Mentor F2Q07 (Qtr End 9/30/07) Earnings Call Transcript

Mentor Corp. (MNT)

F2Q08 (Qtr End 09/30/07) Earnings Call

November 7, 2007 5:00 pm ET

Executives

Joe Newcomb - VP and General Counsel

Josh Levine - President and CEO

Loren McFarland - VP and CFO

Analysts

Tom Gunderson - Piper Jaffray

Greg Gilbert - Merrill Lynch

Alex Arrow - Lazard Capital Markets

Frank Pinkerton - Banc of America Securities

Jonathan Block - Suntrust Robinson Humphrey

Angela Waddell - CIBC World Markets

Jayson Bedford - Raymond James

Roy - Leerink Swann

Peter Bye - Jefferies & Company

Presentation

Operator

Good day and welcome to the Mentor Corporation Q2 Earnings Conference.

I would now like to turn our program over to Mr. Joe Newcomb, Vice President and General Counsel of Mentor Corporation. Go ahead, please.

Joe Newcomb

Thank you, Andrea. Good afternoon, everyone, and thank you for joining us today. With me are Josh Levine, President and Chief Executive Officer, and Loren McFarland, Vice President and Chief Financial Officer.

This conference call elaborates on a press release that was issued earlier today. If you have not already received the copy of our press release, please call Vicky Johnson at 805-879-6082 and she will fax or e-mail a copy to you. The press release may also be found on our website, www.mentorcorp.com.

As a reminder, Mentor has a fiscal year that ends March 31st and we make reference to any quarter or year today on the call, we will be referring to our fiscal year unless otherwise noted. During this call, we'll discuss our financial results for the second quarter ended September 30, 2007, which is our fiscal year 2008.

This conference call will include a discussion of non-GAAP financial measures as that term is defined in regulation G. The most directly comparable GAAP financial measures and information reconciling these non-GAAP financial measures to the company's financial results in accordance with GAAP have been provided with the press release and posted on the company's website.

Before we begin, I've been asked to read the following Safe Harbor statement pertaining to forward-looking statements, which we'll be making during the course of our conference call.

Today's conference call includes statements regarding Mentor's financial results for the second quarter of fiscal year 2008, guidance for full fiscal year 2008, the MemoryGel silicone gel-filled breast implants post approval study and several product development and clinical programs as well as other forward-looking statements within the meaning of the Federal Securities Law.

It should be clearly understood that these forward-looking statements and our assumptions about the factors that influence them are based on the limited information available to us at this date. Such information is subject to change and we undertake no obligation to revise or update publicly any forward-looking statements for any reason. Actual results may differ substantially from those anticipated.

Specific factors that may affect our business and future results are discussed in our SEC Forms 10-K, 10-Q, 8-K and other SEC filings. A partial list of these important risk factors is set forth at the end of today's press release.

Now I'd like to turn the call over to Josh Levine.

Josh Levine

Thanks, Joe. Good afternoon, everyone and thank you for joining us on the call. For the quarter ending September 30, 2007, we recorded strong sales and operating performance in what has historically been a seasonally slow quarter.

We finished the second quarter with $85.4 million in sales, an increase of 28% over sales of $66.9 million in the second quarter of 2007. Breast aesthetic sales were $75.1 million in the second quarter, an increase of 29% over the sales of $58.2 million in the second quarter of fiscal 2007.

US sales were favorably impacted by the increased market penetration of MemoryGel implants. Also contributing to sales growth was our successful domestic launch of the NeoForm product and strong global sales of tissue expanders, both of which are primarily used for breast reconstruction. We also experienced excellent revenue growth in our international markets.

In addition to strong organic international growth, our Perouse Plastie subsidiary contributed approximately $4.5 million of breast aesthetics revenue. Sales of liposuction equipment and disposables were $3.7 million for the second quarter, a decrease of 4% from the same period in the prior year.

As previously discussed, our decision to exit from a number of low margin product lines in our liposuction business has resulted in lower sales, however, we believe it has improved profitability for the body contouring business overall.

