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Hologic (NASDAQ:HOLX)

Q4 2011 Earnings Call

November 07, 2011 5:00 pm ET

Executives

David P. Harding - Senior Vice President and General Manager of International

Robert A. Cascella - Chief Executive Officer, President and Director

Deborah R. Gordon - Vice President of Investor Relations

Peter Soltani - Senior Vice President and General Manager of Breast Health

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

Analysts

Bill Bonello - RBC Capital Markets, LLC, Research Division

Jonathan P. Groberg - Macquarie Research

Isaac Ro - Goldman Sachs Group Inc., Research Division

Jonathan Block - SunTrust Robinson Humphrey, Inc., Research Division

Nandita Koshal - Barclays Capital, Research Division

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

Sara Michelmore - Brean Murray, Carret & Co., LLC, Research Division

Richard Newitter - Leerink Swann LLC, Research Division

David R. Lewis - Morgan Stanley, Research Division

William R. Quirk - Piper Jaffray Companies, Research Division

Operator

The Hologic Inc. Fourth Quarter and Fiscal 2011 Earnings Conference Call. My name is Jessica, and I'm your operator for today's call. Today's conference is being recorded. [Operator Instructions] I would now like to introduce Deborah Gordon, Vice President, Investor Relations to begin the call.

Deborah R. Gordon

Thank you, Jessica. Good afternoon and thank you for joining us for Hologic's Fourth Quarter and 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 will be made during today's opening remarks. The replay of this call will be archived on our website through Friday, November 25. Please also note that a copy of the press release discussing our fourth quarter and fiscal 2011 results, as well as our first quarter and fiscal 2012 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 statement. 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 detailed 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, circumstances or conditions on which any such statement is based.

Also during this call, we will be discussing certain financial measures not prepared in accordance with Generally Accepted Accounting Principles, or GAAP. A reconciliation of these non-GAAP financial measures to the related GAAP financial measures can be found in Hologic's fourth quarter 2011 earnings release, including the financial tables in the release.

Please note that today's call will consist of 30 minutes of opening remarks from management, followed by a 30-minute question-and-answer session. We therefore ask each participant to please limit his or her questions to just one, with one follow-up, if necessary. We do 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 at that time.

I would now like to turn the call over to Rob Cascella, President and Chief Executive Officer.

Robert A. Cascella

Thank you, Deb. Good afternoon and thank you for dialing in to Hologic's Fourth Quarter Conference Call. Joining me on the call today is Glenn Muir, our Executive Vice President and Chief Financial Officer; Steve Williamson, who is dialing in. He's on the road today. He's our General Manager of our GYN Surgical group; Peter Soltani, our General Manager of Breast Health; and David Harding, the General Manager of International Operations.

Today, I'm going to cover several points. We'll summarize the fourth quarter performance, discuss recent macroeconomic trends and how they impact our business, give you an update on the growth of our digital mammography business, including key elements of the very promising launch of our dimension 3D, or tomosynthesis. I'll provide you with a brief review of other key businesses and reconfirm our strategic vision for fiscal '12 and beyond. Glenn will then talk about financial results in greater detail and provide our fiscal guidance for 2012. We'll then open the call up for 30 minutes of Q&A.

We are once again pleased with our results for this past quarter. For the eighth quarter in a row, we've achieved record revenues. In Q4, revenues of $467 million increased 9% over last year's fourth quarter. We also reported year-over-year growth in all 4 of our operating segments. Non-GAAP earnings per share of $0.34 was above our guidance and 12% above last year.

Overall, I think we were very, very pleased with the financial results. Operationally, we had several positive events occur in the quarter, such as our acquisition of Healthcome, FDA clearance of 2 products and a CE marking for a third.

While it's difficult to have a discussion about financial performance without some reference to the global economy, the capital equipment market appears to be stable, but customers are holding on to equipment longer than typical. Growth will be driven by the introduction of new technologies, successor technologies like tomosynthesis. Our Diagnostic business remains on a positive trend for the current year and is expected to remain as such throughout fiscal '12. It would appear that at a minimum, more women are having their wellness exams.

However, surgical and other more discretionary procedures, are clearly feeling the brunt of the weak economy and persistent unemployment, as evidenced by softness in NovaSure procedures and moderate growth in Adiana.

On a global basis, 50% of our international business comes from Europe, where many Eurozone countries are struggling financially. This potentially could impact our international growth going forward. Markets of strong growth remain Asia, China specifically, and Latin America, where we are investing in these growth markets with infrastructure and people.

I'd like to talk a bit about our Mammography business. We were very pleased with the ongoing performance of Dimensions with the strong uptake of both 2D and tomo sales in the quarter. In order to provide you with a better indicator for early tomo performance, I'm going to compare the market penetration of the products in the U.S. to the pre-reimbursement targets we set a while ago, that being the 500 to 700 units that we've been referring to.

First, we are solidly on plan and encouraged with the initial uptake. We are roughly 6 months from the formal launch of tomo in the U.S. and we are approximately 20% of our 500 to 700 unit goals through this period. Over fiscal '12, we expect 3D penetration to accelerate and should finish the year at roughly 60% of this goal. This is all pre-reimbursement performance, and as we have said before, we expect to gain much more traction once reimbursement is achieved.

Over the course of this year, we will attempt to provide additional detail as to tomo progress, but do not anticipate this level of detail continuing beyond fiscal '12. It is my hope that this additional information will provide some clarity to you.

Now let me review our reimbursement strategy. It's important to stress that over the last year, our approach remains unchanged, and we are on track both in terms of milestones and timing. Recall that a pending reimbursement is a multitiered effort. Short term, we're following the recommendation of the ACR in assisting our early tomo buyers in obtaining reimbursement through the use of a miscellaneous code for the tomo exam, in addition to the reimbursement already established for 2D. We have many cases of payers reimbursing at rates that range from $30 to $70 for the tomo portion of the exam. You may note that we've experienced some higher rates over recent weeks.

We continue to work with various agencies and advocacy groups in order to gain their support. I just spent a day in D.C. making members of Congress much more aware of the benefits of tomo. Around the first of the calendar year, we will begin to have more meaningful discussions with CMS about a coding structure.

