SonoSite Q3 2007 Earnings Call Transcript

SonoSite Inc (SONO)

Q3 2007 Earnings Call

October 29, 2007 4:30 pm ET

Executives

Anne Bugge - VP of Corporate Affairs

Kevin Goodwin - President and CEO

Mike Schuh - CFO

Analysts

Alan Robinson - RBC

Charles Chon - Goldman Sachs

David Khtikian - JP Morgan

Robert Toomey - E.K. Riley Investments

Jason Wittes - Leerink Swann

Presentation

Operator

Good day, everyone, and welcome to the SonoSite Third Quarter Financial Results Conference Call. Today's call is being recorded. At this time for opening remarks and introductions, I would like to turn the conference over to Anne Bugge. Please go ahead Anne.

Anne Bugge

Thank you, Operator, and good afternoon. This is Anne Bugge, Vice President of Corporate Affairs for SonoSite. Before we begin, SonoSite issued its news release after the market closed today, October 29, 2007, regarding financial results for the third quarter and nine months ended September 30, 2007.

If you have not received a copy of the release please contact SonoSite Investor Relations at 425-951-1333 and a copy will be sent to you immediately. You can also access the release on our website at www.sonosite.com under the investor section.

A replay of the call will be available beginning at 4:30 PM Pacific Time today, and available through midnight, Pacific Time, November 12, 2007. The replay number for U.S. participants is 719-457-0820 or toll-free 888-203-1112. The access code is 482-6129. Additionally, this call is being broadcast over the Internet and can be accessed via the company's website at sonosite.com.

I would like to remind you that this conference call contains certain projections or forward-looking statements regarding future events or the future financial performance of the company. Except for historical information discussed in this conference call, the statements made today contain forward-looking statements that involve substantial risks and uncertainties. Actual results could differ materially because of factors listed in the management discussion and analysis section of the company's 2006 Form 10-K and in other filings and reports with the SEC. We do not undertake any duty to publicly update any forward-looking statements.

Now, I would like to turn the call over to Mr. Kevin Goodwin, President and Chief Executive Officer of SonoSite.

Kevin Goodwin

Thanks, Anne. Welcome everyone. I’ve got Mike Schuh, our CFO with me today. First of all, the third quarter showed improving execution on all of our major segments of the business, U.S. hospital and office channels as well as International. There is still a lot of work to be done, but we are very pleased by the evident progress that was made. For the second quarter in a row, revenue growth exceeded our own forecast. This particular quarter was also uniformly strong in each of the three seven months.

Revenue in the third quarter grew 24% to a total of $50 million. In total of the U.S. grew 21% over prior year. Direct hospital sales grew significantly over the prior year. While results in the office channel were down modestly on a year-over-year basis, our partner MarketBridge is improving with sequential growth of 25%. They are definitely making progress.

International put together another solid performance, and grew 28% over the prior year. The performance was broad-based across most of our markets, and we also announced the opening of a subsidiary in India, our 10th international subsidiary.

Gross margin was 69.4% compared to 71% a year ago. The decline reflected lower margin sales to distributors, as we expand our sales mix in emerging markets, and MicroMaxx was 71% of worldwide revenue in the quarter. Improved operating margin was actually masked by higher legal costs, as we move through the discovery process with our two patent litigation cases, Zonare and GE. Due to the higher legal expenses, G&A expense grew 58% on a year-over-year basis and 57% sequentially.

Excluding these patent litigation costs, G&A expenses, as a percent of revenue would have declined in the quarter. R&D expenses hit a peak in terms of dollars for the year and grew 30% as planned over the prior year’s third quarter and increased to 14% of revenue from last year’s 13%.

Now despite the increased product development and G&A expenses, we did leverage our sales and marketing expenses, which decreased as a percentage of revenue to 44% for the quarter, down from 50% a year ago. Overall, sales and marketing costs were held to 10% growth for the quarter.

Net income in the quarter came in at $1.5 million or $0.09 per share, primarily from the positive impact of other income. Cash and investments increased in the quarter to $309 million primarily as a result of the increased cash from the convertible debt offering.

