Hologic's CEO Discusses Q1 2011 Results - Earnings Call Transcript

Jan.31.11 | About: Hologic, Inc. (HOLX)

Hologic (NASDAQ:HOLX)

Q1 2011 Earnings Call

January 31, 2011 5:00 pm ET

Executives

Steven Williamson - Senior Vice President and General Manager of GYN Surgical Products

Robert Cascella - Chief Executive Officer, President and Director

David Harding -

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

Deborah Gordon - Vice President of Investor Relations

Analysts

William Quirk - Piper Jaffray Companies

Joshua Jennings - Jefferies & Company, Inc.

Jonathan Groberg - Macquarie Research

Tycho Peterson - JP Morgan Chase & Co

Vivian Cervantes - Maxim Group LLC

Jayson Bedford - Raymond James & Associates

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

Jonathan Block - SunTrust Robinson Humphrey Capital Markets

James Francescone

Charles Butler - Barclays Capital

Amit Bhalla - Citigroup Inc

Bill Bonello - RBC Capital Markets, LLC

Operator

Good afternoon and welcome to the Hologic Inc. First Quarter Fiscal 2011 Earnings Conference Call. My name is Kelly and I'm your operator for this afternoon's conference. [Operator Instructions] I would now like to introduce, Deborah Gordon, Vice President, Investor Relations. Please go ahead, ma'am.

Deborah Gordon

Good afternoon, and thank you for joining us for Hologic's First Quarter Fiscal 2011 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 through Friday February 18. Please also note that a copy of the press release, discussing our First Quarter 2011 results, as well as our second quarter and fiscal 2011 guidance, is available in 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 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 for the related GAAP financial measures can be found in Hologic's first quarter 2011 earnings release, including the financial tables in the release.

Please also note that today's call will consist of 30 minutes of opening remarks, followed by a 30-minute question-and-answer session. We therefore, ask each participant to please limit his or her question to just one, with one follow-up as necessary. We appreciate you may have additional questions, so please feel free to go back into queue, and if time permits, we'll be more than happy to take your questions.

Before I turn the call over to Rob Cascella, I'd like to inform you that the Hologic management will be presenting at three investor conferences in the month of March. The City Healthcare Conference in New York, the Raymond James Investors' Conference in Orlando, and the Barclays Capital Conference in Miami. Days and times of our presentations will be press released over the next several weeks.

I would now like to turn the call over to Rob Cascella, President and CEO.

Robert Cascella

Thanks, Deb. Good afternoon, and thanks for dialing into Hologic's First Quarter Conference Call. Joining on the call is Glenn Muir, our Executive Vice President and Chief Financial Officer; Steve Williamson, who's our General Manager of our Surgical Group and David Harding, who runs our international operations.

Today, I'd like to briefly review our quarterly performance highlights, and then talk a bit about the status of some of the key strategic initiatives that we covered last quarter. Glenn will then discuss the quarterly results in greater detail, and also cover our guidance for the year, as well as the second quarter. We'll then open up the call for 30 minutes of Q&A.

We're very pleased with the results for our first quarter, both revenues and adjusted earnings exceeded our guidance. Revenues were $432.6 million compared to our guidance of a range of $425 million to $430 million, and it represented a 5% increase over the first quarter of last year. Earnings per share for the quarter on a non-GAAP basis were $0.30, $0.02 ahead of our guidance, and just over a 7% increase when compared to prior year so a strong financial quarter for us.

I'd like to talk a little bit about the individual business units and start with Breast Health, which revenues grew solidly for the quarter when compared to prior year. Glenn's going to cover this in greater detail, but I would like to note a couple of key contributors to this year-over-year improvement.

Service revenues continued to increase strongly, fueled by our growing install base of our digital mammography systems. Other contributors were the growth in mammography and breast biopsy, plus the contribution from our recent acquisition of Sentinelle Medical.

The growth in year-over-year mammography revenues was due to substantial gains in the sales of our 2D/3D dimension systems. Internationally, mammography grew over 25% on a year-over-year basis, and these sales consisted of our 2D and 3D Dimensions. The increase in dimensions' volumes is having a positive impact on our overall ASPs as well.

As we talked about earlier, the market is bifurcating in the United States, where many of our customers are buying low-end systems but another segment of that marketplace is buying the ultra- high-end system, that Selenium or Dimensions 2D system. The reason why they're doing that is because it is the platform for the future, and is completely software upgradable for 3D mammography.

In the quarter, replacement units presented just over 5% of our digital mammography sales, so there's certainly a lot of traction. We expect that this pace will more rapidly accelerate when the commercial release of tomo occurs.

We enjoyed a record quarter for our Breast Biopsy division as well, fueled by strong demand for our vivo product. We once again, strengthened our market share, but although it's a bit early to tell, it would also appear that there is a slight rebound in biopsy volume as well. We benefited by a full quarter of Sentinelle Medical in the first quarter as well.

Moving on to Diagnostics, although we experienced the slight decline of approximately 1% in Diagnostics revenue on a year-over-year basis, primarily as a result of lower ThinPrep volume and unfavorable foreign exchange, this segment did show a nice sequential increase in revenue and volume over the prior quarter. While we're still seeing fewer office visits on a year-over-year basis, we believe that this business is beginning to stabilize.

Our used market share remains strong. In fact, we are confident we have not lost share. And although our international volume was flat to last year in the first quarter, we believe this business will trend up and grow for the balance of the year.

