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Obagi Medical Products, Inc. (NASDAQ:OMPI)

Q2 2010 Earnings Call

August 5, 2010 4:30 pm ET

Executives

Ina McGuinness - Integrated Corporate Relations

Steve Carlson - President and CEO

Preston Romm - CFO and EVP of Finance, Operations, and Administration

Analysts

Annabel Samimy - Stifel Nicolaus

Irina Rivkind - Duncan Williams

Scott Henry - ROTH Capital Partners

Cathy Tong - Sparta Asset Management

Operator

Greetings and welcome to the Obagi Medical Products second quarter 2010 earnings conference call. (Operator Instructions) It is now my pleasure to introduce your host, Ina McGuinness of Integrated Corporate Relations.

Ina McGuinness

Thank you, operator. Earlier this afternoon Obagi Medical Products released its financial results for the second quarter ended June 30, 2010. If you have not received press release it's available on the investor relation section of the Obagi Medical Products website at www.obagi.com.

This call is being webcast and a replay will be available on the company's website for 30 days. Before we begin, we would like to remind you that today's remarks contain forward-looking statements within the meaning of federal securities laws. These statements do not guarantee future performance, and therefore, undue reliance should not be placed on them. We refer you to the risk factors contained in Obagi Medical Products' SEC filings for more details and discussions of the factors that could cause actual results to differ materially from those projected in any forward-looking statements.

All information provided on today's call is as of the date of the live broadcast, Thursday, August 5, 2010, and Obagi Medical Products assumes no obligation to update any such information.

Participating in today's call from the company are President and Chief Executive Officer, Steve Carlson; and Chief Financial Officer and EVP of Finance, Operations, and Administration, Preston Romm.

And with that, I'd like to turn the call over to Steve Carlson. Steve?

Steve Carlson

Thank you, Ina. Good afternoon and welcome to our call. We are very pleased with our double-digit topline growth during the quarter, especially given the current economy. Our revenue increased 11.6% year-over-year to $28.9 million, fueled by growth within the majority of our product lines, especially our Nu-Derm and our Vitamin C product segments.

In spite of some of the higher than expected extraordinary expenses, that Preston will discuss in more detail later, we achieved solid profitability of $3.1 million or $0.14 per diluted share. During the quarter we also made good progress in enhancing and implementing marketing strategies for our current product lines as well as continuing to invest in new product initiatives.

As a result while consumer confidence continues to fluctuate, most of our product lines performed well and we believe that our product quality efficacy and price points compared to alterative esthetic procedures will continue to drive demand.

Now, let me review our second quarter performance by geographies and product lines. Sales from our U.S. business increased 16.3% to $24.4 million year-over-year, while opening 270 new domestic accounts. This account level is down from our prior quarter largely due to our decision to reorganize our 25 person Derm specialty sales force.

We've expanded the physician specialties covered by this sales team to also include emerging growth opportunities with non-Derm physicians, such as ob-gyn and internal medicine. As a result of these sales, people spend a meaningful portion of the quarter developing relationships with existing accounts within these other specialties that were reassigned to them and had less available time to pursue new account openings.

As of June 30, we had 6,350 active accounts, a 7% increase from a year ago, but essentially flat to Q1, as our lower account openings was matched by corresponding level of churn. While our new account adds were lower, with the shifted focus of our sales force, we saw great sales success.

We had a meaningful contribution from our new and improved O-C Rx systems, resulting in our vitamin C product segment up 38.5% year-over-year. During the quarter we initiated an "Obagi for Life" new account seed program, where 220 potentially interested physician practices committed to having the doctors, staff and select patients trying experience Obagi results for themselves prior to becoming an active account.

We anticipate this program will produce strong account growth in the third quarter. We also re-launched the patient education program called Inner Circle, adding nearly 10,000 members and building Obagi's database of end-users of our products to nearly 60,000 patients.

The Inner Circle program is a way for us to reach out to our physician's patients with more information on education about skin care, and the increased patient loyalty to both, their physicians and Obagi products. We believe this program has a lot of future potential and look forward to discussing this in more detail in next quarter's call.