We generated cash from operations of $2.2 million, the ninth consecutive quarter of positive operating cash flow. Netting it all out, we feel, we showed progress in our sales channels, managed our expenses well through some difficult challenges, and successfully launched several new products.

Now one of the most important accomplishments since the quarter ended was the launch of five new products in the month of October, which we think is an inflexion point for the company and the new market space that we lead. These new products the M-Turbo system and the S Series of four specialized products S-Fast, S-Nerve, S-ICU and announced just today the S-Cath have all been well received by the marketplace.

The M-Turbo is the most powerful and versatile system of its kind in the category today. The S-Series is the first suite of specialized products customized to meet the specific needs of the individual markets. Both product lines deploy Texas Instruments' DaVinci Technology, Windows CE and high performance DSP technology, which we see them force multiplying however a strong robust and proprietary [beam] point technology.

We've shown these products at three major point-of-care of meetings, the AmericanCollege of Emergency Physicians, American Society of Anesthesiology, and the American College of Chest Physicians. Leads from our focused markets were up 37% from prior year.

The image quality of a new platform is tracking a high level of interest. Additionally, other product attributes that we have shown, have been designed and these products remain the outstanding leaders, given what we been known for in the past.

This includes easily-to-use interface, sealed surfaces, and the same guarantee of reliability and durability and a five year warranty. We have shipped dental units out in the field and expect to begin the customer shipments of the M-Turbo and S product series in this quarter.

A few words on the outlook for the remainder of the year. We have increased our revenue guidance to the high end of our previous range. We now expect revenue growth of approximately 18% for 2007.

Our global sales team is continuing to make good progress, but we remain in transition with the U.S. office channel and with new products. We are very pleased at how things are unfolding, but think it's important to hold expectations in check as we move through this transition.

With a higher mix of U.S. revenue and the expiration of the royalty to our former parent company, we expect gross margins to increase in the fourth quarter and to come in at approximately 70% for the year, the lower end of our previously issued guidance.

We continue to expect operating expenses to be approximately 67% to 68% of revenue reflecting the higher litigation cost. We now expect other income to be higher, approximately $6 million reflecting the exchange gain recorded this quarter. We expect an annual tax rate of approximately 36% and diluted shares outstanding of $17.2 million, slightly less than we had guided previously.

Looking forward to 2008, we are targeting revenue growth of at least 15% gross margin of 70%, and improving leverage on operating expenses to achieve operating margins of 7% to 8%, which does include anticipated legal expenses for the two patent litigation cases that are pending.

With all that in mind, I am going to open the call now for questions, thank you.

Question-and-Answer session

Operator

(Operator Instructions). We'll hear first from Alan Robinson with RBC

Alan Robinson - RBC

Hi, very good afternoon everybody. Congratulations on the revenue number there.

Anne Bugge

Thank you.

Kevin Goodwin

Hello, Alan.

Alan Robinson - RBC

Just on the guidance first of all, Kevin. So, you are looking at the top end of your previous range now for the year for revenue increase, 18%. I guess. That kind of implies to me sub-14% growth for the fourth quarter of the year, which would be the lowest growth over the last seven quarters. Is there anything really going on there or is it more just a case of conservatism there?

Kevin Goodwin

That's what we’re estimating. Last year, we had a robust quarter in the fourth quarter coming out of a couple of less robust quarters. And I’d say that's where the estimate stands at now. We certainly have momentum but by no means would we over-forecast from here.

Alan Robinson - RBC

I guess the question is, are you scaling down your expectations for the fourth quarter to reflect just caution with regard to the new product launches?

Kevin Goodwin

Well certainly, Alan, when you launch five new products let alone one, and they are all really good, you have a process of having the market and the channels digest them. So, that is the concern, sure.

Mike Schuh

Alan, if I could add, if you look at last year, you also have a difficult comp with the International side, which had 41% growth in the fourth quarter last year. So, just keep that in mind.

