself to 1 question and a follow-up.

Question-and-Answer Session

Operator

[Operator Instructions] And our first question comes from Chris Pasquale from JPMorgan.

Christopher T. Pasquale - JP Morgan Chase & Co, Research Division

I want to start with the strategic initiative. Of the 3 programs you're discontinuing, most surprised by the forward-looking IVUS decision. You had highlight that program at the Analyst Meeting in March. And my understanding was that Pioneer really fit a different niche as a reentry device versus a true lumen solution. So can you talk about what challenges remain to get that product line where you want it to be? It was something that you had been investing in it for some time and seemed like it was finally ready to -- sort of ready for prime time. And why this decision doesn't limit the options you're going to be providing to clinicians down the road?

R. Scott Huennekens

Yes, so Chris, if you look at the clinical application -- this is Scott -- basically you have 3 options. Number one is you start with a wire. Number two is that you go subintimal, and there's different approaches like Pioneer, BridgePoint, Lumen with their Koubek [ph] device. There are also then true lumen-oriented devices. And the way that the market has developed and the clinical data from the first 2 wires alone and reentry devices and where we see things going with the effectiveness of drug-eluting balloons and drug-eluting stents as well as supplementing that with atherectomy, we're seeing that the market opportunity is going to be 90% around just starting with wires and wires-only or reentry devices by going subintimal. And that's true-lumen devices, which are -- will be more expensive would be kind of your fallback position after you try these less-expensive versions of technologies. So it's a combination of where the technology was at, the cost to finish developing it, the risk associated with that, the clinical data development versus the movement in the market itself, which we see as other opportunities as being the primary therapy. Then we see ourselves playing in those in a more significant way with our impact microcatheters, with our ability in wires, with Pioneer, with advancements that we could do to the Pioneer platform. So we made a pretty -- it made it a pretty easy decision once we're able to add Pioneer.

Christopher T. Pasquale - JP Morgan Chase & Co, Research Division

Okay. And then maybe just spend a minute, if you would, on the FFR market. We saw U.S. growth there slow relative to what we saw in the first half of the year. The Japanese market, although still growing very well, seems to have flattened out a bit in the last couple of quarters. What are you seeing there, and what are your expectations as we move into 2014 for that piece of the business?

R. Scott Huennekens

Yes, so I -- 3 things. I think number one is still a dramatically underpenetrated market for the clinical need as well as the clinical data supporting the need. And so we will continue to work with St. Jude relative to developing the market itself. Number two is we are seeing a more competitive market with St. Jude. So our market share gains have slowed down. We believe with Verrata, with iFR, with Sync FFR and our technology moving forward, as well as changes in our sales force for more focus, we think those things will help both on the, number one, the market penetration side of things and market growth, as well as the market share. Thirdly we need to continue to work in huge geography relative to guidelines, reimbursement changes, coverage decisions, et cetera. And we will continue to do that. But we see this market continuing to grow in the mid double digits, and we expect ourselves to grow faster than that.

Operator

And our next question comes from David Roman from Goldman Sachs.

David H. Roman - Goldman Sachs Group Inc., Research Division

Scott, as you referenced in your prepared remarks, there's definitely a lot to cover here. But I was hoping just to start with Japan PCI volumes because that does come as a little bit of a surprise. And I think in your comments, you referenced that the weakness in the U.S. spilled over to Japan. I was hoping you would just go into a little bit more detail there on what's happening. Is that a similar dynamic around appropriate use questions? Is there something cyclical there or health spending priority-wise that you could highlight for us? And why you're sort of taking this as sort of a continued trend versus something that was just a 1-quarter blip?

R. Scott Huennekens

Yes, I think there is a focus on this by the Japanese physicians and the Japanese government. There's a large study done with FFR, the CBIT [ph] trial. I think we highlighted that on our last earnings call with you. That has had some effect in the market where there's been increased FFR usage. There's greater scrutiny and discussion in the market about appropriate use of stenting. There's not appropriate use criteria for stenting like the U.S. that's driving these decisions, but it is something that the market is taking into consideration. So it's an interesting dynamic, David, where on the one hand, you've got some increased FFR and scrutiny by physicians and the government. On the other hand, FFR growth has been slowed a little bit based upon those same centers looking at it and saying, "Hey, if we adopt FFR at a more rapid pace and we eliminate more and more PCIs, we're going to lose that reimbursement," which is -- for PCIs, which is a big part of a lot of hospital budgets. So it's -- I see -- we see a balancing act going on between increased FFR usage and moderate declines in PCI volumes.