As for the clinical data that is necessary, the most important data needed to secure reimbursement is from both U.S. and international studies validating the performance of the technology. We expect to see preliminary data for Mass General and RSNA this month, with published results expected sometime next year. We also expect 8 accepted abstracts to be presented at RSNA, specifically about Hologic's tomo system. So research activities have increased substantially over recent months. In addition, the 25,000-patient Oslo study is ongoing and we look forward to reviewing the preliminary results to be provided at RSNA as well.

It's difficult to predict the timing of any reimbursement decision. However, we believe we have a comprehensive plan in place. Our best estimate today is that we believe we will secure a code and an amount by the first half of 2013.

Next, I'd like to talk a little bit about service revenues and specifically how they relate to our Mammography business. With service comprising about 30% of breast health revenues, it is a key driver of fiscal '11 growth. It was up 14% when compared to the prior year's Q4 and up 20% on an annual basis. Service revenue will continue to be a growing annuity for us. However, as our Dimension sales growth accelerates, it will result in a temporary deceleration and service revenue growth. This is due primarily to the decommissioning of a Selenia and loss of the service contract on that unit while the replacement Dimension is under warranty for the first year, which does not generate service revenue. We estimate this will result in a year-over-year service growth in the mid-single digits for the next couple of years. And it's entirely gated by how quickly the Dimensions uptake occurs.

Now I want to talk a bit about some of the other key businesses. First is our GYN Surgical business, NovaSure specifically. We continue to face headwinds with NovaSure. Fourth quarter posted a small decline when compared to last year. We attribute this primarily to the nature of the indication. It is an elective procedure, which carries a high co-pay and/or deductible. With the current state of the economy and unemployment, we continue to see the vulnerability of such procedures.

With this in mind, we are constantly considering ways to grow this overall market, some of the tactics we're employing are as follows: we're going to continue to invest in DTC but with a greater emphasis on conversion versus awareness. In addition, we're adding to our GSP sales force, or our surgical sales force, that more coverage in areas where there is the greatest potential. Over the last 60 to 90 days, we've added around 30 heads in that group.

With respect to DTC, the program continues to provide positive results but are being offset by the market challenges addressed earlier. Some of the specifics related to DTC performance are as follows: Our information requests exceed 18x our normal rate. These are people that are reaching out to gain information on the technology. We had 93,000 women request information in Q4 alone. So when we talk about conversion, it's this universe of interested women we are targeting. We estimate the incremental revenue pull-through generated by the program for the quarter is approximately $11 million and to date, it's just over $20 million.

Market erosion and some share loss have nearly offset these gains entirely. We obviously expected a more significant return but continue to invest because we believe the market potential is being encumbered by external economic conditions. We also believe the current economic climate has presented opportunities for certain non-GEA competition. Our sense is that such competition is delaying the sales pull-through for NovaSure since they represent lower patient cost alternatives but longer term, do not have the efficacy of our product. We view the effects of these alternatives as potentially delaying the sales of NovaSure, not replacing them. So we remain optimistic that this business will recover with an improvement to the economy.

Now for Adiana, sales grew in the low-double digits for Q4 when compared to a year ago. We are experiencing strong conversion rates, which translates into more doctors performing Adiana procedures. Also our reorder rate remains strong and it is clear to us that doctors are not simply trialing. They are continuing to use the product. No doubt, we are facing the competition compounded by a weak U.S. economy, but nonetheless are continuing to increase

penetration.

Some good news finally, we believe the recent Institute of Medicine decision to include hysteroscopic sterilization as a fully covered procedure will benefit this technology during the latter part of fiscal '12. And that our recent CE marking should enable growth of this technology on an international basis.

Turning to MyoSure briefly, we remain very pleased with our MyoSure product. It's proven to be a very good acquisition for us. The feedback from clinicians remains positive and our sales force has embraced the benefits of the technology. Sales continue to grow and we are confident this that product will significantly contribute to Hologic for years to come.

Next I'd like to give an update on our diagnostic group and more specifically, Cervista. Overall, the diagnostic franchise made a strong recovery in Q4. Glenn will provide more details, but our ThinPrep unit volume grew over 11% in the quarter when compared to last year. This is the result of a partial U.S. market recovery complemented by strong international growth, as we focus on emerging markets. We believe international growth will be sustained throughout fiscal '12.

Cervista continues to be a growth driver for the Diagnostic business. We again had double-digit sequential growth from last quarter as we continue to take critical market share in the mid-tier of the HPV market. We believe we can continue to grow this business irrespective of increasing competition, due largely to the quality of our proven assay and strong customer relationships.

With respect to the progress on our high throughput automation, we're in active discussions with the FDA regarding the approval of HTA and still expect approval in the first half of fiscal '12. As noted in today's press release, we received CE marking of our medium throughput automation system. The MTA system is intended for small to midsized labs when we have already begun to launch activities in Europe and are expecting increased international volume as a result of sale.

From a development perspective, we're broadening our product portfolio and are investing heavily in this business. We're actively proceeding with the development of CT/NG and Trichomonas assays, all based on our Invader chemistry, all available from our ThinPrep file, and all able to run on our automation. We expect clinical trials to commence in fiscal '12, with an FDA submission targeted for fiscal '13.

I wanted to touch briefly just on the acquisitions that we did. And as you know, we closed on 3 of them in fiscal '11, Interlace, which is MyoSure and TCT, our Chinese distributor, as well as Healthcome, our Chinese manufacturer of mammography systems. We're pleased with the progress being made on all 3 fronts.

As I said earlier about Interlace, the sales team is thrilled to have the product and it's been very well embraced by our physicians. TCT provides an immediate presence in country, with strong sales and marketing, and it's a sales group that's capable of selling a complete portfolio of diagnostic and surgical products for us.

Healthcome leads the way for offshore mammography production. We believe we will be in local market with our new entry-level digital mammography system by our fiscal second quarter. First intended for the Chinese market, our new Serenity product will be ideal for lower end markets in Eastern Europe, Latin America, India and other parts of Asia. This will be a high-performance, low-priced digital system. We're thrilled to have this in our portfolio at this point.

Around the same time last year, I provided you with our longer term strategic vision and where we plan to take Hologic over the next 5 years. In fiscal '11, we delivered on our first year commitments. We met or exceeded both revenue and earnings targets. Tomo was approved and launched in the U.S. with early signs of success. We completed the first phase of our international expansion. And we closed on a promising tuck-in acquisition, Interlace.

