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Cutera (NASDAQ:CUTR)

Q2 2011 Earnings Call

August 01, 2011 5:00 pm ET

Executives

John Mills - Senior Managing Director

Ronald Santilli - Chief Financial Officer and Executive Vice President

Kevin Connors - Chief Executive Officer, President and Director

Analysts

Larry Haimovitch - HMTC

Thomas Gunderson - Piper Jaffray Companies

Dalton Chandler - Needham & Company, LLC

Anthony Vendetti - Maxim Group LLC

Morris Ajzenman - Griffin Securities, Inc.

Operator

Greetings, and welcome to the Cutera Second Quarter 2011 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Mr. John Mills of ICR. Thank you, Mr. Mills. You may begin.

John Mills

Thank you. By now, everyone should have access to the second quarter 2011 earnings release, which went out today at approximately 4 p.m. Eastern Time. The release is available on the Investor Relations portion of Cutera's website at cutera.com and with its Form 8-K filed today with the SEC and available on its website at sec.gov.

Before we begin, Cutera would like to remind everyone that these prepared remarks contain forward-looking statements, including statements concerning domestic and international growth opportunities and strategies; future spending, expense management and execution on various aspects of our operations and business; expectations for increasing revenue, generating cash and improving profitability; the development and commercialization of existing and planned new products; potential revenue growth from strategic alliances and planned new products; obtaining regulatory clearances; and the impact of natural disasters, including the disastrous earthquake in Japan in March of this year.

Also, management may make additional forward-looking statements in response to your questions. These forward-looking statements do not guarantee future performance and therefore, you shall not rely on them in making an investment decision without considering the risks associated with such statements.

Cutera also cautions you to not place undue reliance on forward-looking statements, which speak only as of the date they were made. Cutera undertakes no obligation to update publicly any forward-looking statements to reflect new information, events or circumstances after the date they were made or to reflect the occurrence of unanticipated events. For a complete list of risk factors that could cause Cutera’s actual results to differ materially from the forward-looking statements, please refer to the section entitled Risk Factors in our most recent 10-Q filed on August 1, 2011, with the Securities and Exchange Commission.

With that, I’ll turn the call over to the company’s President and Chief Executive Officer, Mr. Kevin Connors. Go ahead, Kevin.

Kevin Connors

Thank you, John. Good afternoon, everyone, and thanks for joining us today to discuss Cutera's results for the second quarter ended June 30, 2011. On today's call, I'll provide an overview of our company's performance. Then Ron Santilli, our CFO, will provide an overview of our financial results. Finally, I will provide some closing comments and open the call to your questions.

We are pleased with 22% revenue growth achieved during the past quarter when compared to the second quarter of 2010. This improvement is a direct result of key initiatives associated with realigning our U.S. sales organization and recent new product introductions. In April, our GenesisPlus system received an FDA clearance for toenail fungus. As a result, we focused our sales and marketing efforts related to this product on the approximate 15,000 podiatrists in the United States. We received Health Canada clearance for toenail fungus in July of this year, which we expect will contribute to our third quarter performance. We are encouraged with the early market response over GenesisPlus product, which can be promoted for toenail fungus, warts and other procedures. With the recently granted FDA clearance, we believe PSS, our distribution partner in the United States, who has a strong channel in the podiatry specialty market, will enable us to expand our presence. We also believe that dermatologists are interested in this product, as there is significant patient demand for the treatment of this condition.

We continue to expand clinical research for our Excel V vascular system, as this is required support for successfully penetrating core physicians. During the second quarter, we commenced revenue shipments and are pleased with the response from global key opinion leaders of vascular surgery as well as our customers and expect this to be an important part of our future revenue growth. As a reminder, we believe this to be a premier vascular system in this market, as it provides practitioners an ability to treat all vascular conditions both on the face and body. The Excel V was designed with input from thought leaders in dermatology and plastic surgery.

Shifting to our revenue distribution, we are pleased to experience a balanced geographic mix. In the United States, we are pleased with the initiatives that our sales management are driving, as a result of which we experienced 19% growth in the United States in the second quarter 2011. We believe our strengthened team in the United States has us well positioned for continued top line growth. We currently have 27 sales territories in the United States and Canada.