Alan Robinson - RBC

Okay, fair enough. And then just finally with the new S series range that you've announced, it looks like you are moving away from the Swiss Army knife approach to develop more of an application-specific product lineup.

So how does this design approach impact the number of transducers you expect to sell with a typical unit? Will there be fewer per unit or more or the same, or how will that workout?

Kevin Goodwin

We actually expect rather the same number of transducers to be sold per system, but you did the nail on the head. The application-specific ultrasound, first of its kind in the world of ultrasound and medicine, a category that's now being, if you will, derive from the hand-carry ultrasound category, and we are very excited about at the probe it. The probe per unit estimate is really going to be a constant, in our view.

Alan Robinson - RBC

Okay, fair enough. I'd be amiss not to ask the question about acquisitions. Can you give us an update on the state of play there? Perhaps how many people you have working on your working on seeking out possible acquisitions and what’s going on there?

Kevin Goodwin

Well, we have Marcus Smith, who is our Vice President of Corporate Development, spearheading an effort to continue to look at a variety of opportunities and that’s about all I can say right now.

Alan Robinson - RBC

All right. I'll someone else take a turn. Thanks.

Operator

And next we'll hear from Charles Chon with Goldman Sachs.

Charles Chon - Goldman Sachs

Thank you. Can you guys hear me?

Mike Schuh

Yeah.

Kevin Goodwin

How are you Charles?

Charles Chon - Goldman Sachs

Awesome, great. Thanks.

Charles Chon - Goldman Sachs

So I would like to start out with just a couple of house keeping items. First of all, you told us how much the revenue mix was from MicroMaxx. Can you tell us what was for the sale of the TITAN system?

Kevin Goodwin

Let’s see here.

Mike Schuh

Yeah, the combination of the two is probably about 85%, Charles.

Charles Chon - Goldman Sachs

85%. Excellent. And just in general, this is obviously a substantial uptick in terms of the mix for both MicroMaxx and TITAN. Can you tell us what might be going on there? Was there a significant - was there some promotional activities around the two products?

Kevin Goodwin

No. I mean, MicroMaxx candidly has been doing very well all year and getting better as the year goes on. The MB upgrade, the SonoMB upgrade has been a real solid move for us. So, I would have to tell you, Charlie, that we are in better position vis-à-vis the SonoMB upgrade and MicroMaxx than we thought we would be the three quarters in. So, it’s all good news.

Charles Chon - Goldman Sachs

Great. And can you help us dissect the 21% growth in the U.S.? How strong exactly was the growth in the U.S. hospital channel? And then on the flip side, you spoke to modest year-over-year declines in the office channel. Can you kind of give us some more numbers to work with here?

Kevin Goodwin

Yeah, hospital was up north of 30% for the quarter, and office channel was down, Mike?

Mike Schuh

Just slightly less than 10.

Kevin Goodwin

Just under 10%. But important to know on the office channel side, as they move to a really independent process of generating demand and converting it to revenue, they did much better than last year’s third quarter, when you compare just what they did as an independent. So, there's two ways to look at that. Total office sector revenues, which, of course, were down just under 10%, and then just MarketBridge channel revenues, which were very impressively up.

Charles Chon - Goldman Sachs

Right. And as we….

Kevin Goodwin

Charlie almost a 100%.

Charles Chon - Goldman Sachs

Okay.

Kevin Goodwin

On independent basis.

Charles Chon - Goldman Sachs

I see. So, as we go into the fourth quarter, we should see a year-over-year increase on the office channel side of the business then? Would that be fair?

Mike Schuh

Yeah. We are hoping to see an increase in the fourth quarter, if not just level.

Charles Chon - Goldman Sachs

Okay, great. And finally, and apologize for if I missed this on the call, but did you speak to stock option expense picking up?

Kevin Goodwin

No, we didn’t mention that.

Charles Chon - Goldman Sachs

Okay. I just wanted to make sure. Okay, thank you very much. I'll hop off.

Kevin Goodwin

Thank you.

Operator

(Operator Instructions). We will hear next from David Khtikian with JP Morgan.

David Khtikian - JP Morgan

Hi, guys.