The guidance in our press release, which Glenn will provide more detail, is a result of implementing the next phase of our strategic plan, and it's all about execution. Our summary objectives for the upcoming year, include continued success with our tomo rollout. This is going to happen through broader education and awareness programs, better reimbursement support, obviously expanded clinical trials and a broader indication for use.

We're also going to broaden ThinPrep international expansion activities. We're going to focus on emerging markets like China, Brazil and Turkey and to position ThinPrep as the preferred triage diagnostic for countries considering primary HPV screening.

With respect to Cervista, we're looking for sustained double-digit growth throughout fiscal '12. Obviously, we need to get HTA approved and we will continue to leverage our ThinPrep presence in the U.S. and other international markets, in addition to broadening our product portfolio.

We are going to continue to invest in surgical, both at business and products, we remain committed to this business as we believe it possesses great growth potential across multiple product lines.

In addition to these objectives, there are certain areas where we're investing in '12. We remain consistent with the direction we set last year. Although Glenn will provide more detail on our capital allocation plans, the outline we established a year ago will apply to '12. And that is organic growth in our ongoing investment in R&D. We're focusing on developing next-generation technologies to enhance our broad portfolio of best-in-class products. Our tuck-in acquisition strategy is to acquire product line extensions and new technologies that are complementary to our core business and allow us to leverage our sales and marketing infrastructure. And finally, our aggressive expansion in the international markets, adding infrastructure and acquiring distribution and manufacturing capabilities in places like Asia and Latin America.

In summary, we are pleased with our performance across all 4 operating segments this quarter and fiscal year. Our organic businesses have stabilized and our new product lines continue to gain traction. The early positive response to tomo is extremely encouraging, as are the trends in Diagnostics, particularly in our molecular business, coupled with the stabilization of ThinPrep. We are also very optimistic about the contributions we will have from all 3 of the acquisitions we made this past fiscal year.

While growth in our GYN Surgical segment, particularly NovaSure, is admittedly lagging our expectations, we believe this business has the potential to grow once our DTC efforts take off and the economy stabilizes.

We offer the most advanced products in Women's Health and have the resources to grow our markets to meet their fullest potential. Although we remain conservative with our revenue projections in light of the multiple challenges we face globally, we do expect to deliver improved top and bottom line growth this fiscal year and to generate solid cash flow from operations.

Thanks very much and with that, I'd like to turn the call over to Glenn.

Glenn P. Muir

Thanks, Rob. Consolidated revenues of $467 million this quarter versus $428 million last year grew $38.7 million or 9% year-over-year, exceeding our expectations and driven by growth in all 4 of our operating segments. Our Breast Health segment was the largest contributor to our overall growth, increasing $21.5 million or 10.9% year-over-year. Our Diagnostic segment posted strong performance this quarter, increasing $15.7 million or 11.7% year-over-year. And our GYN Surgical and skeletal health segments, each contributed modestly higher revenues, with increases of 1.4% and 2.1%, respectively.

Consolidated revenue on a constant currency basis increased 7.8% year-over-year. The positive foreign currency impact provided a $5.4 million benefit to the top line and approximately $800,000 to income before taxes.

Revenues in our Breast Health segment grew to $219 million in Q4 from $198 million in Q4 of last year. This year-over-year growth of 10% came from a $12.4 million or 9.2% increase in product revenues and a $9.1 million or 14.4% increase in service revenues. Foreign currency added approximately 0.9% or $1.8 million to the year-over-year growth this quarter. Breast Health product revenues primarily benefited from strong sales of our 2-D/3-D Dimensions mammography systems, as well as from the 20% year-over-year growth in breast biopsy sales. Our digital mammography product sales increased to $83.3 million in the quarter, representing 38% of total Breast Health revenue. Service at $71.9 million, was 33% of total Breast Health revenue.

Looking closer at the digital mammography product sales, revenue of $83.3 million was 18% higher than Q3 of last year and 7.8% higher than -- I'm sorry, 18% higher than Q3 of this year and 8% higher than Q4 of last year. This growth is being driven by a significant increase in both units and revenues of our new Dimensions line, which is accounted for almost 63% of digital mammo product revenue and 49% of units. This is up from 57% of revenues and 43% of units in Q3 of this year and only 37% of revenues and 32% of units one year ago.

We are quite pleased with the uptick we are seeing in 3D tomo and continue to believe that overtime, all 2D Dimensions sold will upgrade to 3D capability. As we have said in the past, 3D Dimensions sales are in the early stage of U.S. launch and while Q4 sales showed a healthy gain from Q3, we still believe that meaningful 3D tomo sales will not really begin to accelerate until mid-fiscal 2012. However, as Rob indicated, at our current run rate, we are well on our way to hit our target of shipping 500 to 700 tomo systems in the U.S. within the first 2 years.

In addition, this quarter marks our highest unit number of digital mammography systems sold since Q4 of 2008, which was September 2008, 3 years ago, which happened to be our peak quarter. We are cautiously optimistic that the upward trend driven by the replacement market is beginning.

Switching to our other segments. Our Diagnostics segment posted year-over-year growth of 11.7%, with revenues of $150.5 million, up from $134.7 million last year. Foreign currency added approximately 2.1% or $2.8 million to this growth. Our growth was driven by a 15.7% increase in sales of ThinPrep, the majority of which came from our acquisition of TCT in China last quarter.

In Q4, TCT contributed revenues of $14 million, of which 80% is incremental since they have been our partner and distributor for the past 10 years. With this being TCT's first full quarter's performance, we are ahead of our internal projections, the integration is on track and we are expecting close to 20% revenue growth versus their results last year.

ThinPrep unit volume worldwide increased 11% year-over-year, from growth both domestically and internationally, continuing to support our view that the U.S. market is stabilizing while we continue to penetrate the international markets. This quarter, our ThinPrep volume was our second-highest total ever on a worldwide basis.

Our molecular business increased 32% year-over-year, led by continued strong growth of our Cervista HPV product, which was up 44% from Q4 of last year.

