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Hologic (NASDAQ:HOLX)

F3Q10 (Qtr End 06/26/2010) Earnings Call

August 02, 2010 5:00 pm ET

Executives

Robert Cascella - Chief Executive Officer, President and Director

Steven Williamson - Senior Vice President of GYN Surgical

David Harding -

Glenn Muir - Chief Financial Officer, Executive Vice President of Finance & Administration, Treasurer and Director

Deborah Gordon - Vice President of Investor Relations

Analysts

Joshua Jennings - Jefferies & Company, Inc.

William Quirk - Piper Jaffray Companies

Tycho Peterson - JP Morgan Chase & Co

David Lewis - Morgan Stanley

Sameer Harish - Needham & Company, LLC

Vivian Cervantes - Maxim Group LLC

Jayson Bedford - Raymond James & Associates

Thomas Kouchoukos - Stifel, Nicolaus & Co., Inc.

Jonathan Block - SunTrust Robinson Humphrey Capital Markets

Amit Hazan - Gleacher & Company, Inc.

Amit Bhalla - Citigroup Inc

Operator

Good afternoon, and welcome to the Hologic Inc. Third Quarter Fiscal Year 2010 Earnings Conference Call. My name is Jessica, and I am your operator for today's conference. [Operator Instructions] I would now like to introduce Deborah Gordon, Vice President, Investor Relations to begin the call. Please go ahead.

Deborah Gordon

Thank you, Jessica. Good afternoon, and thank you for joining us for Hologic's Third Quarter, to Fiscal 2010 Earnings Conference Call. I encourage everyone to visit Hologic's Investor Relations page of our website, in order to view the PowerPoint presentation related to the comments that Glenn Muir, Hologic's Chief Financial Officer, will be making in his opening remarks.

The replay of this conference call will be archived on our website to Friday, August 20. Please also note that a copy of the press release discussed in our third quarter results, as well as our fourth quarter and fiscal year 2010 guidance, is available on the Investor Relations section of our website under the heading Financial Results.

Before we begin, I would like to remind you of our Safe Harbor statements. Certain statements made by management of Hologic Inc. during the course of this conference call, may constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.

Such forward-looking statements involve known and unknown risks, uncertainties and other factors, which may cause actual results, performance or achievements of Hologic to be materially different from future results, performance or achievements, expressed or implied by such forward-looking statements. Such factors include, among others, those details from time to time in the company's filings with the Securities and Exchange Commission. We expressly disclaim any obligation or undertaking to publicly release any updates or revisions to any forward-looking statements to reflect any change in our expectations or any change in events, conditions or circumstances on which any such statement is based.

Also, during this call, we will be discussing certain financial measures not 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 Hologic's third quarter 2010 earnings release, including the financial tables in the release.

Please note that today's conference call will consist of approximately 30 minutes of opening remarks from management, followed by a 30-minute question-and-answer session. We therefore please ask, each participant to limit his or her questions to just one, with one follow up as necessary. We do appreciate you may have additional questions, so please feel free to get back into the queue, and if time permits, we'll be more than happy to take your additional questions at that time. With that, I would now like to turn the call over to Mr. Rob Cascella, President and Chief Executive Officer.

Robert Cascella

Thank you, Deb. Good afternoon, and thank you for dialing into our conference call. Joining me on the call is Glenn Muir, our Executive Vice President and CFO; Steve Williamson, Head of our GYN Surgical business; and David Harding, Head of our International Business. We all will be available during the question-and-answer session.

Our agenda for today's call is as follows: I will review our business performance in the recently completed third quarter, and Glenn will discuss in more detail our financial results, as well as provide our guidance for the fourth quarter and full year of fiscal 2010. We will then open up the call for Q&A. As Deb stated, we will conclude this call in about an hour.

While I'm very pleased to report that once again, our quarterly revenues and adjusted earnings exceeded our guidance. As stated in our earnings release, Q3 2010 revenues were approximately $421 million, a 4.4% increase from Q3 of '09 and slightly ahead of our guidance of $415 million to $420 million. Taking into consideration the impact of discontinued products and the effects of foreign exchange in the quarter of $5 million, revenues would've increased approximately 6% over Q3 from last year. Our third-quarter performance is driven chiefly by growth in our Breast Health and GYN Surgical businesses, offset by declines in Diagnostics and Skeletal Health.

The improvement in Breast Health came from a combination of increases in revenues from Service and our 2D and 3D Selenia Dimensions, while GYN Surgical growth was led by demand for both Adiana and NovaSure. Our revenue mix remains strongly weighted toward our Service and Consumable businesses, namely Diagnostics, Surgical and Breast Biopsy, which represented 74% of total revenues.

Third quarter non-GAAP earnings per diluted share were $0.30, ahead of our guidance of $0.29. This compares to our non-GAAP EPS of $0.29 for the same period last year. Our earnings are generally impacted by many changing variables. This quarter for instance, earnings were affected favorably by increased revenues and tight control of our operating expenses. Unfortunately, earnings were also negatively impacted by product mix shift. In the quarter, we experienced higher Breast Health revenues, which carry a lower gross margin than our average corporate rate, and also saw a reduction in our higher-margin ThinPrep volume on a year-over-year basis.

I would now like to review our revenue performance in each of the four segments. In Breast Health, we recorded revenues of $189.3 million, an increase of 8% from $175 million for the same quarter from a year ago. Sequentially, revenues were flat with Q2. The year-over-year increase was principally the result of strong growth in Service revenues, as well as increased sales of our 2D and 3D Dimensions. Mammography unit volumes were up as compared to last year, as we are seeing a growing number of U.S. customers purchasing the new 2D Selenia Dimensions systems to upgrade their older systems, and a growing number of international customers buying both 2D and 3D systems.