Regarding international, international revenues declined 8.6% year-over-year to $4.5 million. As you know, we're dealing with a lot of small numbers and international orders tend to experience timing shifts. Licensing fees for the quarter were down about 17% to $1 million as a result of Lodo's lower than expected Derma Force sales and a slow Japanese economy.

However, we continue to explore ways to build our international business with a particular focus on growing existing international distributors, such as Canada and the U.K., where we see solid growth and market share gains. As well as capitalizing on emerging opportunities in Korea, China, India and Brazil. As everyone hopefully appreciates, building international relationships, and picking the right partners takes time and patience.

Our performance by specific product lines for the second quarter of 2010 compared to 2009 were as follows, Nu-Derm and Condition Enhance increased 10% to $15.4 million with reorder rates at a high 87%. Sales of our vitamin C based systems and products which include both Obagic-C Rx and Profession-C increased 38.5% to $4.6 million.

This strong growth was attributed to the introduction of a new system for normal to oily skin, which coupled with the reorganized sales force helped grow the vitamin C product segment. ELASTIderm, which includes eye cream, eye gel and decolletage grew 14.6% to $2.6 million. Reorder rates for both the eye cream and the eye gel were high at 90% and 82% respectively.

Sales from our therapeutic products, which include CLENZIderm and Rosaclear declined 5.9% to $2 million, mostly due to large stocking orders of Rosaclear a year ago, shortly after the product was launched in the first quarter. Reorder rates for CLENZIderm, however, was strong at 89% and the initial reorder rates for Rosaclear were high at 78%.

Further, we recently published an article in the July issue of The Journal of the American Academy of Dermatology, this article was our first ever published in this journal featuring CLENZIderm our acne product. In addition, the article once again substantiated our clinical efficacy, which showed equal to and/or superior efficacy of CLENZIderm versus the leading prescription agents in the market for treating acne.

Other product categories were up 11% year-over-year, primarily due to the addition of Refissa, our Tretinoin in third quarter last year, where reorder rates were strong at 77%. Regarding our sales organization, we now have a 117 people in the United States, which is flat to Q1 and we add up four from a year ago.

Regarding new product launches, with the new internal reorganization of the sales force and the success that they've been having with our expanded vitamin C, which was up $2.6 million or 44% for the first six months of 2010 versus a year ago.

We decided to launch only one of the planned products for this year in the fourth quarter. As you know, previously for competitive reasons we did not provide any information regarding the new products indication and greater detail regarding when will be launching.

Lastly on the corporate side, we continue to support our research and development efforts. We hired Greg Skover, PhD, as Senior Vice President of Research and Development. Greg has spent more than 20 years at Johnson & Johnson, primarily focused on aesthetic skin care. I'd like to welcome him in to our team and look forward to working with him.

Greg will succeed Judy Hattendorf, who is retiring at the end of this year after nearly 11 years with the company. And with that I would like to extend my gratitude to Judy for her invaluable contribution to our company's success.

And with that, I would like to turn the call over to Preston.

Preston Romm

Thanks, Steve, and welcome, everybody, to our call. As Steve says, we're very pleased with our topline performance and improved profitability during the second quarter. Our sales increased 11.6% to $28.9 million from $25.9 million in the second quarter a year-ago. For the six moths ended June 2010, our net sales increased 12.5% to $54.6 million compared to $48.5 million a year-ago.

Our operation metrics for the second quarter are as follows; gross margin was 78.5% compared to 79.7% a year-ago. While our gross margins have benefited from our January 1 price increase, another specific items caused reduction in margins this quarter.

During the quarter, our license fee revenues which had very high margins for 200,000 lowers than a year-ago. We also had two specific requirements to increase our inventory reserves; one, we added $300,000 of additional reserves for our Rosaclear product due to the size of the initial stocking inventories we built last year and current dating concerns. Two, we also increased inventory reserves by $151,000 which affects gross margins and at the same time increased our bad debt reserves of $511,000 which affects SG&A expense. This total amount of $662,000 was booked to recognize our entire exposure for non-performing international distributor.

