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Executives

Christine Jacobs – Chairman, President and CEO

Frank Tarallo – CFO and Treasurer

Analysts

Joseph Munda – Sidoti & Company

Brett Rice – Janney Montgomery Scott

Theragenics Corporation (TGX) Q2 2010 Earnings Call Transcript August 10, 2010 11:00 AM ET

Operator

Greetings, and welcome to the Theragenics Corporation second quarter 2010 earnings conference call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. (Operator Instructions) As a reminder, this conference is being recorded. It is now my pleasure to introduce your host Christine Jacobs, chairman and chief executive officer for Theragenics Corporation. Thank you. Ms. Jacobs, you may begin.

Christine Jacobs

Thank you all, and thank you, Jackie. Good morning. And welcome to our second quarter 2010 conference call. We appreciate the fact that you joined us today. And in just a few minutes, I'll provide some comments for the quarter and overall outlook for the second half of the year. But first Frank Tarallo, our chief financial officer, is going to provide a review of the financial results. Frank?

Frank Tarallo

Thank you, Chris. This morning, we released our consolidated financial results for the second quarter of 2010. If you did not receive this news release or if you would like to be added to either our fax or email distribution list, please contact Investor Relations at 800-998-8479 or 770-271-0233.

Before I begin my review, please be aware that some comments made during this conference call may contain forward-looking statements, involving risks and uncertainties regarding our operations and future results. Please see our press release issued today and our filings with the Securities and Exchange Commission, including, without limitation, the company's Form 10-K and Forms 10-Q, which identifies specific factors that may cause the actual results or events to differ materially from those described in the forward looking statements.

Now onto our results, our consolidated revenue was $20.8 million in the second quarter of 2010 and $41.1 million for the first half of this year. These amounts are both records for us.

Profitability was down in 2010, compared to the 2009 periods. EPS in the second quarter of 2010 was $0.02 per share, compared to $0.04 in '09. For the first half of this year, EPS was $0.03 per share, compared to $0.06 in the first half of last year. Yet, while EPS was down compared to last year, the second quarter of 2010 was a significant improvement over this year's first quarter. And we're pleased with the results.

Let me review our segment operating results. Revenue in our surgical product segment was $14.9 million in the second quarter and $29.5 million for the first half of this year. This represents organic growth of 9% in the quarter and 10% for the first half of 2010, compared to last year.

Operating income in our surgical business was $388,000 in the second quarter, compared to $804,000 in 2009. For the first half of this year, we incurred a $2,000 operating loss, compared to operating income of $883,000 last year.

The declining profitability compared with 2009 was primarily due to two items. First, in the 2010 periods, we had lower gross profit margins on sales than in the 2009 periods. However, our second quarter margins this year of 39% showed strong improvements over the 33% we experienced in the first quarter of 2010. Second, we incurred litigation expenses related to the lawsuit that we initiated earlier this year totaling $221,000 in the second quarter and $572,000 in the first half of 2010. This lawsuit was launched to enforce certain non-compete agreements and protect trade secrets related to our wound closure platform.

One item that did not significantly affect operating income in the second quarter of 2010, but will affect results next quarter is the move to our new specialty needle manufacturing facility. Construction on this facility was completed in July. Construction is on budget and ahead of schedule. We actually commenced moving to the new facility late in June incurring $137,000 of moving-related expenses in the second quarter.

Looking forward, the significant portion of the move is expected to be performed and completed in the third quarter. Moving-related expenses in the third quarter are expected to be in the range of $500,000 to $700,000. These one-time expenses will obviously have a significant impact on our profitability in the third quarter and second half of this year.

Moving to our brachytherapy business, revenue declined 9% in the quarter and 13% for the first half of the year, compared to 2009. We believe our decline in revenue is reflective of the overall decline in procedures being experienced in the US brachytherapy market. The decline in our revenues was partially offset by the addition of Core Oncology as a new distributor this year. We spoke about this new agreement last quarter. Sales at Core represented 13% of our brachytherapy product sales in both the second quarter and first half of 2010.

Last month, we announced the addition of Oncura, a unit of GE Healthcare, as another new TheraSeed distributor. The addition of Oncura as a TheraSeed distributor is expected to add incremental revenue for us. Due to the fixed nature of our manufacturing costs, incremental TheraSeed revenue is a healthy contributor to profits and cash flow. However, we do not expect sales to Oncura to be material in 2010.