Kevin Goodwin

Hi, David.

Anne Bugge

Hi.

David Khtikian - JP Morgan

Great quarter.

Anne Bugge

Thank you.

David Khtikian - JP Morgan

I guess if we could maybe, how should we think about, when these new products rolling out, where MicroMaxx and TITAN and the other products are going to fit in, either as a percentage of sales or just more broadly 2008, 2009?

Kevin Goodwin

Well, that’s a great question. MicroMaxx is intended to go long in part of really a three-tiered product ladder with the M-Turbo at the top, multifunctional Swiss Army knife-like device. Down in the middle, your broad range of application-specific S products and down below that from a price-positioning standpoint.

MicroMaxx, however, we are not planning on lowering our price in the MicroMaxx, so the ladder if you will, from a pricing dimension is structured around above the MicroMaxx and then the TITAN and 180 are really heading towards the end of their lifecycle in the next 12 months.

And so what we envision is having quite a strong line-up. If you consider that MicroMaxx or SonoMB has got us this far, up 24% for this year, and in general building momentum, and then we carry forward here from Q4, we transition cut the new ones in, and that process will one fold, of course, beginning next years.

So that’s the way we are thinking about it, next 24 months, next eight quarters, we'll have that three-tiered product line-up of M-Turbo, S line and then MicroMaxx.

David Khtikian - JP Morgan

And then can you, are you able to talk about pricing at all? I mean, you say MicroMaxx is going to be the, you are saying that’s kind of the base price? Is that correct?

Kevin Goodwin

What we are not doing is we are not dropping the price on MicroMaxx.

David Khtikian - JP Morgan

Okay. And any S products are, you are saying incrementally more expensive?

Kevin Goodwin

The M-Turbo is incrementally more expensive and then the S product line is targeted to a particular segment and its price point varies from higher to lower depending on the situation than the MicroMaxx. But the margins are, the margin plan is neutral. So, we expect to be able to trade revenue and unit growth with margins hitting the target of 70%.

David Khtikian - JP Morgan

Okay. And then I guess here, one last question on the S products. How do we think about that with the physician office? Are these products going to be more geared toward those customers, are those customers going to be more apt to take on those products or are these going to be spread across hospitals and physician office market?

Kevin Goodwin

We believe once we get the strategy fully implemented, and that’s not going to happen in one quarter. But there is a broad range of clinical segments that should be right for this application-specific approach which I might add is the industry's first zero-footprint ultrasound. You basically you can wall mount this, desk mounted it like a PC monitor. It’s got a very similar design concept to the iMac G5, where the imaging engine is right behind the glass.

So, there is a lot of ways you can install this in the clinical practice segment by segment. So, we think it's got a wide angle potential, a range of price points, but it’s not going to be implemented in one quarter. And I would also say that the heavy R&D, our product development investment you've seen is slated to continue the delivery of more of these innovations such as the S line.

David Khtikian - JP Morgan

Okay. Thanks for taking the question. Yeah it's great. Thank you.

Operator

(Operator Instructions). We will hear next from Robert Toomey with E.K. Riley Investments.

Robert Toomey - E.K. Riley Investments

Hi, good afternoon.

Kevin Goodwin

Hello, Bob.

Anne Bugge,

Hi.

Robert Toomey - E.K. Riley Investments

Hi. A couple of follow-ups. There was very, very good information there. I just wanted to follow-up on that last question, Kevin, with respect to the Cart-based market and your ability to penetrate some of those applications.

Is anything changing there materially with this new three-tiered product lineup? In other words, can you just give us a little update on Cart-based and are you having more success in penetrating that market?

Kevin Goodwin

Well, I'd say our penetrations' constant, Bob and has we remain so.

Robert Toomey - E.K. Riley Investments

Okay.

Kevin Goodwin

Hasn’t been hurt, hasn’t really gone up that much as far as we can tell. Where we have increased our penetration in market share in our own point of view is in these new emerging markets, and this new product line is only going to help that, because it's been custom-designed based on nine years doing business with these people, for exactly what they need.