In GYN Surgical, we reported revenue growth of 1.4% this quarter and 0.5% on a constant currency basis. Revenues increased to $74 million in Q4 from $73 million in Q4 of last year. Sales of our MyoSure products were the primary driver of growth in the period, and to a lesser extent, Adiana system sales. Both of these increases combined to offset the year-over-year decline in NovaSure sales this quarter as utilization of elective procedures in the U.S. continues to be weak.

Our Skeletal Health segment also posted positive growth of 2.1% this quarter and 1.1% on a constant currency basis, with revenues of $23.4 million, up from $22.9 million as bone densitometry product sales once again increased.

We are seeing continued growth internationally as our focus on international expansion is gaining traction. This quarter, our international revenues were $115 million, a new high and now represents 25% of our total revenues versus 23% last quarter and 20% a year ago.

Turning to the rest of the P&L. Our gross margins on a non-GAAP basis were 61.9%, up 80 basis points from last year as total gross margins for each of our 4 operating segments were up year-over-year, with the strongest contribution coming from Breast Health, largely due to increased service contract revenue resulting from increased service efficiencies and the inclusion of an increasing number of 3D tomo sales.

This gross margin performance resulted in our achieving the midpoint of our guidance range of 61.5% to 62.5%. Regarding operating expenses, our non-GAAP expenses continue to be well controlled and were at the low end of our guidance, totaling $143.6 million, an increase of $18.4 million or 14.7% above our fourth quarter 2010 non-GAAP expenses.

The expected increase was primarily due to the inclusion of acquisitions, namely TCT, Healthcome and Interlace this year and a full quarter of expenses from Sentinelle, acquired last year.

In addition, this quarter also reflected an increase in expenses from our NovaSure DTC campaign. Our R&D efforts increased but remain within the range of 6% to 7% of revenues.

Our non-GAAP earnings exclude certain items that are fully detailed in our earnings release. Absent the non-GAAP items, our adjusted pretax income this quarter was $132.5 million versus $125.3 million in Q4 of last year, an increase of 5.8%. Using our annual effective tax rate of 33.2% for the year, non-GAAP adjusted net income increased 13% to $89.6 million compared to $79.3 million for the same period last year. We reported fully diluted non-GAAP EPS this quarter of $0.34 versus $0.30 a year ago and above our guidance of $0.32 to $0.33.

For the full year fiscal 2011, we reported revenue growth of 6.5% over fiscal 2010 or 5.8% on a constant currency basis. Fiscal year revenue growth was primarily driven by the 9.3% year-over-year revenue increase in our Breast Health segment, although, all 4 of our operating segments posted positive growth.

Contributions from our 3 acquisitions this year added approximately 1% to our total company revenue growth this year. On a non-GAAP basis, gross margins for fiscal 2011 were 61.7% versus 61.5% a year ago and at the higher end of our guidance.

Operating expenses on a non-GAAP basis increased 12.5% year-over-year to $560 million, representing 31.3% of total sales versus 29.6% last year. This increase in operating expenses was driven by the 4 acquisitions and the NovaSure DTC program.

Non-GAAP adjusted net income for this year increased 8.4% to $333.8 million or $1.26 per share, at the high end of our guidance range and compared to $308 million or $1.18 per share last year.

Turning to the balance sheet, our cash balance totaled $713 million, up approximately $196 million or 38% from $517 million at the end of fiscal 2010. The growth in our cash balance is primarily due to the continued strong generation of cash from operations. Importantly, this growth in cash was net of the 3 acquisitions made in fiscal '11.

Regarding free cash flow, we generated approximately $106 million this quarter, consistent with Q3 last quarter. The current quarter's cash flows were comprised of approximately $119 million of cash flows from operations, less capital expenditures of $13 million. For the year, our total free cash flow was $406 million, which was slightly below our target, primarily due to the increased working capital requirements of our recent acquisitions.

Now moving onto guidance, for the first quarter of fiscal 2012, we are expecting revenues of $465 million to $470 million. Year-over-year, this reflects an increase in revenues, primarily due to the contributions from our TCT and Interlace acquisitions and a slight decrease sequentially in the Breast Health segment, which we normally see this quarter as capital equipment customers begin to slow down their order activity going into RSNA. This results in expected growth rate of 8% to 9% on a year-over-year basis.

We expect gross margins of approximately 61.5% to 62.5%. We expect non-GAAP operating expenses to increase on a sequential basis from Q4 to $150 million to $155 million or approximately 31% to 33% of revenue, primarily due to the seasonal increase related to trade shows, RSNA, and our national sales meetings.

We expect non-GAAP interest expense to be approximately $10 million in Q1, excluding $19 million of noncash interest expense related to our convertible notes. Our effective tax rate is expected to be approximately 34%, and we expect non-GAAP EPS to be approximately $0.32 on diluted shares outstanding of 266 million. This does reflect the expected seasonal increase in operating expenses related to RSNA and our national sales meetings.

For fiscal of 2012, which ends on September 29, we are introducing total revenue guidance of $1.9 billion to $1.925 billion, which represents growth of approximately 6% to 7%. This guidance reflects our expectations that: one, Breast Health will grow in the mid-single digits, led by Dimensions and breast biopsy; two, that Diagnostics will grow in the high-single digits, led by TCT and Cervista HPV; and three, GYN Surgical will grow in the high-single digits, led by MyoSure and a rebound in NovaSure. We expect contributions from our 3 fiscal 2011 acquisitions to account for approximately 2% of the total top line growth.

We are guiding to non-GAAP gross margins of 61.5% to 62.5% for the year. The key driver to future margin improvement is the expected increase in revenues. We expect operating expenses to be in the range of $590 million to $600 million, up approximately 6.7% from fiscal 2011. This reflects the additional costs primarily associated with the full year of TCT, Healthcome and Interlace.

And we are expecting interest expense to be approximately $42 million, excluding $79 million of noncash interest expense related to our convert. The effective tax rate we're expecting is approximately 34%, and we are guiding to non-GAAP EPS of $1.35 to $1.37, which implies growth of 7% to 9% year-over-year. This increase is the result of our expected increase in revenues.

We expect 269 million of diluted shares outstanding for the year.

We are sensitive to the multiple macro headwinds out there, so we remain cautious with our guidance. At the same time, we expect to see growth across all of our operating segments, especially in the United States. We are encouraged that as we look forward to FY '12 that many of our new products, such as tomo, MyoSure, Cervista HPV and our expanded distribution in China can all be meaningful contributors.