Operating income in our brachytherapy business was $1.1 million in the second quarter of 2010, compared to $1.4 million in '09. For the first half of this year, operating income was $2.1 million, compared to $2.5 million last year. The decline in revenue had an effect on our profitability in this business because of the relatively fixed nature of our manufacturing costs. We have been successful in reducing certain operating costs in our brachy business as we continually monitor expenses. Looking forward, however, we may not be able to continue to reduce operating costs in the future.

Returning to the consolidated results, adjusted EBITDA was $3.4 million in the second quarter and $6 million in the first half of the year. Cash flow from operations was $1.7 million in the second quarter and $3 million for the first half of 2010. We ended the quarter with $39.6 million in cash, cash equivalents, and marketable securities. We have $28.7 million outstanding under our credit agreement, resulting in a net positive cash position of $10.9 million.

In our last several calls, we've talked about the expected use of cash in 2010 for capital expenditures and for repaying our debt. In the first half of this year, we spent $7 million for capital expenditures, most of which was for our new specialty needle manufacturing facility.

Our capital expenditures also include our new ERP system. In our previous conference call, we mentioned that two of our primary locations went live on the new system in the first quarter. We expect to complete implementation of our ERP system at remaining locations within the next year.

Now that our new needle facility has been completed, we expect the rate of our capital expenditures to decline, including finishing up construction of the new facility and our ERP implementation, we expect our CapEx spend could be another $2 million to $3 million in the second half of this year. Of course, this amount can be affected by opportunities, changes in our businesses, and other factors that are difficult to predict.

We also used cash to continue to repay our debt in accordance with the terms of our credit agreement. We paid down principal by $1.7 million in the first half of this year. The terms of our credit agreement require principal payments of $3.3 million annually through May 2012.

Finally, we used cash to build inventories this year. Inventories have increased to $1.6 million from year-end. We've discussed this in prior calls. This has been done to support growth in our cervical products business and to support the move to the new facility for our needle manufacturing operation.

That wraps up my comments. And I'd now like to turn the call back over to Chris.

Christine Jacobs

Thank you, Frank, and welcome again. On a consolidated basis, we delivered another quarter of record revenue. The surgical products business delivered 9% organic revenue growth and its highest quarterly revenue ever. Our brachy business continues to suffer from the difficulties facing the entire US brachy market. Yet, it contributed substantially to the profitability again this quarter.

Before I comment on our results, let me update you on something that occurred earlier this summer. You may recall that we made a presentation at the Sidoti & Company micro-cap investor conference in June. Sidoti is a sell-side equity research firm that's devoted to covering equities of small cap companies. Recently, Sidoti announced that they were going to provide research coverage on Theragenics for their clients. Joe Munda is the analyst that's now following us. I think Joe might be on the call this morning, so I'd like to say welcome.

Of course, Sidoti's opinions, estimates, and forecasts regarding Theragenics' performance are theirs alone. They don't represent forecasts or predictions of Theragenics. And we cannot and do not endorse or concur with Sidoti's information. However, we think that Sidoti's coverage of the company for their clients should be beneficial for our shareholders.

Now, let me go on to some segment operations and discuss surgical products first. You may recall that the last several quarters, I've talked about challenges that that business incurred, including unpredictable customer behavior and pricing pressures. We saw erosions in gross margins on sales in the first quarter of this year due to spikes in demand and increases in our back orders. And back orders are orders for which we have missed the promised ship date. This caused us to incur overtime, bring on temporary labor. We added a third shift in one plant, and took other steps, all of which created additional costs that eroded first quarter margins.

During the second quarter of this year, we were able to reduce the back orders and more effectively manage our manufacturing costs. As a result, the gross margins improved in the second quarter of this year when compared to the first. Yet, gross margins for 2010 continue to run lower than what we experienced in '09.

So what's changed? Well, in sum, it's customer behavior. Customers continue to exhibit unpredictable behavior in the current environment. Ordering patterns of our large customers are more volatile than we've seen in recent years. Going forward, we expect sudden spikes and declines in demand, including sporadic behavior. And we expect this is going to continue to affect our manufacturing costs and gross margins on sales.

We talked about this on several occasions. We call it the bullwhip effect. When a customer experiences a change in demand, even a small one, there's a resulting amplification further down the supply chain. Our manufacturing costs can be significantly impacted when customers call with rush orders or they call to delay a shipment on orders that we already have in process.

The erratic patterns of our customers, combined with continued uncertainties related to the macro economy, make us hesitant to bring on fulltime labor or to make sweeping changes in our operations or factory automation. Add to this pricing pressure from customers in competition, and all these continues to play a significant role on our margins. We plan to run our operations assuming this pressure's not going to go away any time soon. But we also plan to be proactive where we can, rather than reactive.