Overall, ASPs were consistent with prior year, due to larger percentage of higher-priced Dimensions shipped in the quarter, which offset the shift in sales to lower priced defeatured Selenia. We expect product mix to change favorably with the emerging replacement market over the next nine to 12 months. Demand for our Eviva breast biopsy product remains robust and we believe we are continuing to take share in this area of active market. Similar to their prior two quarters, however, this business was once again impacted by a reduction in a number of mammography screening exams, which consequently reduced the number of breast biopsy procedures. From a longer-term perspective, we are cautiously optimistic the mammography interventional breast product lines will trend upwards.

Turning now to Diagnostics, we recorded revenues of $137.4 million, a decrease of 1.5% from the $139 million in Q3 of '09 and down 1.5% sequentially, due mainly to a reduction in ThinPrep volume. We believe the softness and wellness visits to OB GYNs in the U.S. is primarily due to the effects of high unemployment, coupled with economic uncertainty. It is important to note that based on our sales intelligence, and discussions with national labs, we continue to believe we are maintaining our market share, but the declines in volume are not the results of competitive pressures.

Also important to note, is that although imaging revenues were slightly down due to a reduction in patient visits, image or adoption continues to increase. Furthermore, we are very pleased of Cervista HPV, they also increased both sequentially and year-over-year, as we continue to open new accounts and gain traction in existing ones. Despite the softness in patient visits and ThinPrep's test volumes, Cervista sales continue to grow, and we remain very optimistic about its potential to help drive our topline over the next year.

In GYN Surgical, revenues totaled $71.6 million, an increase of approximately 9% compared to $65.8 million in Q3 of '09, and a gain of approximately 7% sequentially. The improvement versus last year is primarily the result of continued adoption of our Adiana system in the U.S. and worldwide growth in NovaSure.

With respect to Adiana launch activities expanded in the quarter, and we now have our full sales team focused on training doctors and selling the product into our target accounts. We believe we continue to take share from a competing technology, and have now reached low double-digit market share.

In Skeletal Health, revenues totaled $22.4 million, a decline of 2% compared to $22.9 million in Q3 of '09, and a 4% increase sequentially. We continue to remain optimistic, the results of recent favorable changes to reimbursement will have a positive impact on demand for our bone densitometry systems over the next several quarters.

I would now like to talk about a few topics of interest. The first being, our acquisition of Sentinelle Medical. In early July, we announced the signing of a definitive agreement to acquire Sentinelle Medical, a Toronto-based company established in 2004, and engaged in the development and marketing of MRI breast coils, patient positioning and transport systems and MR-CAD workstation (sic)[MR-CADWorks] solutions. The closing of the transaction is expected to occur later this week.

Sentinelle has developed a strong brand by delivering superior image quality through the use of proprietary coils. They have also developed an innovative MR-CAD and workflow solution, which potentially surpasses many of the existing products on the market. The Sentinelle team will remain in Toronto and will be run as a division within our Breast Health group. We fully intend to maintain and grow our strong OEM relationships, while also selectively selling certain more complementary products direct.

We believe Sentinelle represents best-of-breed technology, consistent with the approach Hologic has taken. This acquisition is yet another example of expanding our offerings in the Breast Health market, and provide significant product and technology synergies with both our Breast Imaging and Interventional businesses. Hologic and Sentinelle also share common operating philosophies, a commitment to excellence, a determination to provide only best-in-class products and a passion for women's health. The people at Sentinelle are some of its greatest assets, which we intend to cultivate.

Now to move onto tomosynthesis. As most of you are aware on July 27, we announced that the company's tomosynthesis system is scheduled to be reviewed by the Radiological Devices Panel of the FDA on September 24 of this year, as part of the company's PMA application. The PMA application being reviewed was originally filed in 2008, and subsequently updated with additional data and seeks approval of the use of the system for both screening and diagnostics.

Scheduling of this Panel review is the result of our ongoing discussions with the FDA. We believe this is the positive turning of events and a valuable next step in our approval process. This does not mean we will discontinue the clinical trial currently underway, and as discussed previously, we anticipate multiple FDA submissions over the next six to nine months. We are extremely pleased to have a set Panel date to review our exciting next-generation technology and remain committed to striving to work some level of approval in 2011.

Now for a brief update on the economy. We continue to closely monitor the effects that unemployment is having on the healthcare consumer. As we have mentioned in today's discussion, we have felt the impact of wellness exams being deferred, in favor of addressing the mandatory healthcare needs of the family. This is translating into lighter procedure volumes for ThinPrep and breast biopsy products. We continue to believe the fundamentals of these businesses are sound and its recent softness is short term in nature.

On the European front, we are seeing an impact from the economic conditions they are experiencing. Both in terms of unit volumes and foreign currency. Although we are not in a position to project the outcome of austerity measures that may be implemented, or any potential impact such measures may have on our business, we did experience lower procedure volumes and equipment purchases in the quarter, resulting from the current economic climate. We will update you in the future as we gain more clarity on the economic conditions abroad, the impacts of reform, including changes in reimbursement rates and our efforts to preserve and enhance our profitability in the face of these changes.

With that, allow me to summarize. I am encouraged by Hologic's performance in the third quarter, particularly as our Capital Equipment business continues to show signs of stabilization and our most recently approved products, Cervista and Adiana, are gaining traction in contributing to the growth of our business. Nonetheless, we continue to face some challenges related to higher rates of unemployment in the U.S. and the European economy in general.