John T. Dahldorf

Yes, David, the other thing that we know or at least that we've heard as far as impacting PCIs in Japan as well, we've actually been hearing this for a couple of quarters, is that the number of restenosis cases have declined. And that's been primarily due to the introduction of kind of next-generation drug-eluting stents. And so some physicians do feel that that's had an impact on procedure volume as well.

David H. Roman - Goldman Sachs Group Inc., Research Division

Interesting. And...

R. Scott Huennekens

You got to remember, drug-eluting stents were introduced to the Japanese market a number of years after they were introduced in Europe and the U.S.

David H. Roman - Goldman Sachs Group Inc., Research Division

Okay. That's helpful. Then maybe for -- as a follow-up just to the kept going a little bit further on the question around FFR in the U.S., one of the things that we've seen for the past several quarters has been this pretty precipitous decline in stable PCI volumes, but I think what's been decent volumes elsewhere. Can you maybe just go a little bit deeper? How -- is FFR significantly more penetrated in the stable segment of the market versus the rest of the market, which would further pressure the FFR franchise assuming that all these declines are on the stable side? Or is that -- does that not factor in here at all and the issue really is just that tightening up of the market share competition?

R. Scott Huennekens

Yes, I would say it's more of the tightening up of the market share situation. It's not as easy as saying stable and unstable. You have STEMI, non-steady -- non-STEMI. You got unstable angina. So it's a -- FFR, as we've laid out, is applicable based on FAME and FAME II with strong Level I evidence New England Journal of Medicine randomized clinical trials for 37% of PCIs, and it's currently in the -- what do we...

John T. Dahldorf

I'd say mid to high-teens.

R. Scott Huennekens

Mid to high-teens at this point in time. So there's -- the market can be 3x as big as it is today taking the guidelines as we kind of see that based upon clinical data. So there's more market development that needs to take place. There's an interesting dynamic when we've done market research that if you ask someone how much FFR they used, they say, "We use a lot more than we used to. We estimate that we use over 30%." And the reality is that they're using more in the mid-teens. So there's different marketing programs, more focused selling, more education and training, all of these things. St. Jude and Volcano both need to do relative to continuing to increase the market size and the benefits to patients. And we -- that growth is happening as you see in the growth numbers that we've shared and shown and the growth numbers that St. Jude has talked about, or at least that analysts have projected from St. Jude.

Operator

And our next question comes from Chris Lewis from Roth Capital Partners.

Chris Lewis - Roth Capital Partners, LLC, Research Division

First, just on the restructuring charges, I think you said $12 million. Will you take that in time for cost savings and reinvest that into the sales and marketing strategies you discussed? Or will be there -- or will there be some cost synergies there?

John T. Dahldorf

The $12 million that Scott discussed in his scripted remarks will be reinvested in distribution expansion in the U.S. and Europe, and then reprioritized in our R&D and clinical spending. So it's a combination.

Chris Lewis - Roth Capital Partners, LLC, Research Division

Okay. And then you mentioned the plans that kind of change and improve the sales strategy that I was just hoping if you could talk in more detail on what types of changes you're exactly planning to make there and when we can expect some of those changes to take effect?

R. Scott Huennekens

Yes, we will expand our distribution in the Europe and the U.S. You can expect more expansion in U.S. than Europe, and that expansion will be 100% focused on peripheral. So there also may be some reallocation of people currently focused on both markets going in peripheral, towards peripheral. And we believe that's going to help. We've got great data from ADAPT-DES. We've got great data, as we've talked about, in market growth in coronary FFR. We need salespeople focused on those markets for growth as a vertical. We need sales reps focused on peripheral growth with what we have going with IVUS imaging. We'll have peripheral FFR opportunities. We also have Pioneer with Crux IVC filter. So having more focused efforts, expanding our current peripheral-only sales force in the U.S., those are things that will happen here before year end and into first quarter.