Sales of our other aesthetic products, which include our facial products for the second quarter, were $6.7 million, an increase of 37% over the same period prior year. During the quarter, we saw strong international sales growth in our dermal fillers and [another] line of skin care products that we sell domestically. Also included in the growth and other aesthetic products is $400,000 of non-breast implant related Perouse products.

I'll now turn the call over to Loren who can give you a more detailed review of our financial results.

Loren McFarland

Thanks, Josh. As required under generally accepted accounting principals, the operating results of our discontinued urology business are reported below net income from continuing operations. My comments today will only cover our continuing operation.

Starting first with sales: Net sales for the second fiscal quarter were $85.4 million, an increase of 28% from $66.9 million reported in the prior year, and included $1.2 million of positive foreign currency effect.

Sales from our new Perouse subsidiary for the quarter were approximately $4.9 million, primarily breast implants. Excluding the effect of currency and the Perouse acquisition, our organic sales growth rate from all products was 19%.

As we introduced on our last call, we are now providing a unit demand statistic for domestics market splits between gels and saline breast implants. For the second quarter, in the US market, over 42% of the average unit demand was MemoryGel products, whereas the remaining 58% of the average unit demand was saline implants.

We expect that this will generally increase for the remainder of the year, and that MemoryGel demand will approach half of all domestic breast implant unit volume by the end of the fourth quarter of our fiscal year 2008.

We are reiterating our full year guidance of sales to be in the range of $370 million to $385 million. Gross margin for the second quarter of fiscal year 2008 was 70.2% compared to 72.3% for the comparable period in fiscal year 2007.

Cost of sales for the second quarter of fiscal year 2008 included $1.4 million of cost related to the sale of inventory valued at fair value, as a result of the purchase accounting treatment under FAS 141 business combinations in our Perouse acquisition.

These fair value cost go to the cost of sales line of the income statement with the sale of the acquired inventory, the first inventory turn and then cost of sales were normalized. We expect this adjustment will add $1 million more to cost of sales in the third quarter.

On a non-GAAP basis, excluding these extra costs, gross margin was 71.8%. The gross margin was also affected by lower gross margin from Perouse sales and non-cash amortization expense partially offset by the benefit of higher sales in MemoryGel breast implants, favorable manufacturing variances and lower warranty costs.

As a reminder, our September quarter is our seasonally weakest quarter and we are maintaining our guidance at gross profit margin for the full year will be in the range of 73% to 75% of sales.

SG&A expense in the second quarter of fiscal year 2008 was $33.4 million, or 39.1% of sales, compared to $28.7 million, or 42.9% of sales in the second quarter of fiscal year 2007.

SG&A expense in the second quarter of fiscal 2008 included approximately $2.6 million of compensation expense associated with the company's long-term equity compensation program and approximately $700,000 of integration expenses related to the integration of Perouse Plastie.

We expect SG&A expense to be in the range of 39% to 41% of sales in FY 2008. This will include equity compensation expense in the range of $13 million to $14 million.

Research and development expenses in the second quarter of fiscal 2008 were $12.2 million, an increase of 36% over the $9 million reported in the second quarter of fiscal year 2007.

For the quarter, our investment in R&D supported our botulinum toxin clinical development program, a hyaluronic acid dermal filler development program, the MemoryGel post-approval conditions and the ongoing FDA review of the Contra Profile Gel breast implant, PMA.

Of the second quarter R&D expenses, approximately $2 million were related to the MemoryGel post-approval condition. As far as guidance for R&D, we now expect a cost of the MemoryGel post-approval condition to be approximately $9 million in fiscal year 2008 and we expect total R&D expenses to be in the range of $12 million to $14 million in fiscal year 2008.

Operating income in the second quarter was $14.3 million, an increase of 34% over the $10.7 million reported in the second quarter of the prior year. We estimate operating income for the full year 2008 will be approximately 20% of sales on a GAAP basis.

This includes a full year charge for equity compensation expense under FAS 123R, the results of Perouse Plastie for the remainder of the year and the additional cost of sales as a result of charging the acquired Perouse inventory through cost of sales at fair value and our substantially increased investment in R&D.