Our Molecular Diagnostic division was very strong with over 27% on a year-over-year basis in terms of growth over the prior year's quarter. And specifically, within Cervista and our HPV product, it increased 60% over the same quarter from a year ago and 20% sequentially. We attribute this to continued share gains, and are confident that the sales growth will continue to accelerate during the course of fiscal '11 as we win new accounts.

We are unfortunately experiencing a delay with our HTA filing. The FDA has asked for some additional testing data, and we are working with the agency to meet the new requirement. As a result, we have not yet filed with the FDA and are studying the issue now, and we'll report back when we have a better handle on timing.

In GYN Surgical, we had a record revenue quarter for both NovaSure and Adiana product lines. The 6% year-over-year growth was fueled by strong adoption of the Adiana system, as well as modest growth in NovaSure. Adiana continues to gain momentum, and we are realizing competitive wins on a routine basis.

We also continue to increase the number of physicians trained to perform the Adiana procedure and a reorder rate is averaging somewhere north of 70%. Some other positive notes about Adiana is that we believe that the yield in scrap rates continue to improve. And lastly, we're encouraged that our commercial results and commercial efficacy rates are improved over our clinical trial results as we would expected.

As for NovaSure, sales rose in the low-single digits as expected. Earlier this month, we kicked off our director consumer marketing program and I'll discuss that in greater detail on a few minutes. Overall, surgical continues to be an important growth driver for fiscal '11 and beyond in both the U.S. and international markets.

In Skeletal Health, our bone product line demonstrated some renewed growth resulting in a 4% growth on a year-over-year basis. This is really the result of an improved reimbursement climate, as well as enhanced activity in the replacement cycle within the acute care market. We believe the demand for bone densitometry systems will continue to increase throughout fiscal 11.

Moving on to some points of interest. I wanted to cover and give a brief update on some of the acquisitions. As you know Sentinelle Medical was closed in August, and for those that don't recall, this is a company that specializes in custom MR breast coils and other specialty body coils, as well as patient positioners at MR CAD. The integration and training activities of our sales group are completed. We've had our first full quarter of revenue, and the revenues for the quarter met our expectations from back when the acquisition was first closed. Overall, we're extremely pleased with the business and believe there are a broad range of MR imaging applications to this new technology.

More recently, we closed on Interlace Medical. I'm extremely pleased to bring this product and this technology to women around the world. Fibroids and polyps can be painful and debilitating condition for women causing abdominal pain, heavy menstrual bleeding and impaired fertility. The technology called the MyoSure tissue removal system fits extremely well within our surgical product portfolio, alongside other therapies for abnormal uterine bleeding and permanent contraception. We believe the addressable annual market for MyoSure approaches $300 million to $400 million in the U.S., and we are optimistic that we will garner the majority share of that market over the next five years.

In addition, in this simply-elegant technology which we firmly believe will change the way such interventions are conducted in the future. It's an attractive product extension and a great strategic fit to our existing product line. And considering revenues for the balance of this year, we have taken a very conservative view that expect to achieve something just less than $10 million for fiscal '11.

Interlace is a terrific example of the acquisition strategy outlined in our last quarter's call. This is an ideal tuck in, complementary to other surgical products and easily fits the calling patterns of our sales reps. Needless to say, we're very excited about it.

Lastly, I wanted to give an update on some of the incremental investments that we spoke of last quarter. But first, I'll include an update on tomosynthesis. As you all knew, we were very pleased when we receive our approval letter in November just prior to our RSNA. The next step was a facility audit and the FDA's inspection of our Danbury operation was completed in December and there were no substantial findings. We now await the FDA's final report, and believe we were on track for the March commercial date that we've previously discussed.

In addition, we completed the design of a comprehensive of physician training program per FDA requirement, and it's been modeled after the successful programs that we implemented overseas, where we've been shipping tomo for the last year.

In addition, we're working diligently with various pair groups to be certain that we have both a short-term plan and longer-term strategy for reimbursement. Short term, we're focusing on private payor education to get them excited about the technology and its potential cost savings. Longer-term, we continue to have discussions with the ACR Advocacy groups and CMS but we require FDA approval before these talks can be more meaningful.

On an international front, we now have clinical trials underway for tomo in various parts of Europe, including Norway, Italy, France and UK. These are being designed to help gain public-sector support and help to spur market adoption on a worldwide basis. We won't see results from these clinical trials for then, until the next 12 to 24 months, but again, we're very excited to report back to you when those are available.

The next area of investment is our focused international expansion. We've begun to build out our international infrastructure and management resources, particularly in emerging markets like China and Latin America. We've added to the bench strength of our sales, service and marketing groups and more recently, are also adding to the ranks of senior management. We hired recently, a vice president and general manager of Asia Pacific, and in addition to that, hired a CFO for our Asian operations. We intend to continue our investment in the leadership of our European and Latin American operations as well. We believe this is a critical element of our strategy as we search for acquisitions in different parts of the world, to expand our distribution and manufacturing capabilities.

Regarding our launch of our DTC awareness campaign for NovaSure, I am pleased to report that a couple of weeks ago, we officially kicked off our marketing efforts in all of our target markets, with advertising appearing in several leading women's magazine, online websites, television spots and social networks. An increasing number of communications will be appearing over the next 12 months. All in, the campaign is expected to create 1.6 billion impressions in our target market over the 15-month time period of the program.