Some additional comments on this distributor. A, this was not forecasted and was unknown when we gave our initial Q2 guidance last quarter. B, we have already started the process to protect our interest in this matter; and C, although we cannot tell you the distributor's country, this is neither a systematic issue nor a strategic geographic region.

Total operating expenses for the second quarter 2010 were $17.5 million which is up from $16.1 million a year-ago. As you saw from our press release and in addition to the bad debt reserve mentioned above we had higher than expected fees associated with the lawsuit in arbitration filed against us by Zein Obagi, which amounted to $1.3 million for the second quarter.

Based on where we are in the discover process, our best estimate at this time is that we will incur expenses of approximately $2 million per quarter for the rest of this year. This amounts to approximately $0.05 to $0.06 per quarter. We have been and will continuously to vigorously defend ourselves against these claims and actions. Our operating income for the second quarter 2010 including these expenses increased 14% to $5.2 million, 18% of the sales from $4.6 million to 17.7% of sales a year-ago.

And our net income for the quarter came in $3.1 million or $0.14 per diluted share which was up from $2.8 million or $0.13 per diluted share a year-ago. Year-to-date, net income was up 44%, the $5 million and $0.23 per diluted share compared to $3.5 million or $0.16 per diluted share last year.

Turning to the balance sheet, we have cash, cash equivalence and short-term investments totaling $42.8 million which is up from $36 million at December 31, 2009. The increased working capital is $64.6 million from $57.1 million at the end of December. We generated free cash flow fro operations of $2.3 million in the second quarter and $6.3 million for the year.

Finally, let me provide you with our guidance for the third quarter and total year. Based on historical seasonalization and the current state of consumer confidence, we expect net sales of between $26.5 million and $27.5 million for the third quarter. And $111 million to $113 million for the year, this is an increase from prior guidance of $108 million to $112 million.

Diluted earnings are expected to be between $0.09 and $0.11 per share for the third quarter and between $0.46 and $0.53 per share for the year. The assumptions upon which this guidance is based include revenues from the planned new product launch in the fourth quarter and an assumption that legal fees associated with the Zein Obagi matter will be approximately $2 million per quarter or $0.05 to $0.06 per diluted year for the remainder of the year. This will result in total legal related expenses for this matter of approximately $6 million for the year or $0.16 per diluted share.

Steve, any closing comments?

Steve Carlson

Thank you, Preston. First I want to thank, everyone, for joining our call today. And in summary, as you heard, despite some higher than expected extraordinary expenses and distractions, we're very pleased to have delivered double digit growth through both the second quarter and first half of the year. We're excited and optimistic about our new marketing initiatives and our new product pipeline all while we continue to generate positive cash flow and profits for our shareholders. We look forward to reporting our continued success on the next quarter's call.

And with that, operator, can we open it up to questions operator?

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from the line of Annabel Samimy with Stifel Nicolaus.

Annabel Samimy - Stifel Nicolaus

You originally had some targets for international growth or having international as a certain percentage of your revenues and has that goal changed over time now that you've got some hick-ups in international or some defining growth? Can you give us a better sense of what kind of diversification you can have there as the goals are changed?

Steve Carlson

No, I think our long-term goals are still the international; it's a significant opportunity of growth for us. We are finding it very important to go slow and be patient especially as we look at the significant large geographies such as China India and Brazil. So our goals have not changed as related to diversifying our business and having international become a much more important part of our portfolio.

Annabel Samimy - Stifel Nicolaus

Can you remind me what that goal was as a percentage of revenues?

Steve Carlson

We have not stated a significant target as a percentage of revs.

Annabel Samimy - Stifel Nicolaus

Okay. And in terms of getting into China, India and Brazil, is that going to be again through licensees, like have you formed any licenses in hose areas, or is it something you're still working on?

Steve Carlson

We're still working on establishing the right partners ensuring that there is that mutual interest to success.

Annabel Samimy - Stifel Nicolaus

Okay. And then I have separate topic. The Zein Obagi lawsuit, can you help us understand a little bit more about that lawsuit as well as the impact that it might have should they succeed, but not just from the legal expense perspective, just overall business perspective?