Operator

And our next question comes from Danielle Antalffy from Leerink Swann.

Robert Marcus - Leerink Swann LLC, Research Division

This is Robert Marcus in for Danielle. So you talked about a strong capital allocation strategy. With the share price where it is and a deal not being executed over the past year, how strongly are you considering share buybacks? And going forward, what kind of size and speed would you be expecting?

John T. Dahldorf

Yes, I mean, I would say that as we kind of discussed in our remarks, we do look at a pretty wide variety of alternatives in terms of putting excess cash to work, and obviously, one of them is returning the cash to the shareholders via a share repurchase program. And so it is one of those areas that we do spend a lot of time talking to our Board about. At this point, I think it's a little premature for me to be speculating on the size or timing of a share repurchase program.

Robert Marcus - Leerink Swann LLC, Research Division

Okay. And then just as a follow-up, in the quarter we saw pretty good U.S. IVUS catheter growth relative to what we've seen in the past few quarters. How much of that is coming from peripherals? And do you expect the 30% growth to continue going forward?

John T. Dahldorf

Yes, so I -- about 20% of our IVUS disposable number in the U.S. is made up of peripherals. That number has been growing quite well as we reported throughout the first 3 quarters of this year. I think as we kind of sat down and looked at our projections for next year, we thought that the peripheral IVUS business could grow in the low- to mid-20s.

Operator

And our next question comes from Raj Denhoy from Jefferies.

Raj Denhoy - Jefferies LLC, Research Division

Wonder if I could ask a little bit about your thoughts around iFR coming at TCT and the data presented there, obviously assuming to get FDA approval. But what are your views in terms of what that could do to your ability to take share? And then secondly, when you think about the opportunities for that in the STEMI population, what additional data is needed? Do you think there's going to have to be a full PMA trial in that population in order to get that sort of approval?

R. Scott Huennekens

No, we don't -- we don't -- Raj, this is Scott. Thanks for the question. No, we don't believe so relative to your last part of that. We are very optimistic. When you look at wanting to serve all of the different patients -- we talked about the 37%. But now let's talk about all 100%. Let's talk about women. Let's talk about STEMI, non-STEMI. Let's talk about multivessel disease and the practical issues associated with that, doing a wire down 3 different vessels. We really believe, to tackle all 5 of those populations as we showed in our investor presentation at TCT, you need FFR, you need Flow and you need iFR. And there's only 1 company that offers you all 3 on the same platform. So we look at the situation very similarly to the way we look at IVUS back 7 or 8 years ago when we had 20%, 30% share, and we now have 70% share in the U.S. plus, where we said you need to have rotational IVUS, Phase III IVUS, ChromaFlo, VH, roll around, integrated, peripheral versions, coronary versions. We say the same thing on FFR. You need to have FFR, Flow, iFR, coronary, peripheral, co-registration like a Sync platform. You need all of these to compete -- or not only compete but to serve all the different patients that are going to need these kinds of physiologic parameters as we go forward. So I think St. Jude and Volcano are very well positioned as you may see some new entrants like Boston or others that may only have 1 of these things but don't have a number of them like we do or, to a lesser degree, like St. Jude has as we move forward. So we're very optimistic about iFR expanding the market, as well as our ability to use it to drive market share gains.

Raj Denhoy - Jefferies LLC, Research Division

Well, so if you think about the timing, though, 1 of the intriguing comments, 1 of the observations as well is that your FFR growth in the U.S. has slowed, back down to what will be considered maybe market rate and even below market rates as your major competitor there has gotten a little more aggressive, perhaps at least taking share a little bit. When we think about the next several quarters, though, and what reverses that trend for you in the U.S., is iFR that panacea? And if so, when does it start to contribute?

R. Scott Huennekens

Yes, iFR won't be approved, per our comments, till the middle of next year. So I think Verrata is the next-generation wire. We believe it's the best performing wire on the market. So we feel like that makes a difference in the U.S. And then in Japan and Europe, where you have iFR and you have Verrata, that makes the difference in Q4 and Q1 and Q2.