Interest expense net of interest income in the second quarter was an expense of $100,000 as interest income has decreased significantly as a result of lower cash balances due to our share repurchase program.

Moving onto taxes: The effective tax rate for the continuing operations in the second quarter of fiscal year 2008 was 26% compared to 32.7% in the second quarter of fiscal year 2007. The effective rate in the second quarter of prior year was unusually high as the Federal Government had not yet approved the extension of the tax credit for research and development activities. These credits have since been re-enacted and decreased the rate.

Year-to-date, our effective tax rate is 28.7% compared to a full year rate in fiscal 2007 of 29.9%. We are maintaining our guidance for the effective tax rate for the full fiscal year 2008 of approximately 30% of pretax income. Excluding the results of discontinued operations, we reported diluted earnings per share from continuing operations of $0.27 in the second quarter of fiscal year 2008 compared to $0.24 per share in the second quarter of fiscal year 2007, an increase of 13%.

Including the diluted GAAP EPS from continuing operations for the second quarter of fiscal year 2008 were net of tax effect approximately $0.02 per share of cost recorded in the cost of sales related to the sale of inventory recorded at fair value under the provision to FAS 141 "Business Combinations" related to company's acquisition of Perouse Plastie.

Included in the diluted GAAP earnings per share from continuing operations, the second quarter of the prior year were, net of tax effect, approximately $0.02 per share of costs related to the company's business rationalization initiative.

Excluding these charges, diluted non-GAAP earnings per share from continuing operations were $0.29 per share in the second quarter of fiscal year 2008, an increase of 12% over the $0.26 per share diluted non-GAAP earnings per share from continuing operations reported for the second quarter of fiscal year 2007.

We expect diluted GAAP earnings per share from continuing operation for the full fiscal year 2008 to be in the range of $1.40 to $1.45 per share. This guidance include the full year charge for equity compensation expense under FAS 123R, the result of Perouse Plastie for the remainder of the year, and the additional cost of sales as a result of charging the results of acquired Perouse inventory through cost of sales at fair value.

And a substantial increased investment in R&D, as well as, a lower number of shares outstanding as a result of our share repurchase program. As previously discussed in our last conference call, since April 1, we have retired 8.7 million shares at an average price of approximately $41 per share for total of approximately $358 million.

These repurchases represent 20% of our diluted outstanding shares as of March 31, 2007. No, additional shares have been repurchased since our first quarter call. As a result of the shares repurchased and retired in this program, we expect the number of shares outstanding for the diluted earnings per share calculation purposes to decrease to approximately 40 million shares for the third and fourth quarters and approximately 42 million shares for the full year.

I will finish up with the comment on our cash position and cash flow and then turn the call back over to Josh. We reported cash and marketable securities to $102 million as of September 30, a substantial decrease from our March 31st balance of $488 million, primarily as a result of our share repurchase program.

In the first half of the fiscal year we repurchased 8.7 million shares approximately $358 million and also funded the cash portion of our acquisition of Perouse Plastie for approximately $53 million and paid dividends of $16 million. For the second quarter, our operating cash flow from continuing operations was approximately $20 million.

Depreciation and amortization expense were approximately $3.7 million and our capital spending on PP&E was $4 million. For the full year, we expect depreciation and amortization for fiscal year 2008 to be in the range of $12 to $14 million.

Investment and capital spending in FY 2008 includes an expansion of our botulinum toxin facility to provide with the eventual vertical integration of certain processes currently being outsourced and the anticipated milestone payments to Genzyme as we progress with our HA dermal filler program.

For those of you modeling cash flows, you should include accurate capital spending for FY 2008 in the range of $20 million to $25 million. Josh?

Josh Levine

Thanks, Loren. Starting first with our HA dermal fillers, all of which are formulated with Lidocaine for patient comfort, we are pleased to announce that during the quarter our PMA for Puragen Plus was accepted for filing by the FDA and we expect approval in mid-fiscal year 2009.

This represents a modest delay from earlier forecasts and is being driven primarily by the timing of the FD audit of the manufacturing facility as part of the PMA review process. For Prevelle Plus we anticipate FDA approval in late fiscal year 2008. We continue to make progress in our development of dermal gel extra and during the quarter, we completed patient enrollment in that clinical trial.