As a reminder, we are undertaking this critical step in market development because we firmly believe that this market remains substantially under penetrated. We see an enormous opportunity for this product, and it all comes down to raising the awareness among women, that a permanent curative solution to excessive menstrual bleeding is available in her doctor's office that can be performed in less than five minutes. In short, we intend to establish NovaSure as the first line of therapy for women suffering from abnormal uterine bleeding.

Lastly, I'd like to welcome Mark Myslinski to Hologic as our new Senior Vice President and General Manager of our Diagnostics Group. As you may have seen in the press release we issued this morning, Mark will oversee both our Diagnostics and Molecular Diagnostic divisions. Mark brings to Hologic, 30 years of life science and Diagnostics industry experience, serving most recently as President and CEO of RedPath, a genomics-based cancer diagnostic company. And prior to that as Vice President and a board member of Ortho Clinical Diagnostics, a division of J & J. Mark's expertise complements the strategic emphasis of this very important franchise. I have every confidence that under his leadership, our Diagnostic business will flourish.

With that I'd like to turn the call over to Glenn Muir

Glenn Muir

Thanks, Rob. Consolidated revenues exceeded our expectations with year-over-year revenue growth of 5%, largely due to the strong performance in our Breast Health segment, led by service and the continued shift to our 2D/3D Dimensions product platform.

Our Dimensions line now represents 37% of all digital mammography revenues. Service, a steady contributor, was up $13 million, or 24% year-over-year. In addition, Breast Health benefited from the inclusion of sales from Sentinelle Medical. Sales in our GYN Surgical and Skeletal Health segments were also up, while a slight decline in Diagnostics revenues, partially offset this growth, mainly due to a reduction in ThinPrep volume and in an unfavorable foreign currency impact.

Two of our newer products, Adiana and Cervista HPV, both continue to steadily increase, and contributed to our first quarter solid top line results. Our mix of domestic and international sales was approximately 78% and 22% in Q1, and our mix of disposables versus capital equipment sales was 76% and 24%.

Foreign currency translation, which primarily affects Breast Health in Diagnostics revenue, had an unfavorable impact of $1.7 million, and reduced our reported revenue growth by approximately 40 basis points.

Turning to the rest of the P&L, our gross margin on a non-GAAP basis was 62%, down 100 basis points from last year, but nicely up 90 basis points from the fourth quarter. Gross margins exceeded the high end of our guidance range of 60% to 61% due to first, higher service contract revenue and lower service costs, associated with our mammography installed base; second, better-than-expected NovaSure sales which carry a higher-than corporate average gross margin, as well as an improvement in Adiana manufacturing yield; and third, better-than-expected volumes in our Diagnostics segment for both ThinPrep and Cervista HPV products, leading to favorable manufacturing absorption. Non-GAAP gross margins primarily exclude $42.1 million of amortization of intangible assets this quarter and $43.5 million in the prior-year first quarter.

Regarding operating margins, our expenses continue to be well-controlled and on a non-GAAP basis, excluding a few charges that I will discuss in a moment, totaled $136.3 million, an increase of 4.5% compared to last year, and in line with our guidance of $135 million to $140 million.

This increase in expense relative to the year-ago period was primarily due to the inclusion of Sentinelle Medical and the investments we are making in our growth initiatives. But since our DTC campaign for NovaSure. We continue to invest in R&D and reported a ratio of 6.6% as a percent of revenue in Q1 as compared to 6% in Q1 of last year.

Regarding our non-GAAP adjusted earnings, there are three items we normally exclude from expenses and one new item. Consistent with prior quarters, this quarter, we excluded from expenses, the amortization of intangibles of $56.6 million, the non-cash interest expense of $18.5 million, related to the debt discount on our convertible debt, and acquisition-related cost of $3.1 million.

In addition, this quarter, we incurred a non-cash, one-time charge of $29.9 million, in connection with the exchange of $450 million of our convertible notes for new notes, that extend the first put date out and other three years until December 2016. Although the total convertible debt we have outstanding remains at $1.725 billion, this exchange provides us with greater flexibility in managing our future liquidity needs.

Absent the non-GAAP charges, our pretax income this quarter was $121 million versus pretax earnings of $116.5 million in Q1 of last year, and our non-GAAP adjusted net income increased 7.1% to $79.9 million.

We reported fully diluted, non-GAAP EPS' quarter of $0.30 versus $0.29 a year ago, which was $0.02 above the guidance we provided last quarter. This increase in EPS over expectations was due to the higher revenue growth and margin improvements, coupled with the lower-than-expected tax rate in Q1, resulting from the reinstatement of the R&D tax credit. The total backlog for all of our products was $275 million at the end of December, which was flat with the backlog at the end of September.

And turning to the balance sheet, we grew our cash balance to $609 million from $516.6 million at the end of fiscal 2010, an increase of over $92 million. Our plans for use of cash remain focused on investing in our current technologies and operations, potential future tuck-in acquisitions, including our recent acquisition of Interlace Medical, and preparing for the possible redemption of the first tranche of our convertible notes, with the value of $1.275 billion beginning in December 2013.

Regarding free cash flow, we generated approximately $122 million in the first quarter of fiscal 2011. These cash flows were comprised of approximately $135 million of cash flow from operations, less capital expenditures, of $13 million.