Our business outside the United States grew 24% in the second quarter 2011 when compared to the same period in 2010, with particularly strong performance from Canada, Australia and our network distributors in the Asia Pacific and European markets. We are encouraged with an apparent rebound of our Japanese business, given the uncertainty associated with the March disaster.

During the second quarter, we continue to have success in combining Cutera products and upgrades with filler and cosmeceutical products with Merz and Obagi. These filler and cosmeceutical products continue to complement our laser and light-based products and have provided us with a growing recurring revenue stream.

Turning to research and development, we believe that strategic ongoing investments in product research and development are critical to our future success. The team led by Chief Technology Officer Len DeBenedictis has our R&D team well positioned for future product offerings. In line with that principle, we are continuing to invest in R&D for the next generation of technology and have increased our engineering and clinical research expenditures to develop innovative solutions, and expand the clinical understanding and applications of the current products.

Approximately one year ago, we discussed our goal of launching 3 new products before the end of 2011. We are pleased with the recent GenesisPlus and Excel V product launches and our ability to secure a significant number of successful global regulatory clearances. We view FDA clearance for the GenesisPlus early in the second quarter as a significant milestone, given an unsuccessful outcome would have resulted in a major setback on the domestic market. With this clearance, however, the agency required additional engineering efforts to successfully secure the product clearance from the FDA.

In addition, we experienced a longer-than-anticipated engineering handoff to manufacturing with Excel V launch. These 2 factors resorted in resources being diverted from our originally planned third product launch in the second half of 2011. As a result, there could potentially be a delay in that launch. We will provide an update on our progress during the third quarter conference call.

We are pleased with the pipeline of new product opportunities in R&D and have augmented our team with top talent that we believe will provide differentiated, exciting products for years to come. Now I'd like to turn the call over to Ron to discuss our financials in more detail.

Ronald Santilli

Thanks, Kevin, and thanks to all of you for joining us today on our second quarter 2011 conference call. Second quarter 2011 revenue was $14.9 million or 22% higher than the second quarter of 2010. Net loss for the second quarter of 2011 was $2.5 million or $0.18 per diluted share.

Kevin already discussed the geographical performance, and I will now discuss revenue by product category. Product revenue increased in the second quarter by 43% when compared to the second quarter of 2010. This increase was primarily driven by sales of our GenesisPlus product into the podiatrist specialty as well as other physician specialties. In addition, this product can be used for treating warts and other procedures.

Upgrade revenue had declined 36% in the second quarter 2011 when compared to the second quarter 2010. Historically, a new product launch has resulted in an increase in upgrade revenue. However, our recent product launches of GenesisPlus and Excel V are new platforms versus the handpiece that is upgradable on one of our existing platforms.

Service revenue for the second quarter of 2011 compared to the second quarter of 2010 increased by approximately $200,000 from $3.4 million to $3.6 million. The primary component of service revenue is extended service contract amortization. Service revenue has remained flat over the past several quarters due primarily to lower service contract amortization as a result of lower ASPs, offset by higher revenue from consumable handpiece purchases and time and material fees charged to customers who are out of warranty.

Titan annuity revenue in the second quarter of 2011 was in line with our expectations of $1.2 million, an increase of $300,000 from the same quarter in the prior year. This increase was primarily due to our voluntary recall of certain Titan XL handpieces. The voluntary recall occurred in the second quarter of 2010 and concluded in the third quarter of 2010. We provided our eligible customers with a fully refilled Titan XL handpiece, which resulted in a lower-than-normal Titan annuity revenue. We've been slowly increasing our revenue category -- revenue from this category, as many customers are now requiring the recall replacement handpiece to be refilled. We expect this revenue category to slow its growth rate, as we are close to achieving the quarterly run rate prior to the voluntary recall.

Fillers and Cosmeceuticals revenues was $1.1 million in the second quarter of 2011, which increased by 31% from the $806,000 in the second quarter of 2010. The growth of this revenue category was derived primarily from sales of our distributed Obagi projects in Japan. A significant percentage of our revenue is sourced from existing customers. During the second quarter of 2011, 45% of our revenue was derived from sales of upgrades, service Titan annuity, filler and cosmeceutical products. We remain committed to strong customer satisfaction and believe we will continue to realize revenue from these annuity revenue categories.