I remain confident however, in Hologic's longer-term growth prospects, particularly as our new products mature and increasingly contribute to our revenue and earnings, and as we continue to build our international infrastructure in order to grow our business outside the U.S. I will now turn the call over to Glenn to provide third quarter financial details, and guidance for the fourth quarter and full year fiscal 2010.

Glenn Muir

Thank you, Rob. As Rob stated, consolidated revenues came in just slightly above our expectations. Primarily, as a result of the strong performance in our Breast Health segment, led by Service, which was up $13 million year-over-year.

We also saw a nice growth in GYN Surgical from an increase in NovaSure procedures, coupled with growing Adiana sales. Our mix of domestic and international sales was 80% and 20%. Foreign currency translation had a modest negative impact of $1.5 million, which was less than 1/2% year-over-year on our reported revenues, primarily within the Breast Health and Diagnostics segments.

Turning to the rest of the P&L, our gross margins on a non-GAAP basis were 60.2%, down 130 basis points from the second quarter, and down 240 basis points from last year. The growth margins were just below our guidance range of 61% to 62%, due chiefly to: First, we saw unfavorable yield and scrap on our Adiana manufacturing line, resulting in unacceptable margin levels, that are improving with time and volume;

second, the write-off of unabsorbed overhead on our NovaSure line, resulting from an adjustment in production levels related to the switch, to the new generation Protostar [ph](23:15) version; and third, lower ThinPrep volumes, which is a higher-than-average growth margin product for us.

Non-GAAP gross margins exclude $43.5 million of amortization intangibles in the third quarter. On a GAAP basis, gross margins are 50%. Going forward, we are expecting gross margins on Adiana and the new NovaSure Protostar [ph] (23:40) to improve with increased volume.

Our operating expenses continue to be well controlled. Operating expenses on a non-GAAP basis of $116.7 million, primarily excluding amortization of intangibles of $13.6 million, came in $8.7 million below our second quarter and down 2% compared to last year. This is below our guidance range of $128 million to $130 million.

This decrease from Q2 of 2010, primarily resulted from a reduction in our legal fees. We do continue to invest in R&D related to clinical studies and next-generation products, and reported an R&D ratio of 5.8%, as a percent of revenues in both Q3 of 2010 and Q3 of last year.

In the first quarter of fiscal 2010, we adopted a new standard that changed the accounting for convertible debt instruments with cash-settlement features. The additional charge resulting from the adoption of this accounting guidance was $18.5 million this quarter and $17.1 million in the third quarter of last year. This non-cash interest expense charge has been excluded from our non-GAAP results of operations for all periods presented.

Absent the acquisition-related and other charges, pretax earnings this quarter were $122.1 million. Using our annual effective tax rate of 36% for the quarter, non-GAAP net income was $78.2 million versus non-GAAP net income of $75.5 million last year, an increase of 3.5%.

Our total dollar backlog for all of our products was $286 million at the end of June, down from $297 million at the end of March. The majority of this $11 million decrease was in Breast Health, where the reduction in backlog was related to a weakness in international orders. The summer is always a seasonally slower quarter for our CapEx business, which makes up the majority of our backlog. Even still, we are encouraged at this point in the quarter and are expecting Q4 bookings to be similar with Q3.

Turning to the balance sheet, during the third quarter, we fully repaid our $540 million term loan, with a final payment of $47 million in April. Our plans for use of cash are focused on investing in our current technologies and operations, our current acquisition of Sentinelle and potential future deals, as well as preparing for the possible redemption of the convertible notes beginning in December of 2013.

Regarding free cash flow, we generated approximately $125 million in the third quarter of 2010, comprised of approximately $137 million of cash flow from operations, less capital expenditures of $12 million. Now moving on to guidance. All of our guidance does exclude the acquisition of Sentinelle, which we are expecting to close later this week.

For the fourth quarter of fiscal 2010 ending on September 25, we are expecting revenues in the range of $415 million to $420 million, comparable to the Q3. We expect gross margins of approximately 60% to 61% on a non-GAAP basis. We are expecting operating expenses, primarily excluding amortization of intangibles, to increase slightly on a sequential basis from Q3 to $118 million to $121 million or approximately 28% to 29% of revenue.

We expect interest expense to be approximately $29 million in Q4, including $18.7 million of non-cash interest expense, as a result of our adopting the new accounting guidance related to our convert. Our effective tax rate is expected to be 36%, and we expect non-GAAP earnings per share of $0.30 per diluted share.

Now for fiscal 2010, which ends on September 25. We are increasing our total revenue guidance. We are now guiding to full-year total revenues in the range of $1.665 billion and $1.67 billion, up from prior guidance of $1.64 billion to $1.665 billion. This is due primarily to our revenue per out performance in Q3. This reflects the current level of capital equipment stabilization and our outlook for flat to slightly increased GYN Surgical revenues and flat to slightly decreased Diagnostics revenues for the remainder of the year. We are guiding to non-GAAP adjusted EPS of approximately $1.17 per share, compared to our prior guidance range of $1.16 to $1.20 per share. This guidance reflects gross margins of 60% to 61% for the year.

We are expecting operating expenses to be in the range of $491 million to $494 million, up approximately 2% to 3% from fiscal 2009 and excluding amortization of intangibles. We're expecting interest expense to be approximately $126 million, including $73 million of non-cash interest expense from the new accounting guidance related to the convert. And we are expecting an effective tax rate of 36%.

Turning to cash flow guidance. In fiscal 2010, we expect to generate approximately $450 million of free cash flow, excluding the $70 million payment from KV we received in January, and excluding the $85 million payment we expect to make this quarter to acquire Sentinelle Medical. We are expecting capital expenditures of close to $50 million and depreciation of approximately $70 million for the year.