If customer behavior returns to more predictable and consistent patterns, we're going to move away from costly temporary fixes and reduce some of the pressure on our margins. But until then, we're pleased to have consistently delivered organic revenue growth during the worst economic environment in a very long time. And as long as customer demand materializes, we feel quite bullish about the future. And margin erosion is going to be an issue we're just going to have to deal within the short term.

Frank mentioned that our needle manufacturing plant was completed in July. Earlier, we've disclosed that this operation was in a seriously cramped plant that dated back to 1905. This added to inefficiencies and reduced the options available to us to increase customer orders and to better manage the operations. So our new plant has more capacity and should allow us to attract new business, and to become more efficient over time.

We're currently moving into the new plant. And in anticipation of the move, we've built inventories. We communicated with our customers. And we've taken other steps to minimize the impact of the move. But indeed, we've been taking customers on preview tours to show them our future capabilities and our increased capacity. Thus far, we have not seen any significant negative impact on the ability to meet our orders and shipments of costumers' products.

As we've discussed, operating costs are expected to increase in the new larger facility. We've gone from a cramped, inefficient 51,000 square feet spread over two locations into a 73,000-square foot facility all under one roof. So in the short term, it's going to erode margins. In the long term, process efficiencies from the new plant, combined with larger capacity, should allow us to gain benefits of scale and have a positive effect on margins. The move into the new plant should be completed during third quarter. And we're expecting to be fully operational there by the start of the fourth quarter.

Frank mentioned that we expect to incur up to $700,000 in moving-related expenses in the third quarter. And I want to reiterate that the moving-related expenses will obviously have a negative impact on earnings next quarter.

Next topic, we initiated a lawsuit in the first quarter of 2010 to enforce certain non-compete agreements and protect trade secrets related to the wound closure business. The suit continues. I cannot comment on any details of the proceedings as I'm sure you can understand. But what I can say is that we will continue to protect the assets of Theragenics. The litigation-related expenses for this suit declined in the second quarter from what we've spent in the first. However, like I said, the suit's ongoing. And we're going to continue to incur legal expenses that are related to it.

So to summarize where we stand with our surgical products business, first, organic revenue growth continues. Second, gross margins on sales for the second quarter improved over the first. However, margins have eroded from '09 due to macro and microeconomic events. Third, customer behavior remains uncertain. Yet, demand in some of our product lines remained strong. Fourth, we added capacity for the needle platform. Construction was completed on budget and ahead of schedule. Fifth, we have a lawsuit that we expect to continue for the foreseeable future. And sixth or last, open orders were $13.6 million at the end of the second quarter. This is a healthy number because the backlogs or the late deliveries have been flushed. Demand and opportunities remain strong.

So now, I'm going to turn to the brachy segment. Brachytherapy procedures for the treatment of prostate cancer in the US continue to decline. We, like all others in the sector, are suffering from the decline. This industry is now operating under fixed reimbursement policies issued by CMS. Alternatives, plus proven technologies for treating prostate cancer, continue to enjoy favorable reimbursement rates when compared to our brachy treatment. We've been very clear about our expectations for this business, and still today don't know where the Neider [ph] is for the marketplace yet.

We have also said that there were going to be opportunities in this sector. And two share opportunities for incremental sales have occurred this year, with Core Oncology, and more recently, our announcement with Oncura. We believe there may be additional opportunities. And we intend to sustain our strong market presence.

So in closing, we've had an exciting first half to 2010. And we're pleased with second quarter results. The uncertainties that we've talked about for some time now in both of our segments that materialized in the first half of the year and will likely continue for the foreseeable future, despite the challenges, we believe we're well-positioned. We have plenty of cash. We've got strong demand in surgical products and a position of strength in the brachy market. So we look forward to reporting on our progress at next quarter's call.

So with that Jacqui [ph], Frank and I will open up for questions.

Question-and-Answer Session

Operator

Thank you. Ladies and gentlemen, at this time, we will be conducting a question-and-answer session. (Operator Instructions) One moment, please, while we poll for questions. Thank you. Our first question is coming of Joseph Munda of Sidoti & Company

Joseph Munda – Sidoti & Company

Good morning, Frank. Good morning, Christine. How are you?

Christine Jacobs

Fine, Joe.

Frank Tarallo

Joe, how are you?

Joseph Munda – Sidoti & Company

I'm good. Frank, I just wanted to touch a little bit on debt that's been paid down. You had mentioned the $3.333 million annually, correct?