Preston Romm

We really don't say much more about the lawsuit than other than what's public. He has alleged a few things. And as we said, we find them wrong, and we're going to defend ourselves against it. At this point, the only guidance I can give you is that we'll continue to incur legal fees to fight this; we are early on in the discovery process. And at this point, we're confident we're going to prevail in this matter. So there's really nothing to add.

Annabel Samimy - Stifel Nicolaus

What exactly was he claiming? Can you speak to that?

Preston Romm

If you see, he's claiming in the lawsuit that we interfered with his ability to do business with the ZO Skin line. And that he had a relationship with a distributor in Japan that he claimed we interfered with.

Annabel Samimy - Stifel Nicolaus

And then just one more question, in terms of the new product launches. Did you have a new product launch within the C Rx line, or is that just from before?

Steve Carlson

We did launch a line extension for normal to oily skin with a new and improved OC Rx system.

Annabel Samimy - Stifel Nicolaus

And that was launched when?

Steve Carlson

That was launched early in the second quarter, and obvious from the result of 38.5% growth from a year ago, it's has been a very successful introduction.

Operator

Our next question comes form the line of Irina Rivkind with Duncan Williams.

Irina Rivkind - Duncan Williams

I wanted to see how you view the competitive launches in the hyperpigmentation space by companies such as Clinique, who have been advertising heavily. How does that impact your business?

Steve Carlson

As you know, we focus our business on the position dispense channel and the incorporation of 4% prescription hydroquinones, as well as frequently physicians add prescription tretinoin. So we are not directly impacted by consumer or cosmetic companies that position themselves in the skin whitening or hyperpigmentation arena.

As you probably are aware, Allergan and Clinique sometime ago looks to collaborate in the physician dispense channel by introducing a line of products in that space. And we essentially have seen no negative impact on our business due to that collaboration.

Irina Rivkind - Duncan Williams

I just have two quick ones. Of the 220 Obagi for Life new seed accounts, can you sort of talk about what those physicians are? Are they dermatologists? Are they gynecologists? And then the second question is, the trial with Obagi, the GO Skin is in February, so do you have any expectations for legal fees in the first quarter '11?

Steve Carlson

The Obagi for life program that we have which is essentially a seed or limited trial program for people to experience the results of being on Obagi systems is really made up of profiled motivated practices that want to move into physician dispense and topical skin care, and they encompass all specialties, plastics, derms, gynecology and internal medicine. There isn't one more motivated channel than another.

As it relates to Q1, we had not put any guidance out as it relates to 2011 at this time.

Operator

Our next question comes from the line of Scott Henry with ROTH Capital Partners.

Scott Henry - ROTH Capital Partners

It seems like the base business is going very well, perhaps a little better than expected, perhaps a lot better than expected. But for starters, I just really would like to get my arms around the earnings power. If you kind of strip out the one time stuff, and if we include legal as one time for now, it looked to me like the quarter could have been around $0.20 to $0.21 if you pulled out the legal as well as some of the reserves. Do you think that is a fair assessment, Preston?

Preston Romm

It's approaching there. $0.20 plus or minus, of you strip out those two kind of extraordinary items.

Scott Henry - ROTH Capital Partners

And then, I guess also, if we start to look at the annual earnings power, it is pretty easy to go from $0.46 to $0.53 if we add $0.16, we get to $0.62 to $0.69. Now, revenues are higher and your prior guidance was $0.67 to $0.71. So, I am just wondering if you could talk about what else do you think is one-time versus recurring? What else would you consider stripping out as a one-time, if one wanted to look at it that way? I don't know, bad debt expense is sort of a recurring item, but some of the others aren't?

Preston Romm

You get into an accounting definition of one-tome, but I would look at this whole non-performing distributor as a one-time, and as I said, not systematic and not in a geographic location that we view as strategic. So we kind of view that as unfortunate and one-time. And I would view all the legal bills as kind of focused on what event and not core to the business. On those two things, I think we're getting back up into our original guidance for the year.

Scott Henry - ROTH Capital Partners

And I guess, going to the legal expense, it seems like things took a turn for the worse somewhere here. Just given that you never factored it into your prior guidance and you factor it in now, did something happen in the courtroom? Is there a reason why it seems to have become a larger issue? Maybe you can disagree with that? I don't know?