In summary, we are pleased with our third quarter revenue performance in the face of weak office visits, caused by economic factors impacting unemployment, as well as the ongoing difficult global economic environment, including uncertainty over changes in healthcare regulations. Despite these headwinds, we were able to increase our revenues and we believe, our market share for many of our products.

We expect to see our gross margins and earnings improve over the near to long term, as many of our new products grow in volume. Given the continued external pressures to control healthcare costs, we are attempting to remain conservative in our outlook. Now with that, let me turn the call back to Rob.

Robert Cascella

Thanks, Glenn. To wrap up, we remain on track to meet our full-year guidance and are optimistic as we begin to look out to the next fiscal year and beyond. We believe we have a strong product portfolio that can fuel growth over the long term. Our focus in the meantime is to continue to build our foundation for future growth both domestically and abroad, invest selectively in new opportunities through product development and acquisition and finally, manage our businesses within an extra ordinary commitment to our customers.

Finally, I'd like to thank you all for your participation on the call. This now concludes our opening remarks, and we'd be happy to answer any questions that you might have. With that, operator, please open the line for questions.

Question-and-Answer Session

Operator

[Operator Instructions] And our first question comes from Thomas Kouchoukos from Stifel, Nicolaus.

Thomas Kouchoukos - Stifel, Nicolaus & Co., Inc.

Just wanted to start on the ThinPrep business. I don't think it should be surprising when the patient volumes were down, but you also commented on the extended intervals as having some impact during the quarter. And just looking forward, assuming that we do see patient volumes tick back up over time, how do you see the interval issue effect in your business going forward?

Robert Cascella

Certainly, it is the lesser of the two areas of concern. But nonetheless, we would anticipate based on changes in guidelines. A higher degree of co-testing for HPV that Pap intervals will expand. As I said, I think it will be the lesser of the effect than what we're seeing today but nonetheless, we would expect it to continue.

Thomas Kouchoukos - Stifel, Nicolaus & Co., Inc.

Just looking at Adiana, I know there's been some concerns in the recent past about Adiana not being able to share the 58565 code with Essure in the marketplace. I don't know that anything as definitive has been published at this point, but I was wondering if you could comment on that and maybe your outlook for that reimbursement code.

Glenn Muir

Sure and on February, the AMA had a meeting to discuss the code and the ability for Adiana to share the 58565 code. The results of that meeting were private, but the decision of that Panel was subsequently appealed to a meeting that was held in June. Again, the June results are private, but what I can tell you is that we'll continue to tell our customers to use 58565 and until something becomes available, where we can share the final results.

Operator

And we'll now go to Bill Quirk from Piper Jaffray.

William Quirk - Piper Jaffray Companies

Glenn, just thinking what the bottom-line guidance here. We beat by a penny but trimming the full-year number by a penny. I assume a lot of this has to do with mix, but can you give us any additional color around that?

Glenn Muir

Bill, on mix?

William Quirk - Piper Jaffray Companies

Looking at the fourth quarter guidance, or rather the full-year guidance, we just beat by a penny here in the third quarter, but we're basically taking the fourth quarter down by a penny. I guess I was just trying to figure out here, you mentioned mix earlier, obviously, higher mammo, lower Diagnostics. Is that essentially why we have the guidance changed?

Glenn Muir

I think mix is a big part of it. I think it doesn't help that if we look at our revenue for a moment and our earnings and our gross margins are going to be very dependent on our revenue growth going forward, and to a certain extent, we are guiding to a flat Q4 from Q3. But within the revenue stream itself, you are correct, that some of our higher gross margin products such as ThinPrep are down a little bit. We are seeing this weak visits on the patient side, and they are being replaced in other areas of the business, such as on the Breast Health side. Where even though Service is growing and even though we are holding up nicely on the product side, it does comment a little bit of a cost on the gross margin side. So that makes differential did have an impact in our guidance when we looked at Q4. That's correct.

William Quirk - Piper Jaffray Companies

and then just a follow up, Rob, I certainly appreciate the color on the physician office trends and essentially, your view on that. I guess the guidance doesn't imply that we see much of an improvement here in the fourth quarter. Can you talk a little bit, I guess the longer term here? Do you expect to see a bit of a deductible phenomenon here in the calendar fourth quarter? Or is this something we have to wait until 2011 before we start seeing people going back to the doctor?

Robert Cascella

We are not expecting a trend change in our fiscal fourth quarter. However, we do think, as we roll into our new fiscal year, that we'll see some of the benefits of a re-upping on insurance and resetting of deductible. The unfortunate part is that we believe that until there is a material improvement in unemployment, that there's always going to be some downward pressures on wellness visits. So that is a gating item and we think improves over time. But we certainly don't see that in the near quarter.

Operator

We'll now go to Sameer Harish from Needham & Company.

Sameer Harish - Needham & Company, LLC

Just maybe talk a little bit about the upcoming tomosynthesis Panel that you have in September. Just how you're viewing the potential outcomes of the Panel meeting both in terms of time lines for approval and expense expectations coming out of it?

Robert Cascella

Yes, obviously, whenever dealing with a situation like this, and particularly with the agency, it's difficult to predict the outcome. We are encouraged about the indications that we've seen and heard thus far. We are not changing our data saying that sometime within 2011, that we'll have approval. But again, we believe this is a very, very encouraging sign for us to now have a Panel date and be able to present in greater granularity some of the benefits of the technology. And sorry to be vague about it. It is just very difficult to predict the outcome of such things, other than if we believe it is a positive move on both part.