Now moving onto guidance which includes the operations of our recent acquisition of Interlace Medical and excludes any anticipated U.S. revenues, resulting from the expected approval of our tomo 3D mammography system, as well as any other future acquisitions. For the second quarter of fiscal 2011 ending on March 26, we are expecting revenues comparable to the Q1 results, approximately $432 million. This reflects an increase in revenues in our Breast Health segment, primarily related to increased service in Sentinelle MRI coil sales, partially offset by a decrease in our GYN Surgical segment due to normal quarterly seasonality.

Year-over-year, this is an increase in revenues of 3% over Q2 fiscal 2010 revenue. The inclusion of Interlace revenues will have a negligible impact in the second quarter. This quarter we are focused on training our sales team, introducing the product to our customers and beginning to ramp up production. Full market launch will not occur until our fiscal third quarter.

We are expecting gross margins of approximately 60% to 61% on a non-GAAP basis, declining slightly due to lower consumable sales as the percentage of total revenues. We expect non-GAAP operating expenses, primarily excluding amortization expense, to increase on a sequential basis from Q1 to $140 million to $145 million, or approximately 32% to 34% of revenue, primarily resulting from the increased sales and marketing expenses for the NovaSure DTC campaign, the inclusion of Interlace Medical expenses, as well as the other investments Rob discussed in his opening remarks.

We expect non-GAAP interest expense to be approximately $10 million in Q2, excluding $17.8 million of non-cash interest expense related to our convertible notes. Our non-GAAP effective tax rate is expected to be approximately to be 34%, as we will realize the continued benefit from the reinstatement of the R&D tax credits. And we expect non-GAAP earnings per diluted share to be $0.28 on shares of $264 million.

For fiscal 2011, which ends on September 24, we are reaffirming our revenue guidance in the range of $1.73 billion to $1.76 billion, or growth of between 3% and 5%. This guidance reflects our expectations that Breast Health will grow in the low single-digit, reflecting the current level of capital equipment market stabilization, continued growth in service revenue and the contribution from Sentinelle Medical, that diagnostic will be flat with the prior year, GYN Surgical will grow in low double-digit and Skeletal Health will improve slightly.

We are also slightly increasing our non-GAAP adjusted EPS to $1.22 to $1.24 per share. This guidance reflects the lower tax rate of 34% now expected, due to the reinstatement of the R&D tax credit, offset a bit by an increase in the share count to $265 million at year-end, primarily due to the increase in our stock price.

We estimate both Sentinelle and Interlace will be neutral to fiscal 2011 earnings. We are still expecting gross margins of 60% to 61% for the year. The key drivers to future margin improvement are revenue growth, which will lead to increased overhead absorption and a shift to higher-margin disposable sales.

We expect non-GAAP operating expenses to be in the range of $540 million to $545 million, up approximately 8% to 9% from fiscal 2010. This increase will reflect our ongoing commitment to R&D at a rate of 6.8% of revenues, the additions of Sentinelle and Interlace for the year, and increased expenses associated with our NovaSure DTC initiative.

We are expecting interest expense to be approximately $40 million, excluding $73 million of non-cash interest expense related to the convert and we are expecting an effective tax rate of approximately 34%.

Turning to cash flow, we are also reaffirming our free cash flow guidance of approximately $450 million. And in summary, we are pleased with our first quarter operating results. We saw improvements in revenues, margins and earnings, exceeded expectations and improved liquidity by expanding just over one quarter of our convertible notes. We remained very optimistic that we will deliver improved results in 2011. And with that, let me turn the call back to Rob.

Robert Cascella

Okay, thanks, Glenn. So in summary, I guess we keep saying it, we're very pleased with Hologic's first quarter. Our performance improvement was broad-based with three business units reporting solid year-over-year gains, and our Diagnostic business showed some signs of stabilization, all very positive.

Share gains continued in our Breast Health business, including both mammography and breast biopsy, our Diagnostic business led by Cervista and finally, in our Surgical business led by Adiana. We expanded our Breast Health and surgical product portfolios with the acquisitions of Sentinelle and Interlace, and we're just around the corner from a PMA approval of our tomosynthesis product. We did all of this while generating tremendous cash flow and better positioning us to continue to fund our long-term growth initiatives.

Finally, and as Glenn said, we are cautiously optimistic about Q2 and the balance of this fiscal year. Although difficult economic times in the U.S. and around the world, we're extremely bullish about our products and our programs for the balance of this year and beyond. I'd now like to turn the program back over to the operator, and thank you for your participation in this call, we'll open the call up for 30 minutes of questions. Thank you very much.

Question-and-Answer Session

Operator

[Operator Instructions] We'll go first today to Thomas Kouchoukos with Stifel, Nicolaus.

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

I'd like to start with the GYN Surgical side of things. I think you talked about record numbers on both products, but it was a little lighter than what we had expected. I'm just wondering if you could share the, kind of the growth dynamics between what you saw U.S. and o U.S. with NovaSure, and then maybe comment on -- did you see Adiana grow sequentially from your Q4 number?