Turning to cash flow guidance, we expect to generate approximately $400 million to $425 million of free cash flows, which continues to be driven primarily by our operating earnings. As you are aware, capital expenditures are not a big part of our business and we are expecting steady CapEx of about $50 million and depreciation of approximately $65 million for the year. Our plans for use of cash remains focused on investing in our current technologies and operations, potential tuck-in acquisitions and preparing for the possible redemption of the first tranche of our $1.275 billion of convertible notes, which are expected to be redeemed in December 2013.

Our capital allocation plan is focused: First, on being opportunistic regarding tuck-in type acquisitions that will help drive above average top line revenue and earnings growth; and secondly, being mindful of the convert redemption 2 years away.

To try to give a little more clarity on our acquisition strategy, our criteria includes passing financial muster. This entails a fairly rigorous valuation model that test the sensitivity around various revenue assumptions, cost synergies and returns at various risk-adjusted cost of capital metrics. We look at earnings accretion, payback and total IRR, all of which we believe will give us a better answer than alternate uses of capital.

At the same time, we are in no rush and to the extent are unable to find suitable acquisitions intend to address the outstanding convertible by redeeming a portion in order to capture a positive return and deleverage the company. Our preference would be to reduce our debt balance over time.

At the same time, it is unlikely we would enter the market anytime soon to try to redeem part of the convert early, primarily because of the tax recapture payment that would be due. So we do feel we have amplified to see how we make out with bolt-on type acquisitions in the meantime.

In addition to weighing our options regarding our convert, we also spend considerable time analyzing other opportunities for the use of our strong cash balance, including a potential share repurchase. Due in part to our depressed stock price during certain times of the year, we reviewed the benefits of enacting a share buyback program. Although tempting, we decided at this time to stick with our core directives to expand the business in higher return tuck-in acquisitions where we could do -- where we could leverage our operating infrastructure and distribution channels. We will continue to evaluate all options.

In the meantime, we feel that it's in the best interest of our shareholders to maintain a solid cash balance to be able to reinvest in our business, complete future acquisitions, if they are fiscally sound and fit into our strategic initiatives.

In summary, in a somewhat challenging environment, we are pleased with the year, the potential of our recent acquisitions, our push into international markets and mostly, the opportunity 3D tomo presents as the replacement market develops and tomo becomes recognized as the standard of care.

And with that, let me turn the call back to Rob.

Robert A. Cascella

Thanks, Glenn. I just want to remind everyone that we're holding our Analyst Day at the RSNA in Chicago this year. Once again, that event will take place on Tuesday, November 29 and will begin at 8:00 in the morning. The agenda will really be a much deeper dive into Dimensions and a look at some of the influential data that will be coming out of the Oslo study, as well as Mass General.

Thank you very much, and we really appreciate you participating on this call. And I'd like to now turn the call over to the operator so that we can open it up for Q&A.

Question-and-Answer Session

Operator

[Operator Instructions] We'll first go to Jon Groberg from Macquarie.

Jonathan P. Groberg - Macquarie Research

Obviously a lot of questions, and we can obviously just ask one, and one that most people are kind of focused on is guidance. I guess there is one thing to kind of nit-pick at here, would be that still your earnings growth is kind of tied to your revenue growth. Maybe you can just talk about as you think about '12, what the puts and takes are in terms of getting a little bit more earnings leverage from the top line that you're talking about?

Glenn P. Muir

Yes. I think it's a combination of a couple of things. I mean obviously we think we do get better leverage as our revenues materialize and as our revenues grow more quickly. We also think that product mix is a big contributor. So in providing guidance, we took a maybe perhaps a conservative view on product mix, but they affect material changes in gross margin as we shift to higher margin tomosynthesis products, higher margin Diagnostic products and/or surgical. So there's really a blend in terms of the assumptions that were used in that gross margin. We believe that depending on that, combined with an uptake in revenue, could materially change the margins within that range.

Operator

We'll now go to Thomas Kouchoukos from Stifel, Nicolaus.

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

Let's say I guess on tomo, you guys actually -- I think you provided a lot more of the metrics that I think people have been asking about. One question, and we appreciate that. One question I have is just looking at your mix of 2D, 3D systems as a whole, I don't know if you can provide an actual number, but maybe you can give us some sense of when a customer buys 3D or upgrades to 3D, how many machines are you selling out there that's kind of every day encapsulated in one versus maybe some of them that bought a 2D system last year and just decided to upgrade to 3D?

Glenn P. Muir

Yes. I think let me start with that question, Tom. I think there's I guess 2 questions there. One relates to Dimensions in general and what percent of total sales that we're seeing today and it is substantial. Over 60% of our units now of digital mammography are of the 2D, 3D Dimensions. And then to further break that down, the 3D comes in 2 pieces. One is a complete system sale as part of Dimensions and secondarily, as part of an upgrade to an already existing unit. So first of all, most of our 3D tomo sales are in fact of a complete system. And we are seeing the tomo upgrades to that installed base, but it's a much smaller number than the initial full bodied 3D going out the door. At the same time, the rationale for most people on moving to the Dimensions platform is to add 3D over time. So our expectation would be to see those software upgrades kicking in the future, probably at a point in time where we get better traction or visibility on a, the reimbursement and b, the clinical evidence, the publications in the marketplace supporting the clinical utility of tomo itself.

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

Okay. That's very helpful. If I could follow-up one quickly on your Adiana CE mark. One, I just wonder how important is radiopaque to the product and then what does that mean for FDA approval in terms of the process that you would have to go through?

Robert A. Cascella

Sure. We think obviously radio cadence is an improvement. It's an evolutionary improvement for the product. We think that, that will be important, both for our international sales and here in the States. We're in discussions with the FDA around radiopaque at this point in time. So it is unclear as to what the approval timeline would be for that product.

Operator

And we'll now go to David Lewis from Morgan Stanley.

David R. Lewis - Morgan Stanley, Research Division

Glenn, first question on leverage, I wanted to come back to it. If I basically look at the impact that DTC had on your SG&A spend for 2011 and then think about 2012, I guess I'm surprised to see you growing SG&A pretty close to in line with revenue. Can we walk through some other components that are driving that? Or do you plan on spending more money on DTC than you were spending in 2011?