Sameer Harish - Needham & Company, LLC

And just in terms -- to follow up on organizational changes with 3D mammography, what would you have to do within the organization to say, "Do an initial launch of that product?" And what sort of investment would you have to make?

Robert Cascella

And keep in mind that we have launched 3D mammography or tomosynthesis abroad. So we are selling product routinely in Europe and in other parts of the world. The requirements for tomosynthesis is that it's differently than digital mammography. It does not only cause us to provide clinical training, but it also requires us to provide training to the radiologists in terms of how to read tomo, not just how to operate the systems. So we have built an infrastructure and a training protocol for our European sales to affect just that. And we anticipate that, that would be done on a U.S. basis as well, whereby we would conduct fairly comprehensive reader-type training programs, and that really being the only thing different in terms of the launch of the product. It's service requirements are very similar I think from a sales perspective. Obviously, there's much more sales training that we'll go into it. But the true incremental cost will be physician training.

Operator

We'll now go to David Lewis for Morgan Stanley.

David Lewis - Morgan Stanley

One question for Rob, one question for Glenn. Glenn, I just wanted to start with you. This is kind of an interesting quarter. SG&A in both the relative and absolute basis was the lowest we've seen in I think two and a half years. And what we've seen in that time frames is GM's come down incrementally and operating margin still maintained at the same level through lower SG&A. I wonder can you comment at sort of the $92 million SG&A at these levels? Is this trend we've been seeing the last two and a half years sustainable?

Glenn Muir

Well, there was a conscious effort going into '09 when we were concerned about the economics out there in the world that we consciously brought down our expenses by over $50 million that year. And I think in 2010, we've tried to hold expenses. And as a quarter looks a little bit weaker than another, there are levers that we can pull on the SG&A side. So I would say that a big chunk of that is the controls that we put in place. But David, I don't think it's sustainable to the extent that we can continue to drive it down. I think at this point, we have driven it down to a fairly low level for the type of operation that we have. And I would expect going forward, and as our guidance underscores in Q4, we will see a few million dollar increase in Q4. And when we look out into 2011, we'd expect it to come up as well. I mean R&D is that one area where we're trending right now just under 6% that we wouldn't expect that to go down in the short term. I mean we do have a lot of initiatives internally that we're looking at and a lot of programs underway that we think can move the market in the future. So we're going to continue at that 6% level even on a higher revenue base. But on the G&A and sales and marketing side, that's where we have more flexibility.

David Lewis - Morgan Stanley

Rob, just two questions. You made a statement about tomo that you expect an approval one way or the other in 2011. When you say "an approval one way or the other", and I'm sorry I'm paraphrasing it, do you mean screening or diagnostic, is it which meant to say? And my second question, could you share with us at all, because it will be a matter of public record in six weeks, what additional data was provided to the agency that we will see at the panel?

Robert Cascella

Sure, and look, we intend as we had said earlier in my portion of the script that the initial PMA call for both screening and diagnostic, and that is our intent. That is the approach that we're taking with the FDA. Whether or not we prevail is another matter, and whether there is a more limited indication is certainly something that will have to come out. It's not just the panel but obviously in the FDA's final review. The additional data that we referred to, David, had to do with a follow-up to our original submission. All done within the original PMA. So when we submitted clinical data, the FDA came back and asked for some additional information, and we had submitted that a year ago. It really was a matter of I think the FDA now having the mindset that they would review that data more carefully that has now prompted us to go to panel with that information. So there really was no information for many of these additional clinical trials that we've done. It is simply data that was presented probably well over a year ago.

Operator

Our next question comes from Jayson Bedford from Raymond James.

Jayson Bedford - Raymond James & Associates

Can you help us reconcile the U.S. mammography market in terms of -- you are growing units on a year-over-year basis, yet the MQSA data is going the opposite direction. So is there any color you can give? It certainly seems like you've taken some share. But I guess maybe best guess in terms of replacing digital for digital?

Robert Cascella

Yes, I think you're right on the first point of taking share. Our focus has been in this somewhat more mature market, the emphasis has really been on going after as much of the available market as possible but at high-end, mid-tier and low-end products. So we have segmented the market with a pretty broad range of product offerings. With respect to what happens going forward relative to the replacement market, we had said and continue to say that, that replacement market is yet to really evolve, and that it's probably now nine to 12 months away in terms of it being a more normalized replacement market. And what I mean by that is that in complete market maturity, that's probably more like a 10% or 12% number of the installed base turning over on an annual basis. We're nowheres near that today, and feel that over the next nine to 12 months, we will be approaching probably a 5% to 7% of the install base turnover, but it won't be for another couple of years until we're back to our level of market maturity that would suggest that the only units being sold are those that are replacement in nature. And by the time that happens, we feel pretty comfortable that there'll be yet another new technology which will be tomosynthesis, and it will start that whole technological succession over again.

Jayson Bedford - Raymond James & Associates

And Rob, I may be misunderstanding this, but is it fair to say less than 10% of your new digital units being sold in the U.S. are replacing existing digital?

Robert Cascella

Yes, I think it's very accurate. It is clearly less than 10% today.

Jayson Bedford - Raymond James & Associates

On the gross margin side, Glenn, you listed three factors impacting that. Just trying to figure out kind of what is the biggest impact from those three? Meaning, you mentioned scrap on Adiana, write off of the NovaSure overhead and lower ThinPrep volumes. What's had the biggest impact?