Preston Romm

Well, I do. Nothing happened. It's progressed to law. We didn't give full year guidance on the number before because it was very early in the process and people were talking to each other. We are now getting into the fat of discovery and depositions, which as you know, gets expensive and that takes a lot of lawyer time to go through all the documents and to talk to people and preparing a case. So we are right in the fat of this and so we have a little better visibility of where it's going and how much it is going to cost, and we had this time last quarter or even in the first quarter. So nothing has changed, it's just progressing along.

Scott Henry - ROTH Capital Partners

And then I guess for the remainder of the year when we think about guidance, do you expect any other one-time impacts other than legal?

Preston Romm

At this time no.

Scott Henry - ROTH Capital Partners

And then, I guess, just one question for Steve. Generally speaking, any comments on the overall marketplace for aesthetics, and do you still feel that the lower price point is being impacted less? Just generally, what are you seeing out there in the tone of the market?

Steve Carlson

Well, I think as demonstrated by double digit growth that we've been seeing over the last two quarters, same store sales, foot traffic, consumer confidence and all of that is moving in the right direction. There is still a fair amount of instability as we see around us, but certainly people are feeling better than they were a year ago and we don't see that trend changing, as we look at the back half of the year.

Operator

(Operator Instructions) Our next question comes from the line of Bill Plovanic from Canaccord Genuity.

Unidentified Analyst

This is Mark on for Bill. Had a quick question on what color are you getting from Rodo on what they are seeing in the Japanese Market, and what are they expecting in the back half of the year and how would that translate into your gross margin projection?

Preston Romm

They have a new product launch in the fourth quarter we understand, that should give us a touch of an uplift although we need to see it come on board. The economy is very tough in Japan. It's impacting their consumer sales, which is where our products are with Rodo. So we are not totally surprised it's down from a year-ago, but we are still optimistic that they have new product launches coming.

Unidentified Analyst

And then, any color on higher churn rate in the first half of the year, and what your expectations are for the second half in 2011?

Preston Romm

Churn rate in the second quarter kind of mirror the first quarter. Still again, as we define churn, it's someone who has not bought in a year. So you can kind of figure they peeled off or went out of business a year ago. A lot of those are medi-spas that really got impacted in the downturn in late '08 and early '09. What we anticipate is the churn rate improves in our favor over the remaining part of this year and going into 2011, because things seem to get better in second half of 2009 and the first half of 2010. So we should see an improvement in that metrics.

Unidentified Analyst

And then last question, just on the guidance, looks like you took the low end of $3 million and upper end of only $1 million. Just wanted to know, if there is any reason for the conservatism there?

Preston Romm

I'd stay away from saying it's conservative, but we really didn't base this guidance on what the last guidance was. We based on what we think we are going to do for the next couple of quarters. So as you see on the revenue we continue to be pretty bullish on the revenue line and that mirrors in the profits putting aside as, Scott called them, these one time events.

Operator

Our next question comes from the line of Cathy Tong with Sparta Asset Management.

Cathy Tong - Sparta Asset Management

I have two questions. One is regarding the lawsuit, can you give us some guidance as to timing of this lawsuit, trial date I assume sometime next year? With that timing, what is the trajectory just on the expenses in the normal process? Can you just give us an idea of what we should think about going forward?

Preston Romm

Well, I'll say two things, Cathy. We've given guidance on what we think the legal bills are going to be as from how we see them today for third quarter and fourth quarter and the trial date set for February. Other than that, don't want to give any further guidance or guesses on our part.

Cathy Tong - Sparta Asset Management

And secondly, you have $42 million in cash, and stock has been relatively weak in regards to this whole lawsuit. Is there any thinking on the board level as to a share buyback?

Preston Romm

Well, I give you this answer, it's not our cash, it's shareholders' cash and we are having discussions with the board on what to do that's accretive for the shareholders. And I would just say stay tuned.

Operator

Ladies and gentlemen, that was our last question at this time. This does conclude today's teleconference. Thank you for your participation. You may disconnect your lines at this time and have a wonderful day.

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