Glenn P. Muir

Yes, well there's a couple of good questions in there, David, One having to do with DTC, and maybe I could just start to answer the DTC one first. And our initial program for DTC was over a 15-month period to allocate approximately $20 million to that program. And we're about 12 months into that program. So we've already spent close to $15 million in DTC, and we are getting a return. And it has been a positive return but as Rob indicated, not anywhere were we had hoped it would be. But at the same time, we're still seeing some of the benefits from that awareness and do expect that to also present itself in FY '12 for the first half of the year. So we're still expecting to see a continued growth in NovaSure directly related to that DTC. Now will we continue to spend at this level in FY '12? No, we won't at all. I mean a lot of that awareness is out there today and we will maintain some of the expenses to keep it going. But it will be nowhere near the level that we spent in FY '11. So then the question is where's the leverage on the SG&A side if we're not spending on DTC? And a big part of that is being taken up by the new products, the 3 acquisitions and the expenses associated with those 3 acquisitions and growing their particular market or their particular territory. So we're kind of shifting resources from the DTC to new products that we believe will help grow the top line revenue. Our revenue guidance going into the year, as I've said, was about 6% to 7% for FY '12 over FY '11. But that is basically where our breakeven is. Our breakeven on leverage is about 6% revenue growth. But I think there's a lot of upside if we think about the 3 segments and the potential in those segments. Within Breast Health, we have the upside conceivable from tomosynthesis kicking in. In the GYN Surgical, it's MyoSure. And within Diagnostics, it's both Cervista HPV and it's the TCT efforts in China. So there's a lot of positives as we look forward into FY '12. But you're correct, we have to move that revenue needle up beyond 6% to get real leverage in the business. At which point, I think we'll get pretty significant leverage. But it's still early for the year and it is still -- our guidance, I think, does reflect that it's early in the year for us to make that revenue projection.

David R. Lewis - Morgan Stanley, Research Division

And Rob, just a quick follow-up here. Ever since our model Diagnostics seems to be driving more of the upside. But I actually had a question on surgical. Just considering the trends we saw with NovaSure this particular quarter, and you're still sort of guiding to upper-single digit surgical business, it does imply probably a bigger number for MyoSure than I guess we had in our model. Maybe just talk to us about your confidence that NovaSure can trough and rebound throughout the balance of the year and your confidence that MyoSure can make up the difference.

Robert A. Cascella

We obviously do think, I think highly of the MyoSure product and the potential for it, David. So there is a component of that growth that's being related to it. Obviously we express it as a business segment versus this product line. And we have to say, there's a growth element in Adiana, and there's a growth element in NovaSure. So between the 2 kind of legacy products, if you will, and the addition of MyoSure, that's really where the upper-single digit growth number came from.

Operator

We'll now go to Bill Quirk from Piper Jaffray.

William R. Quirk - Piper Jaffray Companies, Research Division

Two questions for me. First off, Rob, a little color on the OUS mammography business. You obviously talked at length about the U.S. side, but curious to see what the trends are there.

Robert A. Cascella

Sure. I'm going to have David Harding chat about that with you. David?

David P. Harding

We continue to see very good adoption of both our base Selenia business and our Dimensions business in a wide variety of places all across the world. We saw a pretty dramatic uptick in Europe despite all of the headwinds in the Southern European countries. We saw good growth in Asia. We saw good growth in Latin America and also in Australia and New Zealand, as well as in the Middle East and South Asia. So really across the entire world, we are seeing new countries come on board with Dimensions, both tomo and 2D, while we continue to penetrate I guess the lower end of the market with our Selenia units. So we're very, very excited about the growth there and saw a good strong double-digit growth in virtually every market across the world.

William R. Quirk - Piper Jaffray Companies, Research Division

Very good. And then just thinking a little about Cervista and now that we have another competitor on the market, we've had some accounts, I think, they've been waiting to see the fourth one enter. Now, our diligence suggests we could be seeing a number of different valuation protocols at this point. Rob, any comments here about how you think about this franchise going forward? Any changes to competitive positioning, et cetera?

Robert A. Cascella

Well sure. And as we've stated earlier, our strategy thus far has really been to segment the market and go after the low to middle tier. We think our product, our assay, is most appropriate for that segment of the market. I think with the approval, the pending approval in HDA, we do think that, that changes the game a bit, and we believe that we would be better positioned to go after a larger segment of the market as well. So I think where this is going to shake out is that there's not going to be one company that prevails in this battle for HPV, and it's going to be software companies buying for share and the upper tier of the market is going to get a bit crowded. And I think that the load at the mid-tier of the market may be a place that we can excel. And that's where we approve, and that our product is appropriately positioned. So we'll certainly continue to exercise that while we duke it out at the upper tier of the market with the other 2 entrees.

Operator

We'll now go to Nandita Koshal from Barclays Capital.

Nandita Koshal - Barclays Capital, Research Division

I guess my first question is could you talk about what proportion of tomo you have today are reimbursed in an amount over say a minimum $20? And you sort of gave us that range of $30 to $70 but what does the average look like?

Robert A. Cascella

The average is probably somewhere near your $40 to $50. And it's early on, so we want to be clear about that. But it's encouraging and what this does is establish a value to the tomo portion of the exam. And that's where this is going to be useful for when we do finalize a permanent reimbursement solution. So I want to caution that we don't believe this is a long-term solution. It is a way for our customers to have an interim solution that we then can also use to establish value when a permanent solution is derived.

Nandita Koshal - Barclays Capital, Research Division

Okay. That's very helpful. And Glenn, if you could help us with the margin outlook for the Breast Health segment next year, how does the service versus the instrument, versus the software upgrade piece play out? And what are the expectations baked in around that in your guidance right now?

Robert A. Cascella

Sure, I'll give you kind of a rough sketch and hopefully, this will make sense and it's one of the reasons why we've had detailed a bit more about service as well was that if you look at the business, what we see is that there's going to be some margin improvement that is going to be fueled by a higher quantity of tomo systems sold. So even the complete gantry, inclusive of tomo and not just the standalone software upgrade, we'll have attractive margins. That will drive the business relative to a gross margin improvement. Now partial offset maybe the -- as service revenues slow, there can be a negative impact on margins as a result of that. But overall, we think that the margins for Breast Health will be favorable for the year.