Glenn Muir

Jayson, I really listed them in order. So number one with the biggest impact is the start up cost related to Adiana. And this is all about yield. And it's about scrap. I mean, it was a tough product for us to transfer from California down to Costa Rica, and we're making tremendous progress and we've now gotten the manufacturing volume up, where we can meet the sales demand but nowhere near the margins that we feel are acceptable over time. So that's number one. And that is followed by the Protostar [ph], by NovaSure. As we built up production prior to the launch of Protostar [ph] of the old version in order to have enough on hand, it did create an imbalance between quarters as far as our production volumes. And it did create some unabsorbed overhead in earlier quarters that could expensed out in Q3 in the start-up on Protostar[ph]. That is secondary to Adiana, but I would say that those two points, they're pretty much one time. I made they're early on in the process. We feel very confident going to get better on those two items going forward. The third, on ThinPrep, is a little bit harder to tell. That was directly related to volumes of ThinPrep, especially here in the United States. International seems to be holding but it was affected here in the United States, and that's one of our higher gross margin products. So that did have a strong impact on the gross margin.

Operator

We'll now go next to Tycho Peterson from JPMorgan.

Tycho Peterson - JP Morgan Chase & Co

Just a question I guess on mix. Can you talk specifically on mammography, what maybe percentage of the units you're placing now are upgradable versus kind of the encore or the value system?

Robert Cascella

When you say upgradable, you made the dimensions unit?

Tycho Peterson - JP Morgan Chase & Co

Yes, tomo capable.

Robert Cascella

It's probably somewhere in the area of I would say 18% to 20%.

Tycho Peterson - JP Morgan Chase & Co

And then I guess to your comment before on -- we're not really seeing a replacement cycle yet, but can you just talk about the competitive dynamic as it stands today? Obviously, you now have more of a timeline potentially around that 3D product. Just talk about your discussions with some of the GE customers you've always talked about, the opportunity to swap out some of those early adopters, how you're looking at that?

Robert Cascella

Yes, we are heavily focused on looking at older units from any of the other manufacturers, including our own. And we believe that we have a strong reason for them now to convert than to trade up to a product that is truly software-upgradable for tomosynthesis. It is a matter of we really working the existing install base of products, Tycho, and every one of them is obviously a sales opportunity and yet also a sales challenge. Then you could rest assured that our competitors are not lying silently in the dark and allowing us access without some level of a response about their future product line, or their future roadmap for their product line, I should say. So it is clearly a focus but every one is not a win. But we clearly are making inroads into install bases of competitive products for the reasons I just gave in terms of the nearness of the dimensions product.

Tycho Peterson - JP Morgan Chase & Co

And then with regards to the follow-on studies for tomo, I mean, have those been halted? Or how do we think about the additional data generation? Or just to you use that for marketing purposes what's the...

Robert Cascella

Yes, we're continuing on with the clinical trial. We're continuing to aggregate cases. That data are going to be used for a variety of different reasons. It'll be ongoing clinical studies. It could be used for the FDA, if need be. An in addition to that, we intend to use that data for reimbursement purposes. So it will be a strong support of the clinical benefits of the product primarily from a private pay perspective to show better cancer detection rates, lower recall rates and so on and so forth. In addition to that, we are conducting a variety of international studies all over Europe to gain clinical adoption and credibility for the product in different parts of Europe.

Tycho Peterson - JP Morgan Chase & Co

And then last clarification, one for Glenn. In your comments on the margins before for Adiana, I mean, is it fair to assume that this is a little bit more of a hurdle than you anticipated and how we think about for that product in particular getting back to, I think you called it unacceptable margins? How do we think about you getting back to acceptable margins there?

Glenn Muir

Well, the acceptable margins would be closer to the type of NovaSure margins that we get, which is in the 70% range, and that's what we are aiming to get to. But Tycho, that's probably a year away. It'll take us a little bit of time to get up to that level. Part of it will be volume, and part of it are the engineering changes that we're making on the product itself.

Operator

[Operator Instructions] Our next question will come from Amit Bhalla from Citi.

Amit Bhalla - Citigroup Inc

So I actually do have a follow up on this gross margin. Glenn, you mentioned that the factors that you laid out, those three, the biggest chunks of them were one time in nature. But you are taken down the full year gross margin by a point. So I'm wondering, if you just walk through how and to what level the gross margin's going to improve over the next three or four quarters and what the longer-term targets are for gross margin?

Glenn Muir

Well, if we think about Q4 though, I mean I just want to be careful that we don't expect any quick fix here that would impact Q4. So we are more comfortable in the 60% to 61% range. But anytime you talk about gross margins, then I try to identify some of the major pieces. But underlying those pieces, there's other factors in our business as well, and you almost have to look segment by segment. So we look at the two biggest pieces, and the biggest negative impact in gross margins came first of all from the GYN Surgical. And in that group, I would have to say, some of that we can work ourselves out of through manufacturing improvement and through volume, as Adiana continues to build. In the other area of Diagnostics, primarily on ThinPrep, we'll need the ThinPrep volumes to go back up to get any kind of real improvement. But at the same time, we do see Cervista growing on the molecular side, so that's helpful over time as well. And we're estimating right now with Cervista that our market share is at the high single-digit kind of level. So we continue to make progress in the marketplace with Cervista. But then the third change I'm trying to get to is really in the Breast Health group. And even though if we look at the PowerPoint and the numbers that we put forth in that segment, that it doesn't look like the gross margins didn't change very much, and it didn't. There's some underlying dynamics in that the biggest growth driver we have today in Breast Health happens to be from Service. So as I look out into the next year, we are continuing to expect Service to grow. We can see that volume because we know the products that's been put in the field. On the other hand, there's more uncertainty around the product. So there is a change even in the Breast Health that the gross margin may come down a little bit because of service and a reduction on the product side. But at the end of the day, the service has a net margin that's more profitable to us than the product does just because it doesn't have R&D, it doesn't have sales and marketing, it has very little G&A. So it's a very profitable part of the business. We just wont see it in gross margin but it's going to drop to the bottom on a net margin basis.