During the second quarter of 2011, approximately 58% of our North American orders came from the podiatry specialty, which represents an expansion target market for us and also represents an opportunity to now actively market and sell our GenesisPlus and other products. As Kevin mentioned earlier, we are actively engaged with PSS to sufficiently capture this opportunity in the U.S. 15% of our North American orders were derived from core positions. We are continuing to target the core market segments, as well as other established medical offices. Towards this goal, we believe the recently launched Excel V product expands the product offering for this market segment. We believe that the core market segment offers us the greatest long-term growth opportunity.

I will now address our operating performance. Our gross margin was 57% in the second quarter of 2011 compared to 56% in the second quarter of 2010. The increase in gross margin was due primarily to improved leverage associated from our fixed costs on the overall -- on the higher overall revenue volume. The 57% gross margin rate is lower than we had previously expected at this revenue level, due to higher service-related expenses and higher manufacturing expenses related to the ramp-up of production of our recently launched products. At current revenue levels, we believe our gross margin will be approximately 57%. And with revenue levels higher than the $15 million, we expect that our margin will improve due to leverage in our model. We believe that the manufacturing expenses will trend down, and we are actively managing our service and warranty expenses in order to improve margin levels moving forward.

Sales and marketing expenses were $6.3 million or 43% of revenue in the second quarter of 2011 compared to $6.5 million or 53% of revenue in the second quarter of 2010. The decline in expenses is primarily the result of lower promotional-related expenses, partially offset by higher commissions in line with the higher revenue.

Research and development expenses were $2.3 million for the second quarter of 2011 or a 56% increase when compared to the $1.5 million for the second quarter 2010. This increase was due primarily to higher materials spending and personnel expenses associated with our stepped-up engineering and clinical development efforts. We remain committed to investing in R&D and expect many new product launches in the future.

General and administrative expenses declined by 6% to $2.6 million in the second quarter of 2011 compared to $2.7 million in the same period in 2010. This slight decline was due to a lower personnel-related expenses. On seasonal basis, our second quarter G&A expenses are typically higher than the other quarters due to the annual grant of stock to our outside board members. We expect general and administrative expenses to decline by approximately $250,000 from the second quarter of 2011 to approximately $2.3 million in the third and fourth quarters of 2011.

Interest and other income net increased to $199,000 in the second quarter of 2011 compared to $141,000 in the second quarter of 2010, which was due primarily to improved yields on our portfolio investments. In the second quarter of 2011, we had a tax benefit of $208,000 due primarily to a nonrecurring adjustment of approximately $246,000, resulting from the carryback of our 2010 tax return loss to obtain a refund of alternative minimum taxes paid in 2008. As a reminder, we have 100% valuation allowance for our U.S. deferred tax assets and have only a small amount of minimum and capital based tax in the U.S. Therefore, for modeling purposes, we suggest using an effective income tax expense of approximately $50,000 per quarter for the remainder of 2011.

Turning to the balance sheet. Our financial position remains strong. As of June 30, 2011, we had approximately $95 million in cash, marketable securities and long-term investments with no debt. This represents approximately $6.85 per outstanding share. During the second quarter, our operations consumed approximately $767,000 of cash. However, note that our inventories increased by $1 million due to the ramp-up of production for our new products, GenesisPlus and Excel V. Had our inventory levels not increased, we would have generated cash from operations this quarter.

Due to the leverage in our business model, as our revenue improves, this should result in improved profitability and cash from operations. Net accounts receivables at the end of the second quarter 2011 were $3.3 million and our DSOs were 20 days. Inventories increased by approximately $1 million at the end of the second quarter 2011 when compared to March 2011. This increase was in line with our expectations and was due primarily to our buildup of the GenesisPlus and Excel V product launches. We continue to aggressively manage this asset and are turning our inventory in the range of 3 to 4x per year.

Now that I've concluded my overview of Cutera's operating and financial performance, I'll turn the call back to Kevin.