Raj Denhoy - Jefferies LLC, Research Division

And just lastly, you made a comment about perhaps Boston Scientific getting into the market, and they made similar comments obviously. In your guidance you've given for '14, have you contemplated a third player in the U.S. market with FFR?

R. Scott Huennekens

We have contemplated an entering by Boston. We've not contemplated a player who may do irrational things.

Operator

And our next question comes from Bruce Nudell from Crédit Suisse.

Bruce M. Nudell - Crédit Suisse AG, Research Division

You're now -- as you noted, you kind of have stable share in the U.S. FFR market, and if the market's growing in that 10% to 15% rate, in my experience, markets very rarely reaccelerate without indication expansion. What do you think the big hangups are, where you do have really good FAME I and FAME II data and stable angina cases. What is preventing further penetration of that market?

R. Scott Huennekens

So I think the biggest one, unfortunately, with that is physician adoption and -- obviously, and what does that -- what do I mean by that? I mean that there are financial incentives against the use of a product, and we have to continue to push against those. So you have physicians not wanting to reduce the number of PCIs. And in fact, the financial wherewithal will be either their own income or the hospital's income. So we need to continue to educate payers. We need to continue to educate the government. We need to continue to drive on guideline changes on the one hand. On the second hand, we need to continue to educate physicians. Some of them aren't trained on it. They don't feel comfortable with it. We need to provide educational and training programs, show them how easy FFR is to implement in their practice, multivessel cases, et cetera, which we will continue to do. So we see the market continuing to grow at the rates they have been in the next year. We see additional clinical data that will continue to support expansion of the opportunity as well, and technology advancements that also make it easier to implement in multivessel cases, STEMI cases, non-STEMI cases, the Flow cases I mentioned either -- earlier with women.

Bruce M. Nudell - Crédit Suisse AG, Research Division

And then at the TCT, you guys had one of your clinical KOLs talking about specific peripheral indications, DVT and venous compressions. And he basically asserted that -- he was fairly certain that outcomes are better for the -- because of the availability of imaging during these cases. Is there like a single application that's big that you could drive with definitive clinical evidence in the periphery where imaging is vastly underused?

R. Scott Huennekens

Yes, so we have a hypothesis generating or a small 100 to 150 patient studies ongoing or contemplated to start here in the near term in 4 different indications, the kind of EVAR, TEVAR market. Number two, it's helping with atherectomy guidance in the SFA. The May-Thurners or vein compression market relative to stent placement. And then also AV Fistula market is the fourth one. The other area that we are earlier on in -- just lost my train of thought. Come back to me, and I'll come back to that fifth one.

John T. Dahldorf

Venous stenting.

R. Scott Huennekens

No, I said venous stenting. But those 4 are ongoing. The fifth was the partnering area -- I forget what I was going to mention.

Bruce M. Nudell - Crédit Suisse AG, Research Division

But do you think that those -- are they still kind of in the pilot stage? You haven't kind of hit on the magic bullet yet is what I think I'm hearing.

R. Scott Huennekens

No, there's strong data on AAA. There's strong data in SFA. There's strong initial data on venous stenting. So there's enough data there to generate market penetration in the 3% to 10% range, and that's not within our projection. But in order to get 20%, 30% penetration, you have to do the more comprehensive studies. So we've got plenty enough data to drive our growth in the peripheral market, we believe, the next 2 years. It's not like we're waiting for anything data-wise to achieve the peripheral growth that we have projected in our plans. Oh, I'm sorry, the fifth area was IVC filter placement bedside while we're moving to get the IVUS indication.

Operator

And our next question comes from Ben Andrew from William Blair.

Ben Andrew - William Blair & Company L.L.C., Research Division

I mean, you gave some pretty specific comments relative to what you've seen and project in Japan, but maybe talk a little bit about -- more about what changed there? And do you feel comfortable that you've sort of bracketed the downside risk? Or is perhaps Japan going to go through something similar to the U.S. downturn in terms of magnitude, more like double-digits at some point?