Amit Bhalla - Citigroup Inc

So Glenn, additional follow up question is on Cervista. Can you talk about some of the trends and adoption of Cervista? And that comment you just made about high single-digit levels per share, I thought you were talking last quarter about double digits. Did something change?

Glenn Muir

No, nothing changed. I'm pretty sure we said high single digits.

Robert Cascella

I think we've been kind of around that area of high single digits. I think we'll crossover the low double digits over the next quarter to two. But that's been fairly consistent. With respect to Cervista though, you had a specific question, I'm sorry?

Amit Bhalla - Citigroup Inc

Can you talk about some of the adoption, give us some more color on sites that are still validating the technology and what trends you're seeing in adoption?

Robert Cascella

We remain pretty encouraged about Cervista, and what I mean by that is that we continue to win additional labs on a monthly and quarterly basis. We are now finding that obviously 16% to 18% is rolling out to the national labs. We're in ongoing discussion with the national labs from an initial adoption point of view of a high-risk test. All but four of the national labs were having very good success with our first phase of automation. Though, I think the results are very positive, obviously, the hurdle for us as it has been is we want to continue to be in the market with our current levels of automation, and we want to get our HDA product across the finish line as we had talked about in 2011.

Operator

We'll now go to Josh Jennings of Jefferies & Company.

Joshua Jennings - Jefferies & Company, Inc.

Just on the GYN Surgical guidance, flat to slightly up. And if you look at where NovaSure was last year and Adiana, I mean is this suggesting that you're going to have sort of a year-over-year downtick in the NovaSure product line?

Robert Cascella

No, we actually, for GYN Surgical, we had a record quarter this quarter. We continue to see growth obviously from Adiana and taking share from Adiana. But on the NovaSure perspective, we see growth both domestically and internationally with the product. And we're encouraged with where the product is in the marketplace.

Joshua Jennings - Jefferies & Company, Inc.

In therms of the guidance for Q4, you're still expecting NovaSure product year-over-year to grow?

Robert Cascella

Yes.

Joshua Jennings - Jefferies & Company, Inc.

And then just in terms of your international strategy there, can you just talk about sort of what inning you're in international with NovaSure through some of the strategic initiatives you have to sort of grow that business? Or maybe just give us an idea what percentage of revenue for the NovaSure product does come from international markets?

David Harding

This is David Harding. As far as our strategic initiative, they are several-fold. We invest most of our efforts strategically in Europe, as that is the largest marketplace for NovaSure. The real growth areas are coming out of our Benelux region. Certainly, the U.K. has been exceptionally strong. And we are investing more and more in the Southern European countries as well as Germany. So from a strategic-focus perspective, adding some headcount, adding more sales people there to take advantage not only of NovaSure but also of Adiana potential has been an area for us. Australia is also a very rapidly growing area. We are going to add some additional resources there. In terms of the mix of revenues, I don't think we're prepared to kind of disclose the various mixes between international and domestic at that level of granularity, but suffice it to say that we are in fact growing NovaSure in kind of a 20% to 30% range on a year-over-year basis in terms of international revenue. So we're very, very excited about that product and about Adiana as well.

Operator

Our next question comes from Amit Hazan from Gleacher.

Amit Hazan - Gleacher & Company, Inc.

I thought maybe first question would be about the backlog. It looks like it's the second quarter in a row where backlog has declined. And as I try to reconcile some of the things you said on the call, your units on Breast Health were up, but you attribute the backlog decline to Breast Health. And so I'm wondering if you can just talk about what's been going on there for the last two quarters if units have been increasing, if we really have that significant of a drop in ASP to take your total backlog down?

Glenn Muir

Amit, it's Glenn. The backlog has come down the last two quarters, and it is a function not related to ASPs but as far as order volume. And especially this quarter, we've seen it on the International side. And that's why I did make that comment what we're seeing in the market in going into the summer months is a pretty stable order rate for us, comparable to Q3. So we feel good about the current order rate. But we do appreciate that, for the last two quarters, it wasn't at the same level as our shipment rate. So that's why you saw the backlog come down. But as it relates to ASP, and Rob touched a bit upon this, we are getting a positive ASP from the sale of our dimension product line. And if we look at just the 2D version for a moment, because we are selling the 2D heavily, we are at that 20% level as far as our total units. And I'm not trying to give out unit numbers but just to illustrate that, that 2D is becoming more important, and it's a product that not just new customers look for but replacement customers look for as well. And that product is helping on our ASP side of the equation, more so than some of the defeatured Selenia that we've talked about in the past.

Amit Hazan - Gleacher & Company, Inc.

And then second question is on the Diagnostic side, on Pap testing in particular. I'm just trying to figure out, since your revenues were down sequentially as well, whether testing volume in terms of the economic weakness had changed at all from Q1 to Q2? Because what we'd heard from most companies is that that was still weak but about the same. And if it hadn't, then to what extent or how do we know how much of this is really related to kind of the second point that you had mentioned, which is a transition to HPV testing? And if you can comment on whether your Pap testing revenue can grow sustainably as you think about it over the next year or two?