Glenn P. Muir

Let me also add to that, if I could. Rob is absolutely right on. Breast Health as we know, because of the capital equipment nature of that business, is our lowest gross margin segment. The Diagnostic and disposable units provide gross margins in excess of 60%. So the corporate average is 61%, 62%. So within Breast Health, where we currently are today, it's in the -- just over 51% with gross margins. And I think if we look in FY '12, we're looking for upside to that gross margin as revenues continue to increase in that segment, which really helps in our overhead and our allocation. And it's really being driven by the revenue increases we see from some of the higher gross margin products. And that would be the 3D tomo. And in the future, as these 2D Dimensions are being placed in the marketplace, if we get to the point where 3D becomes accepted as the standard of care, it will be at that point in time where we see the software upgrade to 3D tomo happen to what might be a side of installed base at that point in time. And once again, it's all about reimbursement and the clinical evidence. But at that point, we would get the software upgrade, and that software upgrade is a 95% plus gross margin component. So I think the outlook for FY '12 is very positive, I think directionally for that gross margin within Breast Health because of the expected revenue increase and the product mix moving to tomosynthesis.

Operator

We'll now go next to Rich Newitter from Leerink Swann.

Richard Newitter - Leerink Swann LLC, Research Division

Just 2 quick ones. One, since you're talking about the leverage being very much predicated on revenue growth acceleration perhaps relative to your initial forecast, can you help me understand some of the underlying baseline assumptions, for example, behind your GYN Surgical unit? What are you assuming in terms of any kind of market pickup? What more precisely are you thinking in terms of growth in NovaSure versus MyoSure and Adiana? And what's the baseline and what would constitute upside that could give us that leverage?

Robert A. Cascella

I think we're trying to stay a little bit away from the product line by product line, but I will say this that it may help is that as we look at obviously NovaSure and any of the other business in surgical, we are looking for some level of a recovery or at least stabilization in that market. And we are anticipating that. And there is some of that, that is reflected in our plan. In addition, we've added a significant number of salespeople to provide better coverage so that we can seize the opportunity going forward. So that the growth thought is one of a bit of a stabilization in the economy over the course of '12 that really gets complemented by a broader sales force that are a bigger footprint relative to our coverage.

Richard Newitter - Leerink Swann LLC, Research Division

So is it safe to characterize maybe even your overall sales assumptions as a stabilization in 2012 with any improvement really to provide upside to your preliminary projections?

Robert A. Cascella

I think we feel more about that impacting surgical than I would say the other businesses. I think that we see a stabilization in our domestic Diagnostics business, growth with HPV, stabilization with ThinPrep. I think the capital equipment business, as I said in my opening comments, is really a different animal and that is that it would be fueled by new technologies so the replacement cycles will lengthen them, unless fueled by something that's exciting. And we believe that tomo fuels the replacement of existing mammography equipment. So fortunately or unfortunately, there is no one answer for our 3 businesses because the 3 primary segments, because they are dramatically different. And it's really the surgical business that is most directly impacted by the sluggish economy today. And again, the reasons we gave in our opening comments and that is that it is, it is not a life-threatening procedure. It does carry a very high co-pay and a very high deductible. And as a result of that, it is much more susceptible to the economic woes than some of the other businesses are today.

Operator

Our next question comes from Isaac Ro with Goldman Sachs.

Isaac Ro - Goldman Sachs Group Inc., Research Division

Wanted to follow-up on that last question from Rich regarding your assumptions for the utilization trends on the surgical side next year. I mean if I look back qualitatively during earnings season, it does feel like sequentially the trends here across other companies have not materially improved. And for sure, some of the items in surgical this quarter regarding the acquisitions of MyoSure and so forth, it does feel like the trend there is reflective of that bigger picture. So I'm just wondering what leading indicators do you have that give us some confidence around your expectations for stabilization in surgical next year?

Robert A. Cascella

So I think what we tried to build into the plan, I think, is really it's a bit of a conservative approach but one that is also reflective of the fact that we've added 30 sales people. So we have a brand-new product, which has a lot of leg room for growth, and that is MyoSure. And in addition to that, we've come off of a low with NovaSure, now complemented by the trailing of DTC and another 30 sales heads. But we get much better coverage just as a result of those 2 elements. So when we look at it, certainly there's no way to predict with absolute certainty where the economy's going relative to unemployment or the like, but we also believe that we hedge that with better coverage and a better emphasis on converting the leads that we're now getting out of DTC versus just focusing on awareness.

Isaac Ro - Goldman Sachs Group Inc., Research Division

That's helpful. And then maybe secondly for Glenn on the use of balance sheet. You mentioned the preference is sort of steer clear of buybacks, could you maybe help put that in context? I mean obviously asset prices for med tech have come down over the last year. And so maybe in that setting, you can argue that valuations are more attractive for [indiscernible] candidates. I'm just wondering if that's the main reason why you're keeping it to having more dry powder? Or are -- you sort of have a stronger reason why you don't want to be buying back your stock at these levels?

Glenn P. Muir

No. I think there isn't -- it really has nothing to do with the desire to buy back the stock. I think we all would like to buy back the stock. But we only have limited cash flows as it is. And I think it's a healthy level. And at the moment, as we look forward into the year, I think there will be opportunities that can drive a greater return and provide us with additional revenue and earnings expansion. If we didn't see and didn't believe that the opportunities, I think we'd feel differently about it, but we think there are. If they don't materialize, I mean we're not in a rush and we're not going to do anything silly. If they don't materialize, we would like to deleverage a little bit. So the dollars on the balance sheet might simply be reallocated to lowering that debt level. And we're always looking at stock and considering a buyback. And in the future, we may in fact consider it. But I think at the moment, we're comfortable with where we are.

Operator

And we'll now go to Jonathan Block from SunTrust.

Jonathan Block - SunTrust Robinson Humphrey, Inc., Research Division

The first question, and my apologies if I missed it, but just the backlog number at the end of the quarter and how that compares to the previous quarter?