David Harding

As far as the NovaSure goes, we did see growth both domestically and internationally. I think that the market has been stabilizing as far as the number of patients that are going into the doctors' office. We see that the fewer women have gone in than we were seeing in a year and a half ago. But it seems to be have flattened out where we've got a stable number of patients coming in on a quarterly basis now. So we do see that growth again with NovaSure, and more doctors are offering patients the NovaSure procedure earlier in the treatment-halfway cycle. Internationally, we saw a strong quarter as well. We did see good growth throughout Europe, but the majority of the growth we saw, was in the U.K. and Australia markets for us. And then as far as Adiana goes, typically we see a lot of our doctors are focused on going through the training right now, so we're getting the doctors scheduled, we get them through the online training, we get them through the hands on, they schedule their patients and then move through. So we do see growth in both product lines, and we'd expect it to continue through the rest of the year.

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

If I could ask one quick follow-up, just I guess more big picture, we've seen a nice string of bolt-on acquisitions here in the past several months with Sentinelle, SuperSonic Imagine and Interlace. What can we expect going through the year? Have you kind of met your quota near-term, or do you expect to see more tuck-ins as we move through the year?

Robert Cascella

We're really looking at things on an ongoing basis. These were just two of the acquisitions that we felt very good about initially, and we remained feeling very positive about those, but we're continuing to look at acquisitions across all of the different business units. The one constant will be that these are going to be tuck-in acquisitions, we're looking at spending no more than perhaps, a quarter's worth of cash flow. And the requirement is, is that they fit within our sales calling pattern, possibly our manufacturing and even our engineering organization. So they're very efficient acquisitions for us to affect.

Operator

We'll go next to the Bill Bonello, RBC Capital.

Bill Bonello - RBC Capital Markets, LLC

Can you just give us some sense of your expectation for how service revenue will grow over the next several quarters? And just maybe when we should expect that growth to taper off a bit?

Robert Cascella

As the Mammography business matures, the growth in service revenue will flow. And so we've actually are seeing that today. One would expect that as long as the installed base continues to increase, there'll always be some growth in service revenue. The next real growth spurt for service revenue will be a year following the introduction of tomosynthesis. We'll sell many, many more new products with the commercialization of that product and following warranty, they'll again be a pickup in service revenues. But I would say that, I think we're experiencing today, really the slowdown in the growth as a result of the revenues for the Mammography business slowing down. And won't really see a pickup until again, there's another new product that creates this notion of technological obsolescence where everyone needs to then have access to it.

Operator

We'll move on to Jayson Bedford with Raymond James Investment Bank.

Jayson Bedford - Raymond James & Associates

Just on the gross margin, it appeared to be a nice bump up sequentially, and you mentioned higher service contract revenue and lower service costs. And I'm wondering, is this a dynamic that you'll see going forward? And did you change the service infrastructure at all?

Glenn Muir

James, it's Glenn. I think we're getting better efficiency from service itself. Rob talked a little bit about the service contracts and the trend as it related to digital mammography systems. What's happening today is, we've been very successful in capturing service contracts. So we're getting over 90% of the contracts coming out of warranty are being captured. So it's an efficiency that we have in the marketplace today with our service force, coupled with better reliability of the product. And it's a function of being in the market for a year. And it's a combination of the system itself and also, the detector, being very steady at this point. So we are expecting to continue that as we go forward. And as we've talked about in the past, one of the big drivers for us in helping that overall gross margin, will simply be an overall increase in revenues. And that affects all of our products and all of our businesses, including service because of the efficiency we derive.

Jayson Bedford - Raymond James & Associates

And just as a second question, but 25% growth internationally you said on Breast Health or mammography, what is the real driver there? Was it just the soft comp, or was there something changed in the quarter?

David Harding

This is David. I think there are a couple of factors. Number one, as you know, the European countries went through a pretty tough time in 2009, and I think we're seeing a rebound in volumes there that is helping us. But I also think there is a real strength in our tomosynthesis and overall dimensions' offering that is driving that growth as well. We're seeing a lot of strength out of emerging markets such as Latin America, the Middle East, South Asia and Asia, so we're very encouraged by not only growth in Europe but also, in the emerging markets.

Operator

And Josh Jennings with Jefferies & Company have our next question.

Joshua Jennings - Jefferies & Company, Inc.

Can we just start off back on the follow up on the gross margin side. I know you guys expect a little bit of a down tick in Q2 from an outstanding Q1 performance. And if you could just give us a little more color on what's going to drive that. I know you talked about decreasing levels of consumables, but if you look at each of the business segments gross margin in the quarter, they were all up nicely sequentially, and I was just wondering if that trend can continue, and just maybe some more color?

Glenn Muir

Josh, it's Glenn. And I think this is just particular to Q2. Once again, the guidance that we gave on the revenue side for Q2 is pretty comparable, or flat with Q1 of $432 million, but there is a mix shift of the products. We're expecting, in particular, one of our highest gross margin products, the NovaSure product to be a bit softer in Q2, the March quarter as it always is due to seasonality, and we expect the product line within Breast Health to make up that difference, both on digital mammography and in service. But that capital equipment side of the business is somewhat below our gross margin product. So we're expecting a slight shift for Q2, and then probably, bounce back in the Q3, Q4 timeframe.

Joshua Jennings - Jefferies & Company, Inc.

And just on tomosynthesis, I know it hasn't been too long since you made some other public commentary about potential reimbursement strategies, but can you comment on any discussions you've had with commercial payers, and then sort of re-outline your outlook on reimbursement and your strategy in terms of securing premium reimbursement going forward for tomosynthesis once it's approved.