The greatest evidence Bob is 37% increase in sales leads. We had our single best trade show ever this fall in the nine years I've been around, and in general it's been a great October, very busy and very successful.

Robert Toomey - E.K. Riley Investments

Great. And then I had a clarification, Kevin, on MarketBridge. I think you said that there, I wasn’t clear, was their revenue up 25% sequentially or was the independent market and you said, you also mentioned independent market was up 100%. So, I’m not clear what the status is there with MarketBridge?

Kevin Goodwin

Yeah, on a sequential basis they are up 25% just apples-to-apples.

Robert Toomey - E.K. Riley Investments

Okay.

Kevin Goodwin

And then on a year-over-year basis if you look at the business they are originated and booked and compared it year-to-year, they doubled the business. Now going back to the previous statement of why the office sector was down just under 10%, we have to add in office business that may have been transitioned from our hospital channel to our office channel last year.

So on an apples-to-apples basis, MarketBridge was up 25% Q2 to Q3. And dollar originated book from them only as an independent channel were basically 100% up year-over-year.

Robert Toomey - E.K. Riley Investments

Great, so its sound like it's working well.

Kevin Goodwin

It’s improving. Nothing in the company’s work perfectly, but we are making progress.

Robert Toomey - E.K. Riley Investments

Good. And one last question I had on - you mentioned patent litigation. Can you just give us an update at all, Kevin, on for status where you are with those two litigations, and I know you can’t really talk about particulars, but if you just talk a little bit about the status of where those stand right now.

Kevin Goodwin

Yeah. We envision probably heading to trial next year on both cases. The trials are scheduled next year. And we are actively involved in discovery and all it goes with that. And there is no other opportunity to report anything just yet. There are always other outcomes that could happen, but at this stage the plan and the expense guidance includes go into two trials.

Robert Toomey - E.K. Riley Investments

Okay. And can you breakout what that expense was in the third quarter for litigation?

Kevin Goodwin

No, but it was expensive.

Robert Toomey - E.K. Riley Investments

Okay.

Kevin Goodwin

It's part of the G&A line. Mike, you want to comment on that?

Mike Schuh

Yeah, modestly, in terms of when you look at increases, you can assume that, just the majority of the increase would be attributed to the legal costs.

Kevin Goodwin

So, the actual increased dollars.

And the way to think about that is that we don’t see it as a long-term cost in our business. It’s a short-term cost. And we also believe that we can through the execution of our business plan on the offensive side, hopefully, potentially, outrun that unnecessary rise in cost by growing revenues aggressively with this new product line.

So, I wouldn’t factor one case or another going forward. Some highly negative case or some highly positive case in terms of our P&L. I can tell you the company is building revenue momentum with the new product line; we are going to have even more, and we are just going to bite the bullet on the spending, and go from there.

Robert Toomey - E.K. Riley Investments

Great, thank you.

Operator

And we have no further questions in the queue at this time. I would like to turn the conference back to our speakers’ for. I do apologize, we had some late arrivals. Our next question comes from Charles Chon, a follow-up from Charles Chon with Goldman Sachs.

Charles Chon - Goldman Sachs

Hi guys, thanks for the second question here. I was just curious, to the extent that you might be able to, can you speak to some of the competitive dynamics during the quarter? Was there any aggressive position by competitors ahead of SonoSite’s new product launches here?

Kevin Goodwin

None that we saw. There were a couple of efforts on the part of one competitor to announce a few things new. No real impact by that. So, no, I can’t say there were Charlie.

Charles Chon - Goldman Sachs

Great. Thank you very much.

Kevin Goodwin

Okay.

Operator

And we do have another question from Jason Wittes with Leerink Swann.

Jason Wittes - Leerink Swann

Thank you. (inaudible). So, first off , just a follow-up on the legal expenses. It's obviously, as you are saying, not going to be a long-term expense. But it sounds like you can assume for 2008 that expense should there? Is that a fair assumption looking into next year?

Kevin Goodwin

Yes, if we. If you look at the structure of our guidance for next year, it’s in there.