John T. Dahldorf

Ben, our kind of the experience that we saw in Q3, I don't think that at this point, just again based on feedback that we've gotten, I don't think that we expect to see it any more dramatic than what we're seeing right now. And so that's what's caused us to kind of take that 2% decline that we saw in Q3, throw forward into Q4 as well as 2014. And so based on the data and the feedback that we've gotten up to this point, we do believe that we have it captured and bracketed as you've described in our forward projections.

Ben Andrew - William Blair & Company L.L.C., Research Division

Okay. And then, Scott, you talked about kind of reprioritizing away from OCT to high-res IVUS. What, if anything, do you give up there? And what does that save you from a development and market -- product development, market development standpoint that makes that an attractive switch?

R. Scott Huennekens

Yes, I think they have a full development program and launch the product and do clinicals, everything else was going to require a spend of $8 million a year. So we basically free that $8 million a year up, which you'd spend. And then you have an ongoing spend of probably $3 million to $4 million a year going forward to support that product line, which we don't believe has a long-term market potential greater than somewhere between $50 million and $75 million a year. So we believe high-resolution imaging, what we call fast imaging, where you can have 50 micron near-field imaging, it's going to be the way the market goes. And we've had discussions with other OTC players, not St. Jude, other ones on the market, who share a similar outlook to us. And so if you can operate IVUS catheters at different megahertz, the same catheter that can run at 40 and 60 at either at the same time in the future or at different times, different pullbacks. You can get the essential benefits of OCT near-field wise without having to flush blood, so you can do it relatively quickly, and you can get the benefits of IVUS with the far-field imaging and not have to give that up.

Ben Andrew - William Blair & Company L.L.C., Research Division

Okay. And then, John, in terms of what's baked in the guidance on peripherals for '14, what are you assuming for kind of underlying market volume growth? And then on top of that, the penetration that you can drive with, with your modalities?

John T. Dahldorf

Yes. So we're primarily the -- have the most market share or a big part of the market share. And so we believe that we're kind of growing at the rate that the market is growing. And so as I've mentioned in an answer to an earlier question, we think that's going to be in the mid-20s in 2014. And from a penetration perspective, it's low single digits right now. It may increase 100 basis points, 150 basis points across all the peripheral procedures. And so it doesn't take much incremental penetration to drive the substantial growth that we're talking about.

R. Scott Huennekens

So Ben, I think we've...

Ben Andrew - William Blair & Company L.L.C., Research Division

[indiscernible] what the -- I was actually getting to what the underlying...

R. Scott Huennekens

Yes, so let me try to answer it for you. There's 4 ways that we grow that we've talked about in the past: market penetration of our modality, market procedural growth, price increases, market share gains. In the peripheral market, you're going to see market penetration increases. You're going to see market procedural growth in the procedures that we participate in. They've been running 5% to 7%. You're not going to see price increases. You're not going to see real market share gains because we're the market share leader.

Ben Andrew - William Blair & Company L.L.C., Research Division

Okay. That's what I was trying to get at. That 5% to 7% number.

Operator

And our next question comes from Jayson Bedford from Raymond James.

Michael Rich

This is Mike Rich calling in for Jayson. First as it relates to gross margin, John, I believe you mentioned a dip in 4Q and then that, that might carry over into 2014. But as Costa Rica ramps, can you give us an idea where we might be able to exit 2014 on gross margins?

John T. Dahldorf

Yes, so we'll get into more detail on the Q4 call in February. But we talked about as once we are 100% disposables in Costa Rica and we have Northern California completely rationalized, we believe that gross margins will improve 250 to 300 basis points at least. And I think that we'll start getting our first glimpse of that gross margin improvement, not all of that, but we should be seeing kind of the first glimpse of that as we exit 2014.

Michael Rich

Okay. And then in terms of your distribution post the restructuring, I know you mentioned expanding the peripheral team. What are your plans for increasing the number of folks that touch maybe payers or hospital administrators? Our thought being physicians have obviously bought in, but maybe you're getting more pushbacks from not the docs but their bosses.

R. Scott Huennekens

Yes. So that is also a part of our plan. We currently -- had zero a year ago. We've added 1 headcount, and that headcount will increase as we move forward.

Operator

And our next question comes from Steven Lichtman with Oppenheimer.