Kevin Connors

Thanks, Ron. For the balance of 2011, we've remained focused on the following key initiatives: one, expand our global sales and marketing activities for our GenesisPlus product and for the podiatry specialty and other physician categories; two, increase revenue from our core market through sales of existing and new Excel V product offerings. This will include developing market reference sites with key opinion leaders and expanding the clinical research of Excel V capabilities. Three, continued improvement productivity for our North American sales team. We have confidence in this team and their strategies and are encouraged with their performance to date. Four, continued focus on our research and development efforts to enable many new product launches in the future. With appropriate execution of these key initiatives, we remain focused on expanding our global business, which should translate to improved leverage of our operating expenses, resulting in improved operating performance in cash from operations.

Now, I'd like to open the call for your questions. Operator?

Question-and-Answer Session

Operator

[Operator Instructions] Our first question is from the line of Tom Gunderson with Piper Jaffray.

Thomas Gunderson - Piper Jaffray Companies

Ron, just to start, I need you to repeat a couple of quick numbers, the percent that came from podiatry and the percent that came from core physicians.

Ronald Santilli

Yes, sorry it wasn't clear. 58% of our North American orders came from the podiatry specialty and about 15% came from the core of plastic surgeons and dermatologists.

Thomas Gunderson - Piper Jaffray Companies

And that's the same terminology, 15% of orders in North America?

Ronald Santilli

Yes, that's correct.

Thomas Gunderson - Piper Jaffray Companies

And therefore, 27% came from primary care physicians, is that the way we look at that?

Ronald Santilli

No, because that would also include some non-MDs, some OB/GYN. But primary care physicians are in there about 6%, but then there's a smattering in other specialty. It gets allocated around.

Thomas Gunderson - Piper Jaffray Companies

Got it. And then Kevin, you got FDA approval for the toenail fungus. You talked about GenesisPlus in the prepared remarks. When you get on label like that and your sales force can actually sell the product for which it was intended to the customer, do you foresee marketing costs going up temporarily? Do you do any co-marketing with your customers? Give us a sense of how the change in label helps sell the product.

Kevin Connors

Well, the obvious advantage is that our sales force can openly promote the product for the indication. So we had other indications that were cleared, but this is the one that we are looking forward to getting and we even had a potential plan to begin the clinical studies to support the submission. But we were pleased that we were able to work with the agency to get the current device with some modifications made. We're learning a lot about this market, Tom, and we're doing market research and listening to key opinion leaders in this field. And what you've suggested has been discussed. But in short term, I wouldn't anticipate any significant increases in marketing spending. We think we've got sufficient resources to pursue this opportunity, and it's important that we get our mind around how big this is.

Thomas Gunderson - Piper Jaffray Companies

Okay, and then there again in the prepared remarks, it seemed a little bit more emphasis on your commentary on GenesisPlus and less on Excel V. Should we interpret that to mean that some of the upside that we saw in the quarter, more of it was GenesisPlus and Excel V maybe has a longer sales cycle than we were assuming?

Kevin Connors

Well, we tried to focus the script in line with the business performance. And so obviously with the breakout of this application, being about half the business in North America, we thought it made sense to spend more time on it. We are still extremely excited about Excel V and we have top-notch doctors around the globe that are buying this product. And we're working on validating the technology, as we move forward by commissioning clinical research sort of -- a tremendous amount going on right now, we plan to continue to expand that. So this is a well-differentiated product in vascular surgery and we're really excited about it.

Thomas Gunderson - Piper Jaffray Companies

And then last question, Ron, what percent of revenues were from Japan?

Ronald Santilli

Let's see, I don't have the total percent of revenue, but I can give you an estimate here. It will probably be somewhere in the 15% range.

Operator

Our next question is from the line of Dalton Chandler with Needham & Company.

Dalton Chandler - Needham & Company, LLC

Could you provide us with the percentage of revenue that came from new products that you were not selling in the year-ago quarter?

Ronald Santilli

We didn't disclose that this past quarter. Clearly, the Excel V and the GenesisPlus are the newest products in the last year. But we didn't disclose percentages on those revenue numbers.

Dalton Chandler - Needham & Company, LLC

Okay, just could you maybe talk about it qualitatively?

Ronald Santilli

Well, we talked about it in terms of the specialty in North America being 58% coming from podiatrists. So that certainly lands itself to pretty good revenue piece from the GenesisPlus product. The Excel V fits right into the core physicians, and our existing products also were sold to core physician. But we didn't break out those, the revenue on those 2 separate products.