David Harding

Sure. It's a bit of a multipronged effort. So Initially, we're really working on private pay. We think that we can make a convincing argument to private pay that there's a cost savings advantage to tomosynthesis as a result of reducing the recall rates. We think that, that's a great interim strategy, but a lengthy one. There's 1,000 private pay sources in the United States, some obviously, national and others not. But it's an effort that will commence over the next month with multiple private pay panels, where we will help to educate them. In addition, we're looking at multiple CMS CPT-type strategies that will be both the interim related and more permanent. And as we have said in the past, those are difficult conversations. But until it is FDA approved, but we have ongoing discussions with the ACR and CMS, and we will turn up those activities once we have a commercial release of the product.

Operator

We'll go next to Tycho Peterson with JP Morgan.

Tycho Peterson - JP Morgan Chase & Co

Just maybe starting off on Cervista you talked about nice growth there, and then obviously, you've talked about the automation delay. Can you just talk a little bit about how that may factor into the adoption going forward Cervista? Or was it mainly been lower-volume customers that aren't necessarily going to upgrade to a fully-automate system anyway?

Glenn Muir

Yes. Virtually, no impact on revenue for the near to mid-term. We're really carving out a nice place in the low- to mid-tier labs, either because of a decentralized effort on our part in the labs or otherwise. It's not to say that we're not going after larger labs, and the volume levels are trending up. But in no way, does any of the time delays on HTA jeopardize that revenue trend.

Tycho Peterson - JP Morgan Chase & Co

And then on Adiana, you talked about improving the yields there, is that business profitable for you now? And if not what's the timeline there?

Glenn Muir

Yes. We think over the next year, we are running at bottom line that is about break even with that product. And over the course of this year, as yields and scrap continue to improve, that we hope that the contribution margin of the product improves as well, which we would fully expect.

Operator

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

James Francescone

This is actually James in for David. I have a couple of questions on Interlace. First, where do you see the business mix in terms of end market between physician's office and hospital settings, maybe to give us what do you think the first 12 months after the launch might be, then where that might develop, kind of three to five years out?

Robert Cascella

Steve, would you like to that, or would you like me to handle...

Steven Williamson

Sure. So the business mix in the coming year is right now, reimbursement are already setup for the product in the hospital. There's very favorable reimbursement for both the product and the physician. So the hospital, it's very similar to NovaSure procedure. The physician gets very attractive reimbursement in that side of service as well. It's also reimbursed in the ambulatory surgery centers. Right now, reimbursement doesn't exist globally in the physician's office yet, so that's going to take a little bit of time put in place. But there are several physicians that have gone out and gotten carve outs from their payers, because they understand that the product fits nicely into that office. It's a very low-anesthesia requirement. It's a procedure that can be done quickly, and can send the patient back home immediately after, and to get about whatever it is she's to do.

James Francescone

And can you give us any more color there on what you might be doing to drive, or the strategy around driving reimbursement might be?

Robert Cascella

Well, there are several different things. First of all, you need to put the clinical data together that shows that it's safe and efficacious in the physician's office. We've already put together a clinical strategy on that, and Interlace has already been working on that as well. So we'll put that information together and we'll put it up to the committees. And obviously, we'd look for backing from ACOG, as well as from AAGL for that as well.

James Francescone

Would you care to venture a timeline for when we might see a more meaningful reimbursement there?

David Harding

It's probably a few years out. I don't think it's that important in the short term because it is a procedure where doctors will start using it. There is a very, very large patient population that can benefit from the procedure, so if they can have it in the hospital right and that works for the physicians and it works for the patients, and it works for the hospital, then that's great. It's just over time, if doctors want to move it into the office and you think more and more patients will have the procedure done in that side of service, then I think it becomes a benefit for everybody. I don't necessarily look at it as a detriment though that it can only be done in a hospital, or ambulatory surgery center right now. Just to add onto that, there are some physicians, some of the larger practices that have gone out and shown their payers, what the benefits are to doing a procedure like that in the office for the patients. So we're seeing that in some areas already.

Operator

And Amit Bhalla with Citi has our next question.

Amit Bhalla - Citigroup Inc

The comments you made about Dimensions and the pricing stability I thought were good. I was hoping you could expand on those and quantify what kind of growth rates you're seeing in Dimension units, and pricing stability quarter-over-quarter? Is it 5%, 10%, 20%, what are you seeing, just some numbers there?

Robert Cascella

Because it's a relatively small base, the percentage growth numbers are very, very high. So on a unit basis quarter-over-quarter, we're clearly north of about 20% quarter-over-quarter growth. But as I said, I think we're relatively new with the introduction of that product, and we would suspect that, that would stabilize over time.

Amit Bhalla - Citigroup Inc

And the pricing, you've talked about stability and pricing, and I have one quick follow-up?

Robert Cascella

We have not had a lot of pushback on the Dimensions products. I think the people that are buying, are buying it because it is the next generation of a new platform product that is also they're platform for doing 3D mammography. So it does sell at a premium, it sells at a premium over the competition, it sells at a premium over its predecessor products. And although we certainly have a mission to remain competitive, we have not seen the downward pricing as of yet with that product.

Amit Bhalla - Citigroup Inc

Rob, you mentioned with the HTA delay, so the FDA's asking for more data? But you didn't really go into much detail about what specifically the FDA is focused on? Can you talk about that?