Steven M. Lichtman - Oppenheimer & Co. Inc., Research Division

Just wanted to follow up on the distribution changes and how much things will change. How do you expect the sales force in the U.S. to look a year from now or maybe 18 months from now? Will it be completely separate between peripheral and coronary? And how do you see that effort of breaking apart the sales force? Is it just as important as growing the sales force? It certainly seems there was a bit of borrowing from FFR this quarter with that better growth in the U.S. and maybe a shift in sales force focus.

R. Scott Huennekens

Yes, we're not internally prepared to have that discussion with you at this time. We're still in the midst of finalizing those plans. There may be separate sales forces with the same regional managers that they report up to. There may be allocation of accounts that are different peripheral sales force. So -- but we will have a structure that will deliver on our goals, which is to have focus on peripheral and focus on coronary that we don't have today.

Steven M. Lichtman - Oppenheimer & Co. Inc., Research Division

Okay. Great. And then just in Europe, with the FFR disposals actually doing pretty well here the last couple quarters, how much of that do you think is iFR? And are you seeing any -- I know it's been in a limited launch, but any share wins as a result of iFR in Europe over the last couple of quarters.

R. Scott Huennekens

Yes, I think most of our first implementations are existing Volcano customers data before we say or call it a trend. That would be market expansion more than it would be market share.

Steven M. Lichtman - Oppenheimer & Co. Inc., Research Division

Sure. And then it's about now where you're going to go to a broader launch in Europe and Japan with iFR?

John T. Dahldorf

Yes, we've kicked that off in the fourth quarter.

Operator

And our last question comes from Jason Mills from Canaccord Genuity.

Jason R. Mills - Canaccord Genuity, Research Division

Scott, I plan to go also with my first question, but the previous question sort of got me thinking about access in the cath lab. Splitting the sales force, I don't know if splitting the sales force is the right term, but really driving forward with a specific peripheral sales force. How -- what's your strategy to gain access -- better access to the cath lab vis-à-vis that strategy given there seems to be an increasingly difficult challenge among you and your competitors to get access to docs and access to cath labs? Does this new strategy, you think, gives you more access and therefore helps you to drive growth?

R. Scott Huennekens

Yes, access has become more challenging. There are additional requirements, different restrictions. So it has become more of a challenge. It's not as much a challenge for Volcano as it is maybe for some other vendors given the technologies we have, the limited competition, the help that we provide in training on equipment and reading of images. But it still is an issue. And so if, if you have 2, and in some cases today, we do have 2, we have a peripheral rep and a coronary rep, they do have more access to an account than if you have just one.

Jason R. Mills - Canaccord Genuity, Research Division

Okay. Helpful. And then John, trying to quantify -- you're probably not prepared or else you would've given it, your earnings guidance for 2014. But just helping us directionally to quantify some of the changes you announced today vis-à-vis the restructuring. It certainly seems to be reallocation from, to some extent, from R&D to SG&A as you build out the distribution of most of the company. Directionally should we expect in 2014 R&D nominally expenses of $68 million to go up, be flat, go down? And then from an SG&A perspective, excluding the $12 million, $15 million in December, $12 million in December that will fall in there, on a run rate basis, should we expect -- I guess the question is, should we expect operating expenses in general to grow faster than revenue in 2014 as you sort of reallocate but yet spend a little bit more on your distribution muscle?

John T. Dahldorf

Yes, so Jason, we'll have a lot more to say about that in -- on our Q4 call in February. So I really not -- rather not get into the detail because as Scott talked about, there are still things that we're working through as far as what is the proper prioritization and allocation. But I can be fairly certain at least as I sit here today and share with you that R&D will probably be, well, it won't go up as a percentage of revenue from where we are today. My sense is that it will go down a couple hundred basis points. And then like we talked about, it will be kind of allocated across -- some of that going into sales and marketing.

Operator

I would now like to turn the call back to Mr. Huennekens for any closing remarks.

R. Scott Huennekens

So thank you guys all for participating. Appreciate it, and look forward to seeing you hopefully at one of the upcoming meetings.

John T. Dahldorf

Thank you.

Operator

Ladies and gentlemen, thank you for participating in today's conference. This does conclude today's program. You may all disconnect. Everyone have a great day.

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