Dalton Chandler - Needham & Company, LLC

Okay. And how do you actually work with PSS in the podiatry market? Are they just providing your reps with leads? Or are they actually closing business on their own?

Kevin Connors

Dalton, we're new in this application so we're learning quite a bit as we understand it better. But PSS does call on podiatrists today, and we think that having the ability to talk about a new technology at that [ph] point makes tremendous sense for us. So we really are partnering with them to explore that further. But it's a whole spectrum of experiences with PSS. We have certain situations where the PSS actually closes business or has the business far along when our rep is introduced to it. And it's also the model that you alluded to where they're generating leads or turning leads over to our direct sales force to hopefully close that business.

Operator

Our next question is from the line of Anthony Vendetti with Maxim Group.

Anthony Vendetti - Maxim Group LLC

I missed the OUS growth. U.S. was 19%, up year-over-year. What was OUS again?

Ronald Santilli

Outside the U.S. was 24%, Anthony.

Anthony Vendetti - Maxim Group LLC

24%. And then on the true scope, I know that's something you guys sort of put on the back burner. But do you have any updates there? Or just a refresher on what your new product pipeline looks like and the timing?

Kevin Connors

Well, we're not commenting on the pipeline until we're ready to launch. But we didn't discontinue the true scope. Anthony, if you recall, we talked about having some near-term product and so we had engineering resources directed at some opportunities, including GenesisPlus and Excel V that we can deliver to market in a pretty well-defined period of time. But we continue to have excitement about true scope. We've added some resources to R&D and things like true scope are areas that we want to revisit.

Anthony Vendetti - Maxim Group LLC

Okay. But in terms of just -- I know you can't talk about the types of new products in the pipeline. But time frame for launching a new product, can you update us on that?

Kevin Connors

Well, we just launched 2 and we commented on the call that some of the efforts associated with the FDA clearance required engineering resources to be reallocated. So if you look at the R&D expense line, we are currently stepping on the accelerator in terms of getting new products to the market as quickly as possible, and we expect that.

Anthony Vendetti - Maxim Group LLC

Okay, and then last 2 quick questions. Any large customer purchases this quarter that helped you out?

Ronald Santilli

No.

Kevin Connors

No.

Ronald Santilli

There isn't anything in particular that stands out from a national account perspective.

Anthony Vendetti - Maxim Group LLC

Okay, great. And then lastly what particular graphic area outside the U.S. is showing the best growth right now?

Ronald Santilli

Well, that always changes from quarter-to-quarter. But we've had some good uptake in Canada and Australia. Our Japan business has always been good. Clearly, the disaster in March kind of has affected our performance, but it's really rebounded fairly quickly here in Q2. So we're continuing to see them sporadically in various countries around the world.

Operator

Our next question is from Morris Ajzenman with Griffin Securities.

Morris Ajzenman - Griffin Securities, Inc.

In this quarter, $14.9 million revenues equates to 56.5% gross margins. You had a GAAP loss of $0.18. If my calculations are correct, a pro forma non-GAAP loss of $0.08 a share. What do we need on the top line and what sort of gross margins do we need to get to a -- let's look at both on the GAAP breakeven and the non-GAAP breakeven. Can you kind of help us along that path now?

Ronald Santilli

Sure, Morris. I think first of all, let's kind of keep the numbers to GAAP. It's just easier to stay that way. First of all, we're not happy with the gross margins. The 57% for the quarter on $15 million isn't our target. We really expect to be at 60% of that level. And then north of $15 million, we'd like to be north of 60% of gross margins. So those are areas that we're aggressively working now to improve. The -- another line for the quarter was R&D, and of course we're continuing to invest heavily in new products. But we probably spent a lot of money, particularly in materials spending that we suspect can actually decline in some small ways in the future. So we're working our spending down to be efficient there. It depends on where you're at in life cycle of the product. But for a lot of our projects they've come to where a lot of that materials spending has already occurred. And then the last thing in this current quarter that occurred is in G&A. There was about a $300,000 nonrecurring charge or annual charge that is made for stock that goes to outside board members that won't occur in Q3 or 4 or even Q1 of 2012. So those are areas that we need to more aggressively work, and bring our breakeven point down. Because if we try to work the breakeven point with the results from this quarter, it's in that $17 million to $18 million per quarter range and that's too high. So that's -- we're not pleased with that profit level at that revenue level either.