Frank Tarallo

$3.3 million annually.

Joseph Munda – Sidoti & Company

$3.3 million of the principal.

Frank Tarallo

Correct.

Joseph Munda – Sidoti & Company

What is the interest rate on that debt?

Frank Tarallo

I think that our average interest rate for the period was just a tick about 3%, Joe. We've got some interest rate swaps that lock most of that in, 3.06% I think it was.

Joseph Munda – Sidoti & Company

And you spoke of the moving expenses that are being incurred for the third quarter, $500,000 to $700,000. Are you looking – is that a number that should show up in the fourth quarter? Or are we looking at a significantly less of a number in the fourth quarter?

Frank Tarallo

No. If it goes as expected, it should entirely be third quarter. And there might a little bit of hangover to fourth quarter, Joe. But if so, it would be very small.

Joseph Munda – Sidoti & Company

And where is that being incurred? Is that on the – are you guys recognizing that on the balance sheet or on the income statement number?

Frank Tarallo

No. That'll be an SG&A item primarily.

Joseph Munda – Sidoti & Company

SG&A, okay.

Frank Tarallo

Yes. And on the P&L

Joseph Munda – Sidoti & Company

Okay, and the P&L. And also, you mentioned Oncura. How much revenue do you – you mentioned 2010. But how much revenue do you see with going forward into 2011 that Oncura could generate?

Frank Tarallo

Under the Oncura agreement?

Joseph Munda – Sidoti & Company

Yes.

Frank Tarallo

Yes. We don't forecast. And we don't – we certainly don't talk about specific customers unless they're 10% or greater. So what I – I don't know that I can tell you the exact number we expect, Joe. But what I can tell you is we don't expect them to arrive at the level of 10%.

Joseph Munda – Sidoti & Company

Okay.

Christine Jacobs

And Joe, our filings this quarter, I believe, we've made reference to the core contribution to revenue. So when we've got identifiable terms and information, you'll be seeing it in our filings.

Joseph Munda – Sidoti & Company

Yes. Christine, this question is to you. How often are you in contact with CMS in regards to the reimbursement rates that they're giving you?

Christine Jacobs

Okay. Well, there's a long and a short answer. The short answer is they try to have me not talk with CMS very often because it's frustrating. But we do have a – what I believe is an effective line of communication open between the industry as a whole and CMS. And that is a very active two-way set of conversations with CMS. What I'd also like to say is where we didn't prevail in our activities in Washington early in the year, Joe, because we got confounded and wrapped up in healthcare reform. I am reassessing a Theragenics positioning outside of our industry group in whether or not we're going to swing for defense one more time.

Joseph Munda – Sidoti & Company

Okay.

Christine Jacobs

Okay? So I don't personally talk to them, Joe. But I pretty much drive the strategy back here for the company.

Joseph Munda – Sidoti & Company

Yes, yes. And how many sales reps do you have currently in the sales force?

Christine Jacobs

We don't typically give that number out, I mean because in this area, you get a lot of attrition over time. It's less than 20. That's the ballpark I can give you.

Joseph Munda – Sidoti & Company

Okay. And I actually read an article recently where they mentioned Theragenics. And he got hired, a lot of part time workers due to a spike in demand. Were there any plans to make them fulltime or continue to have them as part-time workers?

Christine Jacobs

Was that our Frank Bloomberg interview?

Joseph Munda – Sidoti & Company

I believe so, yes.

Christine Jacobs

Yes. Actually, my comments this morning, Joe, addressed that. You're absolutely right, especially first quarter. We brought on a lot of temps to reduce the backlog and the spike in demand. And I don't want to move them to fulltime, Joe, until I know that this demand in the surgical products business is sustainable. And I'm not convinced yet.

Joseph Munda – Sidoti & Company

Okay. I'll jump off for a moment so somebody else can come in.

Christine Jacobs

Okay, but thank you.

Frank Tarallo

Thanks, Joe.

Operator

Thank you. (Operator Instructions) Our next question is coming from Brett Rice of Janney Montgomery Scott.

Brett Rice – Janney Montgomery Scott

Hi, Chris. Hi, Frank.

Frank Tarallo

Good morning

Christine Jacobs

Good morning.

Brett Rice – Janney Montgomery Scott

At the end of the first quarter, your open orders were $13.3 million. Do you have that figure for the second quarter? I may have missed it.

Frank Tarallo

It's $13.6 million at the end of the second quarter, Chris – and Chris referred to that, yes.