Robert Cascella

Yes. I think what we'd like to do is, we are -- just similar to what we did with tomo, I think we need to spend some time with the FDA, better understand what the requirements are, and then come back to you folks with something a little bit more comprehensive. Quite frankly, I'm not certain we're in the best position today to be able to give you a definitive timeline or explanation of where some of the shortfalls are, but that is what we are working on today.

Amit Bhalla - Citigroup Inc

For Glenn, on the Surgical division gross margin, it looks like the adjusted gross margin grew over 300 basis points sequentially, what drove that? And how stable is that business gross margin going forward?

Glenn Muir

Yes. Well if we look sequentially from the September quarter, there's a couple of things that happened. Number one was to growth in the NovaSure devices themselves, so that contributed to improved absorption. But number two, we're making a lot of changes on the Adiana product itself, and we're having improved manufacturing yield, really from engineering, design changes and manufacturing process itself. So it's a combination of increased NovaSure, coupled with better Adiana manufacturing cost down in Costa Rica. And we do expect that to continue as we go forward as it relates to volumes. So if we look at Q2, because we are expecting NovaSure to come down a little bit due to seasonality, I would expect to see that gross margin to soften a little bit going into Q2, and then bounce back in Q3 as typically another up quarter for NovaSure.

Operator

Moving on to Tony Butler with Barclays Capital.

Charles Butler - Barclays Capital

The average international customer, when looking at an instrument, are they principally looking at, and are you placing upgradable systems, or are they looking principally at the featured units? And second, could you provide some color on the percent of total shipments or orders that are upgradable systems?

Robert Cascella

I think it's pretty difficult to characterize the average international customer. I would say close to 50% or so, are looking at the dimension system, whether that be a full-scale 3D system or probably, more predominantly, the 2D dimension system. But I would say a good half of those are looking at the dimension side of the ledger. And those are, as you know, pretty full-featured systems that we are offering. When they get to the Selenium offerings, it really runs the gamut from very D-featured systems to the standard base of Selenium, and it's difficult to say what those numbers are right at the moment. But I would say, depending on the market that you're in, and the type of customer that you're talking to, whether it be a small-scale private practice or a large-scale research institution, that sort of determines what kind of offering we're putting out there.

Operator

And Bill Quirk with Piper Jaffray has our next question.

William Quirk - Piper Jaffray Companies

Thinking about the approval letter and the fact that you've had it for three months, and obviously, the sales force is aware of that as well, any feedback from them in terms of sentiment change within the customer base in terms of the potential pace of uptick here once approved?

Robert Cascella

I would have to say that we're hearing a lot of excitement. People are still really forbidden from selling the product because it's not FDA-approved, but we certainly are just hearing a lot of anecdotally stories of excitement, about enthusiasm over the technology, the clinical benefits of it, how will trade-ins be orchestrated and things like that. But I would have to say that we're probably being pretty conservative until we get this product commercially approved, to actually go out in a very broad way and start marketing it.

William Quirk - Piper Jaffray Companies

Just as it relates to the U.S. side of the business guys, where are we, or remind us rather, what percent of the systems out there are field upgradable at this point?

Robert Cascella

I would think that we're probably running at around 25% to 30% of our systems are 2D dimensions. But I'd have to remind everybody that I really think that a customer that is buying a 2D dimensions in the United States today is late for the game in terms of digital mammography. I do not think they are the likely near-term tomosynthesis-upgrade candidates. I think they wanted to invest in tomo or in dimensions because they wanted a product that would be viable for the next seven to 10 years, and had upgrade capability. My sense is, when this product is approved, it will be older Selenia users that will want to trade in their Selenias and buy the complete gantry of 2D and 3D together, and it will be less of the upgrades and much more of the new placement that I think will drive our revenue during that period, that initial period.

Operator

And Jonathan Block with SunTrust Robinson Humphrey has our next question.

Jonathan Block - SunTrust Robinson Humphrey Capital Markets

On Diagnostics, you mentioned some of the pressure in the part business, and maybe if you can try to tease out how much of that pressure is from straight patient volumes, versus what may be the results of interval lengthening or ACOG guideline changes, or even price effects?

Robert Cascella

I think if you look at what happened last year, I think we had a nonlinear drop in the business for a lot of external reasons, meaning those that are perhaps economically-related. Although without a doubt, as a result of interval expansion and market consolidation, that we're going to see very gradual declines in that business. The drop of last year was not gradual and it was very significant relative to patient volumes. When we said today that we thought our ThinPrep business stabilized, it is that portion of erosion that we think has stopped. That's not to say that, that market is going to grow domestically because of all the things that we just mentioned in terms of interval expansion. But again, I think that is a very gradual three to five-year process before we start to materially see the impact of further market consolidation and interval expansion.

Jonathan Block - SunTrust Robinson Humphrey Capital Markets

Just with tomo, maybe if you can speak just to workflow? In other words, here in the U.S., CAD is still prevalent, almost a one-on-one with 2D. And so when you get Dimensions approved and it's out there, can you speak to how people are going to integrate it for a workflow perspective? So they'll use without CAD, and then what do you do? Do you have to wait until approval? Until you turn around and submit sort of a CAD system with 3D?

Robert Cascella

Well, the configuration of the product is a combination imaging products, so it fuses 2D and 3D mammography. 2D CAD is available on the product. It is the same 2D CAD that's on the current Dimensions, 2D product. So the user today will have the benefits of 3D in the efficiency of CAD in the 2D world. And yes, after this product is approved, we are currently developing a 3D CAD offering, which would have a series of algorithms and feature matching, that would take place within the 3D-feature set versus the 2D-feature set. But we think that's a lengthy clinical trial and a fairly rigorous FDA process.