Morris Ajzenman - Griffin Securities, Inc.

So then should we -- I'm not sure what that leads us to a year or so down the road when your product introductions come behind you. So there are always new initiatives. Should the revenue be $16 million to break even? Should it be $15 million? I'm not sure what we should be looking at as time progresses.

Ronald Santilli

Yes, I mean I don't have a specific number for you. Clearly, we're targeting lower -- low numbers to get to our breakeven point. But right now, we're trying to drive that top line and drive gross margins. And once we get those, I think the rest we can bring into line, but we've got to keep that revenue up.

Morris Ajzenman - Griffin Securities, Inc.

Understand. And one last question please. Upgrade revenues, down 36% and then you highlight specifically, you had new launches. There were new platform launches. So now that that's happening, how long will that take before we start seeing an uptick in orders and upgrades specifically.

Ronald Santilli

At this point until we have any new product launch, which is an upgrade to an existing platform, I'm not sure we see any significant uptick in that upgrade category. So for GenesisPlus and Excel V, those are platform purchases. And as a result, they don't -- those never hit the upgrade category. You don't add them on to the Xeo, Solera or CoolGlide lines. So until such time that we come out with new products, which may or may not affect existing products, at this time, you wouldn't see a huge change in our upgrade revenue.

Kevin Connors

The one thing I'd add to that, Ron, is that we do -- we don't have excellent visibility in terms of utilization of our equipment in terms of procedure volume. But we have some indirect ways of monitoring that. And we are getting some anecdotal evidence that utilization of our products has picked up. Meaning that more patients are having these procedures done. And the only direct metric we have on our business is the Titan annuity business, and that's recovered nicely. So there may be some benefit of higher patient demand for these procedures that could drive the interest and upgrades.

Operator

[Operator Instructions] Our next question is from the line of Larry Haimovitch with HMTC.

Larry Haimovitch - HMTC

Kevin, Len DeBenedictis has joined Cutera fairly recently. He has great reputation. I've heard from people in the industry, a very good product developer. What kind of run way does someone like that need before they can start making a contribution to developing new and improved products?

Kevin Connors

Yes, Larry. We're delighted to have Len join the team. He came on board at the beginning of the year. And we've actually found talent beyond Len in R&D of late. We're really delighted to have some top industry technology people join the company. The group we have is quite broad in terms of its technical range. And I think Len is leading that charge. And I think the kinds of thing that he's working on are things that can really transform our business from a technology perspective. So he's very busy here, and he has a team working very hard to get next generation products in the market.

Larry Haimovitch - HMTC

Do you feel an impact over several months? Or is it more longer -- is it longer than that, Kevin.

Kevin Connors

Well, the impact was felt still pretty soon after he joined. I think it's having an impact now. But product development does take some time, and we're here to support Len and his team to expand our product portfolio. But that's the one thing that doesn't show up in the balance sheet is the talent that we have in the organization. And we're quite excited.

Larry Haimovitch - HMTC

Okay. I noticed you burned a little bit of cash in the quarter. It wasn't very much, but burned a little bit, it looked like. Do you have any discomfort with that? Or is that just part of building the business?

Kevin Connors

We like to generate cash, Larry. So, yes, it does cause discomfort. But on the other hand, we have a board that's supportive of us earning our leadership position in this market. And sometimes unfortunately, you have to dip into cash consumption. But from the early days we started this company, we've been focused on generating cash from operations, and that's ultimately what we're here to do. But typically, new products that can transform your business are the best way to control that.

Ronald Santilli

Yes, Larry, we did consume about $750, 000 for the quarter, cash from operations. But if you noticed, about $1 million of it was for inventory increase associated to the GenesisPlus and Excel V products. So we had to invest in some inventory there.

Operator

We have no further questions at this time. I'll now turn floor back over to Mr. Kevin Connors.

Kevin Connors

Thank you for participating on our call today. We look forward to seeing you at the Wedbush Healthcare Conference on August 16, and to updating you on our third quarter conference call in November 2011. Good afternoon and thanks for your continued interest in Cutera.

Operator

Ladies and gentlemen, this does conclude today's teleconference. You may disconnect your lines at this time. Have a wonderful day.

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