Brett Rice – Janney Montgomery Scott

Okay. And the operating income less in the first quarter was a loss of $390,000. Do I add back the $351,000 in legal costs that you had in the first quarter? And would I add back the $221,000 in the second quarter to see how those numbers compare?

Frank Tarallo

Yes. I would do that. And I would do one other thing. And that is, add back the $137,000 of moving expenses in the second quarter. And that'll give you a little better apples-to-apples comparison there, Brett.

Brett Rice – Janney Montgomery Scott

Okay. That's quite a favorable swing this second quarter from first quarter. Or am I reading that right?

Frank Tarallo

No, you are. I think you are. And Chris talked about, in her remarks, the improvements we saw in gross margins from first quarter to second quarter. And I think that's were a lot of improvement comes from. First quarter, we were at 33%. In the second quarter we saw 39%.

Brett Rice – Janney Montgomery Scott

Right, right. Well, that's good to hear. Now, I know you don't like to give numbers. But the amount of sales reps from the prior caller's question, are they higher now than last year?

Frank Tarallo

Well, first remember that those sales reps are only in the brachy business, right, not on the surgical products though. And it is not higher than last year.

Brett Rice – Janney Montgomery Scott

Okay. Well, thank you. And I will hop back.

Frank Tarallo

Okay. Thanks Bret.

Christine Jacobs

Jackie, we got anybody back in the queue?

Operator

There are no further questions at this time.

Christine Jacobs

Okay. Brett or Joe, did you want to jump back on?

Operator

We do have a question coming from Joseph Munda of Sidoti & Company.

Joseph Munda – Sidoti & Company

Yes, just a follow-up regarding margins. I'm showing – you guys had total gross margin of 42.4%.

Frank Tarallo

Yes, consolidated basis. That's right.

Joseph Munda – Sidoti & Company

On a consolidated basis. Are you guys looking for that number to continue in the low 40s going forward? Or do you see gross margin expansion going forward.

Frank Tarallo

Joe, it's hard to really look at that on a consolidated basis because of the way the brachy business works. And because those – though we have had some success in reducing operating costs in the brachy business on the manufacturing side, those costs tend to be fixed. And so, an incremental dollar of revenue can have a pretty significant effect on that consolidated gross margin. And so, that's why we spend a lot of time talking about gross margins by segment in the – especially in the surgical products business. And then really, what drives the brachy results is going to be the top line revenue.

Joseph Munda – Sidoti & Company

Yes. I'm sorry. I don't mean to cut you off. But in regards to brachy – on the brachy business, in our conversations when we met, Christine had mentioned that, obviously, the business is declining. But she had mentioned that when the time comes, she thinks that she'd be able to pick up some assets in that area. Do you see anything that's attractive to you guys to pick up as far as brachy business is concerned?

Frank Tarallo

Let me answer that first.

Christine Jacobs

I could jump in and say I don't know that I would be chasing assets as much as I would market share.

Joseph Munda – Sidoti & Company

Okay.

Christine Jacobs

Go ahead.

Frank Tarallo

When Christine talks about opportunities, and we talked about opportunities in the brachy therapy marketplace, great, great examples of what we're talking about are the agreements that we executed with Core earlier this year and with Oncura that we just announced last month. Because there's really no need, at least in our view, to be paying for in acquiring significant assets because there's more than enough capacity in this space already.

Christine Jacobs

What I'm most focused on is market share.

Frank Tarallo

Right.

Joseph Munda – Sidoti & Company

Yes. And so, in regards to the brachy business, are there more deals like the Oncura and the Core in the pipeline as we speak? Or is this it that we're going to see for 2010 and 2011?

Christine Jacobs

Yes. I can't forecast because this industry is so fluid that I can't confirm or deny. But what I can say is that I got a radar detector out there. We consummated two transactions this year. Everybody in the industry knows where we are and what the phone number is. What I guess I would want you to know is I'm not going to leave any stone unturned if it means an opportunity for market share and incremental revenue.

Because as Frank said, incremental revenue in the brachy business to our operation can have a really significant effect on our financials going forward. Where the brachy industry is concerned, we haven't reached Neider there on the decline. And I think there are more opportunities out there for us. And we're going to swing for them.

Joseph Munda – Sidoti & Company

Okay. Thanks, guys.

Frank Tarallo

Thanks, Joe.

Operator

Thank you. There are no further questions at this time.

Christine Jacobs

Well with that, thank you very much, Joe, it was your first call with us. And Brett, as always, thank you for your attention. And we will talk to you next quarter. Thank you.

Operator

This concludes today's teleconference. You may disconnect your line at this time. Thank you all for your participation.

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