Glenn P. Muir

Yes. The backlog was $264 million at the end of the quarter. It was down $20 million or so from Q3. There is nothing special about that. Our backlog is no longer reflective of our business. It's a combination of capital equipment orders, which I would say is reflective of our business. But it gets masked by all these bulk orders and one-year commitments that we get on the Diagnostics side. And it's very hard to really peel away what's really going on. The way to look at it is backlog's fairly steady, and it's really no longer a good proxy for what's going on in the business. That's too much disposable Diagnostics stuff that's kind of in there.

Jonathan Block - SunTrust Robinson Humphrey, Inc., Research Division

Yes. I understood. I was just hoping to see if it was strong or down q-over-q. And then, Rob, for you, interesting comments on NovaSure. You've done a lot of work there. I just want to make sure I'm understanding this. The rough math, if I take a step back and I think you believe the direct consumer contributed an incremental $20 million to your U.S. NovaSure sales. So if I just exclude that amount and look at what your results would have been x the DTC, you believe the ablation business here in U.S. is down 10% plus in 2011?

Robert A. Cascella

Yes. I think what I stated was that that's our ablation business. As I indicated, it's really a combination of there's market erosion due to some of the economic factors that I gave. But I also believe that we lost share. I believe that we lost share when we introduced MyoSure, and we got distracted relative to training, having a brand-new product in the field. And that is one thing that we are working towards to recover. And then in addition to that, I think there were some non-GEA competition that we would categorize as delaying the uptake in sales. So the combination of those 3 factors, economy, GEA, competition and non-GEA competition led to really offsetting nearly all of the growth that we think we got out of our DTC program.

Operator

And we'll now go to Sara Michelmore from Brean Murray.

Sara Michelmore - Brean Murray, Carret & Co., LLC, Research Division

It does strike me that the kind of main swing factor here in the forecast is the trajectory of the digital mammography business. So I'm just wondering if you can talk through the visibility you have on that and kind of how you thought about building up your forecast, et cetera? Just anything that could give us kind of some sense of your confidence level in terms of how that is going to shake out. And if this is the best case scenario that could potentially be exceeded?

Robert A. Cascella

Yes, I think -- this is Rob. I think when we put together our plan, we went back and we looked very deeply and seriously at the numbers that we gave out earlier about that 500 to 700 unit forecast that we thought was pre-reimbursement and as I said last quarter and I would say it again, that we feel very good about that. And that was comprised of a subset of what we think are early adopters. And there maybe early adopters from a research perspective, or they maybe early adopters from an early commercial perspective, and the reason why they want the technology is to market the benefits of it. So between those 2 elements, we think that, that carries the product through this pre-reimbursement phase. Longer term, that is not going to happen obviously. We need a permanent reimbursement in order for there to be sustained growth in tomosynthesis, and we feel very confident that as we move into fiscal '13 that happens. So as far as our numbers for '12, we feel good about them or they would not have been in our plan at this point.

Sara Michelmore - Brean Murray, Carret & Co., LLC, Research Division

Okay. And then those types of customers that are really the commercially typed that you talked about, I mean can you give us just a little bit of color about what their plans are? What you've seen in terms of marketing? Are there any kind of regional areas that are hot, et cetera?

Robert A. Cascella

I think it really is not so much regionally as it is about the profile of the site. And there are some very commercially oriented sites that look at tomo as a way of marketing, a bit of the sizzle behind the technology relative to its FDA claims, relative to the significance with respect to improved results and outcomes and so on and so forth. So they, I wouldn't want to -- I don't think that it is geographically focused. I think it's much more about profiling the right kind of sites and these are typically multiunit sites that are quite frankly in the business of diagnostic imaging.

Sara Michelmore - Brean Murray, Carret & Co., LLC, Research Division

Okay. And then just one last quick one on ThinPrep, just a clarification. So it does sound like most of the growth was from TCT, although you said the volume growth was up 11% as well. So I'm just wondering what the kind of volume price dynamic was in the U.S. part of that business?

Robert A. Cascella

It's a great question, and I wanted to clarify that we already have the TCT volumes. So incrementally, the volume irrespective of TCT for ThinPrep is up 11%. We actually see other than things like further consolidation in the U.S. market, which has the tendency to bring pricing down because of larger labs buying smaller. There does not seem to be a tremendous amount of downward pressure on pricing here in the States. As we branch off into new more emerging markets in different parts of the world, pricing is lower. But that is -- the dilemma there is once you've walked away from the business, or do you garner the business, but at a lower gross margin at a lower EUP. We have opted to go after that business because something is better than nothing at that point.

Operator

And we have one time for one further question, and that question comes from Bill Bonello with RBC.

Bill Bonello - RBC Capital Markets, LLC, Research Division

Just one more follow-up on the Dimension. Can you give us a sense that the customers that have been ordering Dimensions, sort of how that's coinciding with sort of capital equipment purchasing calendars? In other words, are most of the people into a fiscal '12 calendar? Or is that something that could be a catalyst for additional purchases as we look forward?

Peter Soltani

Sure. This is Peter. I can answer that. Yes, the timing of the approval is certainly sort of mid-year and completely out of phase with the capital cycle. So yes, I think we will see a more planned approach to purchases going into FY '12 for the buyers.

Bill Bonello - RBC Capital Markets, LLC, Research Division

So is it safe to say that the people who have been getting systems thus far are essentially people who were scrounging around and still able to find dollars midyear?

Peter Soltani

I think to some degree, that's probably true.

Bill Bonello - RBC Capital Markets, LLC, Research Division

Okay. And then just one follow-up, which is in terms of the customers looking for more clinical data, customers that would want to wait for more clinical data before adapting, to what extent do you think the kind of data we're going to see at RSNA can be a catalyst on that front?

Peter Soltani

Well of course we don't control the content of what the investigators are going to present at RSNA. But certainly, just to read into the abstracts and based on what we at least we think we know of what they might present, the data that we're seeing, it looks very, very strong. Certainly anecdotally, we see great results from our commercial sites, clinical sites. So we feel pretty strongly that this will be a very important arsenic for those who are interested in getting that really strong clinical assessment as to whether or not some are always in fact for real.

Operator

Thank you. That is all the time we have for questions today. This now concludes Hologic's Fourth Quarter and Fiscal 2011 Earnings Call. Have a great evening.

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