Jason Wittes - Leerink Swann

Okay. And also that I hear you say that gross margin for 2008 would be somewhere in the 70% range, because I thought you got a [percent] bump from a loss of royalty expense?

Kevin Goodwin

That’s right. And we’ve seen a decline in the last two quarters as a result of a rise in our emerging market mix, which is sold through distribution. So, we’re just trying to take a sort of steady position on that, and I’d suggest that you just accept the guidance at face value and leave it at that.

Jason Wittes - Leerink Swann

Okay. So, in other words you are expecting somewhat of an increase in emerging markets next year to offset any increase you get in, say the domestic market on pricing?

Kevin Goodwin

Yeah. It could happen that way. This is simplest way to say. Remember that those emerging markets come with very nice operating margins or net contribution margins, but you have a lower gross margins.

Jason Wittes - Leerink Swann

Okay. And in terms of I think, it was pointed out that next quarter, it looks like you are guiding to a pretty low number relative to the last several quarters. That is the 14% revenue growth number. It sounds awfully conservative given all these product launches, or is it because of these product launches they are just going to make it a little bit longer sale this quarter?

And I guess wrapped in with that, how should we be thinking about the launch of these new products in terms of their dimensional impact on the quarters? Is it going to take several quarters or is this a fourth quarter event?

Kevin Goodwin

Well remember that we always really guide you folks to think about annual numbers, and the ups and downs of quarterly growth rates sometimes could be skewed by factors, which we could go into ad nauseum. But the fact is that the quarter, we are launching five products in, you have to be careful. It does stretch out some buying, things could go wrong, so we’re just trying to be careful here. It’s very good news for the long-term.

Our outlook for next year is again an annual outlook, and I wouldn’t get too highly focused on every quarter’s growth rate. I’m certainly happy that we’ve had three quarters in a row with increasing growth rates. Those were nice pleasant surprises against the way we had forecasted. But at this stage I'd just accept it at face value, we'll move through it and see what happens, but we are certainly looking at things positively.

Jason Wittes - Leerink Swann

Are all the new products out and available at this point, and your sales force fully plugged away at selling them?

Kevin Goodwin

They have been launched. The demos are in the process of shipping or have already shipped depending on which one, and they will all ship for revenue this quarter. The process you follow in this business is you ship demo, field demo units globally first, and have to make their way out into the various distribution channels and shop in front of customers.

We have, of course, shown these devices in approximately six or seven tradeshows already. Three in October and some others that took place late in Q3, on a very quite basis, and we've gotten very good responses. But the physical display of the products is still works in process, a long from done.

And then we'll ship for revenue in the quarter, which means we'll have our final revenue release during the course of the quarter and then as the orders come in we'll convert that to revenue and go from there, get some installations and build on that next quarter.

Jason Wittes - Leerink Swann

Okay. And I guess okay. Okay, so that -- I know that I completely understand why you don’t want to guide towards quarter especially since there's such variability and it doesn't make sense for your business model. But it sounds like it would be optimist to assume you got a huge bump from all these new products. It sounds like its more 2008 event?

Kevin Goodwin

Yeah, I wouldn’t do that for this quarter probably. I would just let it run as it is. If we deliver that, that will be a surprise to us and you, but next year for sure we feel good about our prospects of delivering because of these products.

Jason Wittes - Leerink Swann

Okay. Thank you very much.

Operator

And we have no further questions in the queue. I would like to turn the conference back to our speakers for additional or closing remarks.

Kevin Goodwin

Okay. Well, in closing things are tracking well. The U.S. sales performance is steadily improving. International notched another excellent quarter. The U.S. office channel's improving, and we've just introduced the largest launch of new products in the ultrasound industry, and there is a lot of excitement about what these products offer. Still though, we do ask that you don’t get ahead of us. We are making steady solid progress. We will be in full swing -- we are in full swing for the most important quarter of our year, and we also think that 2008 is shaping up to be a very good year. So, thanks a lot everyone. And we’ll be in touch.

Operator

That does conclude today’s conference. We do thank you for your participation. Have a great day.

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