Robert Cascella

Yes, I mean, I think from our perspective, we viewed that the U.S. market even prior to any of the economic issues that we're faced with today has been one of market maturity. So image or adoption was some upside as well as any kind of competitive wins that we might have in terms of our greater gains in market share. I think what we're seeing today is that although the market has been down relative to OB GYN visits, we were fairly resilient to that in our first quarter and started to see the effects of it in Q2 and then more in Q3. But when you look at our volume decreases in the quarter or our erosion in volume, it's far less than what we've heard from the national labs, what we've read in the press in terms of a reductions in office visits. So we believe that we're holding both market share and holding gains relative to pricing or otherwise appropriately, but nonetheless, the overall market is down because of patient visits, and we are certainly seeing the effects of that and saw the effects of that in our Q3.

Operator

[Operator Instructions] We'll go now to Jonathan Block from SunTrust Robinson Humphrey.

Jonathan Block - SunTrust Robinson Humphrey Capital Markets

Maybe the first one, I hate to burn a question here but Cervista revenue, just the absolute, it seems like you've been willing to give that in the past quarters?

Robert Cascella

We actually have not given the product line revenues. We've been focusing on segment numbers up to this point. So, yes, we prefer not doing that for all the reasons we stated in the past.

Jonathan Block - SunTrust Robinson Humphrey Capital Markets

Maybe just a follow-up on that, I think Cervista was up 24% year-over-year less quarter. Do you have a percentage increase year-over-year?

Robert Cascella

Yes. In a quarter-over-quarter basis, we are growing at a rate of 20% to somewhere north of 20% on a quarter-over-quarter basis.

Jonathan Block - SunTrust Robinson Humphrey Capital Markets

Sequentially?

Robert Cascella

Sequentially.

Jonathan Block - SunTrust Robinson Humphrey Capital Markets

And then, Steve, maybe this one's for you, just sort of parsing through of the surgical side. Adiana revenues may be around $3 million in the quarter. Is that right? And then when we sort of peel back to what that means for NovaSure domestically, after taking into consideration the recent comments on international NovaSure, you get to a number of around 2% or 3%? And so, I know it's not easy out there, but how should we think about that growth rate? Is that purely a function of the slower environment or how much is patient volumes weighing on that? That's a big deceleration from the past.

Steven Williamson

Yes, just to start with the Adiana question, I think your number is a little conservative. We had a very strong Adiana quarter which I understand probably puts a little bit more pressure on the second half of your question. We've done quite a bit internationally with NovaSure. And as David was talking, we've got a consistent growth rates out there that we're very happy with, and we'll continue to invest in that business and expect to grow that in the different markets. As far as domestic NovaSure goes, we do continue to see growth and our checks on the channel continue to show that we're increasing market share to flat on market share. But I think what the economy means to this market is that you're going to see a temporary negative effect on the growth of the overall market. It's not going to continue growing as fast as it was. But when you look at the patients that are in this marketplace, there are women that are underserved first of all. So there's a large group of women out there that are not getting the procedure that should. And over time, it's getting to those women, and that's really been our strategy. And I think that's why we've been able to continue to grow in the tough economic times with the product.

Operator

And our question comes from Vivian Cervantes with Maxim Group.

Vivian Cervantes - Maxim Group LLC

Wanted drill down a little bit on the GYN Surgical. I understand your comments about moving manufacturing for Adiana out and maybe improving gross margins by pushing through with some engineering changes. Will that in any way affect your ability to do a bigger push for Adiana with all these manufacturing changes that are still ongoing?

Robert Cascella

I think if you look at where we are right now from a yield perspective with the product, we've really slowed down the launch of the product and didn't go full market release to all of our sales reps till April. And that was because we really wanted to make sure that we could get out there and make sure that all the customers were serviced. So we really concentrated on getting inventory up as high as we could to support the full market release of the product. Now we've got the engineers that we're working on to just getting production up focused on making it better and making the yields and the margins better. And at the same time, working on next-generation products as well. So as we continue to make improvements to the product and decrease our scrap rates, we don't see that it would negatively affect our ability to roll out next-generation products.

Vivian Cervantes - Maxim Group LLC

When you say next-generation, a new iteration of Adiana in the market at some point soon? Do you have a time frame for that?

Robert Cascella

We're working on several different iterations of the product. This is a product that will continue to evolve over time as we work with different physicians. It's an interesting product in that it's got ease-of-use benefits right now, and there's patient-use benefits as well. But we're going to continue to work on it to make sure that we can get to continue to improve our strength of clinical data and continue to make it something that the marketplace will adopt as the premier transcervical sterilization product.

Vivian Cervantes - Maxim Group LLC

As you have broadened your launch of the product to your entire sales force, are you looking to do something I guess more broader in the sense of a direct-to-consumer campaign or anything of that nature anytime soon?

Robert Cascella

Our competitor has done some direct-to-consumer advertising and I think it's done a lot for the segment, if you will. It's got more women aware that there are alternatives to laparoscopic tubal litigation. And I think that's a benefit to all of us. Right now, we're really focused in a couple of areas. First of all, we're going out and we're getting competitive share. We've got some good relationships out there with doctors that have used our products for quite a while. They're interested in the advantages that the product brings to the market. And secondly, we've been in some accounts that weren't necessarily enamored by the competitive offering, and have looked at transcervical sterilization as something that they want to bring on and something that they are interested in. It's just that they weren't interested in the initial product that was in the market. So we'll do is we'll continue to focus on training doctors. We've got several thousand doctors in the training queue. And it looks very good for the future and very promising for us.

Operator

And that does conclude our question-and-answer session and our conference for today. Thank you for your participation, and have a wonderful day.

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Source: Hologic F3Q10 (Qtr End 06/26/2010) Earnings Call Transcript
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