Operator

We'll go now to Vivian Cervantes with Maxim Group.

Vivian Cervantes - Maxim Group LLC

On diagnostic, this morning, you had announced even before the call, a new change in leadership or diagnostics. Is there, because this, going to be a change in strategy or an approach in how we drive this business going forward?

Robert Cascella

I think it's good to be a little bit of both. We want to nurture and preserve the good about what we're doing today, but we also want to change some of the things that we think might be legacy issues within that business group. So it's a little early to tell, but the expectation is that we really want to focus on the molecular part of the diagnostic business, and look at ways that we can grow through core development, of our own assays, out licensing and partnering, a way to leverage invader platform as we have not done thus far. So there are many elements of it. And as I say, we don't want to throw out the baby with the bathwater, so it will be a matter of Mark spending time to get familiar with the business, and then he and I developing what we think, along with the General Managers on a divisional basis, what we think our growth strategy will be for our diagnostic franchise.

Vivian Cervantes - Maxim Group LLC

And then a follow-up on the replacement cycle. You had mentioned that roughly 5% or so of volume today are replacement, and that, that should increase with the 3D approval. Given the CapEx environment, with the 3D approval, are you saying that there's going to be un-expedited replacement? Or is it going to be the typical five- to seven-year wait before you replace? Just put a color on that.

Robert Cascella

We believe, although we would also say that it's going to take time, is that tomosynthesis has the ability to do the digital, what digital did to analog, and that is create a market dynamic of technological obsolescence. Now that's going to require clinical validation, it's going to require reimbursement, but once that happens, then I think our customer base will rush to acquire tomosynthesis. Because clinically, it will have been proven to be more effective, I think women will read about this as a more effective tool for screening, particularly those women with dense breast. All of those benefits will start percolating to the top of the market, and it will become everyone's priority. And as a result of that, it will cost the replacement cycle to accelerate. Similar to what happened with digital mammography, five years after it was introduced and the American College of Radiology came out with their Dean of study stating that, that product was better for women with dense breasts women that were under 50, women that were pre- and perimenopausal, well that became the reason why everyone needed to have digital at that point. Now I don't think it's good to take five years for tomo, because I think the clinical benefits of tomo are far more compelling, than digital was over analog. But nonetheless, it is going to take some time. But when it does, that will also drive an acceleration in the replacement cycle.

Operator

We'll go next to Jon Groberg with Macquarie.

Jonathan Groberg - Macquarie Research

One quick clarification back to the ThinPrep business, I think you actually said you thought that Europe should trend up and grow for the rest of the year? Kind of in contrast to some of the other trends that you're talking about? So maybe you could just explain why you thought that was going to happen.

David Harding

This is David. We've seen really good growth in a couple of markets in Europe that are continuing to grow and mature. If we look at countries like France, where we've had lots of great large-scale competitive wins, new reimbursement protocols in place in some of the Scandinavian countries that are driving growth, and then just good steady growth in some of our other European markets. And also, outside of Europe, we've also seen good adoption of the ThinPrep technology. Places like Brazil, the Middle East, Eastern Europe, we're seeing good growth in each of those different areas. And as a result of that, we really believe that there will be excellent growth outside of the U.S., not to mention China, where there is still a massive untapped market, and we continue to see strong growth.

Operator

And we'll take a follow-up question from Bill Bonello.

Bill Bonello - RBC Capital Markets, LLC

Can you just give any sense of what your expectations are in terms of any data from your U.S. clinical trial on tomo coming out over the course of the next year and sort of how results from that trial might be disseminated out into the marketplace?

Robert Cascella

In order for there to be data that becomes part of the public domain, all of these clinicians need to write research reports. And we're certainly encouraging them to do so. Obviously, that's a significant commitment, but we believe that data are very encouraging, and this is all but for now, getting the clinician to actually devote the time. And we think that's going to happen through either Mass General, UPMC, some of our earlier data sites that we're at the forefront of tomosynthesis for the last two years. It just has not happened as of yet and as they say, we would expect that, that will be happening over the next year.

Bill Bonello - RBC Capital Markets, LLC

So think of it though as stuff that gets published in journals et cetera, as opposed to some kind of consolidated data release at a conference or something like that.

Robert Cascella

I mean we can publish the data today but it would not be independent at that point. Obviously, we've aggregated the results, we know that they're very favorable, we know that there we're findings that were not present in our original clinical trial meeting, cancers that we're found in only 3D and not 2D, things that were very, very positive, albeit selective. But I think it carries much greater weight and value if it is a peer-reviewed study versus the company publishing its clinical results. And that's why we've been hesitant to do so. Now we will use that data in talking to payer groups and CMS, because we think that it's a compelling reason for both private pay and CMS to look at this as saving lives, as well as saving money. And I think that we'll be a good outlet for this clinical data initially.

Operator

And that is all the time we have for questions today. I'll turn the conference back over to Hologic for closing remarks.

Robert Cascella

I just wanted to thank everyone for participating on the call, and we'll look forward to reporting to you over the balance of fiscal '11. Thanks very much.

Operator

That conclude today's conference. Thank you all for joining us.

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