We expect to complete the follow up for this study in mid-2009 and project the product will be available internationally sometime during fiscal 2009 and domestically in fiscal 2010. On the implant side we completed our PMA for our Contour Profile gel anatomical breast implant in September of last year and the FDA has accepted that filing. We are working actively with the agency to provide additional requested data.

On our botulinum toxin development efforts the results in botulinum toxin Phase II clinical study were very encouraging. All of the study endpoints were met. While we will not be communicating dosing specifics we can confirm that a dose dependent response rate was observed with a positive correlation between dose levels and overall response rates.

For competitive reasons, we will not be more specific regarding the speed of onset, although, we were pleased with what was observed in terms of timing.

In summary, botulinum toxin was well tolerated. There were no apparent dose dependent differences in terms of adverse events identified and we met all safety and efficacy endpoints. We are confident that we have a solid drug candidate to take through the next steps of the regulatory process.

During the quarter, we completed patient enrollment and treatment ahead of schedule in the initial Phase IIIa of our pivotal trial. As a reminder, Phase IIIa is a single dose approach randomized the placebo and is focused on safety and efficacy for the cosmetic treatment of rhytides.

The endpoints for this Phase include assessment of frown line reduction, subject satisfaction and speed of onset of effect. Early feedback is positive and we are on target to complete the six-month follow-up by mid-March. There were two additional pivotal phases, Phase IIIb and IIIc.

During the quarter, we received special protocol assessment approval for our Phase IIIb study. We began start-up activities and we can expect to begin enrollment by calendar year end. Phase IIIb is “a repeat dosing trial ‘randomizing’ the placebo”, with a 13 month follow up. For Phase IIIc we have begun study start up activities for this open label repeat dosing safety trial and anticipate patient enrollment to begin by calendar year end.

Follow-up on this study is three years and the study can run concurrently with Phase IIIa and IIIb. In addition, we are making significant progress in our Phase I multi-center, dose escalation study of our Botulinum Toxin for the treatment of pain from torticollis/cervical dystonia. Multiple cohorts of patients have been treated and follow-up is ongoing.

The study is on target for completion by the end of the fiscal year and we are pleased with the efficacy we are seeing thus far. Before I wrap up our prepared remarks, I want to update you on the progress of our MemoryGel post approval study. We submitted our third interim report to the FDA on-time, and we anticipate a timely submission of our fourth interim report by November 16th.

As of November 6th, we have enrolled approximately 21,000 patients towards the total target of 42,900 patients. And now, we're ready to take your questions.

Question-and-Answer Session

Operator

(Operator Instructions). Thank you. We'll go ahead and take our first question from Tom Gunderson of Piper Jaffray. Go ahead, please.

Tom Gunderson - Piper Jaffray

Hi, good afternoon.

Josh Levine

Hi, Tom.

Tom Gunderson - Piper Jaffray

Two quick questions: One is summer season has got that slower seasonality to it, but then you did well on the revenue site. Did you see any change, unusual change, in the unit sales during the fiscal second quarter? And then the other question I have is sort of the broad one: I'm sure you've been talking to your docs, and others, about any change in consumer demand. Could you comment and give a little color on that, Josh?

Josh Levine

Yeah, great. So, the answer is that, during the last month of the quarter, we did start to see the beginning of some softening in demand and the channel research that we did and the studies that we conducted say that some plastic surgeons were starting to see some drop off in patient consultations, which Tom, as you know is usually a little bit of a precursor to lighter surgical calendars maybe 45 or 60 days out. And some of this feedback was reinforced with additional feedback that we received at the ASPS show in Baltimore in a broader universe of docs.

For the quarter, we projected that procedure or unit volume was growing in about the mid-single-digit range, but based on some of the data points that I just spoke to, we are closely monitoring the demand situation going forward. I've been asked a lot about the impact in terms of spillover on the economy and consumer demand and it was clear that towards the latter part of the quarter, we were starting to see a little bit of a slow down. Again, I can't predict what that means in terms of longer term at this point. It's just something we're going to have to monitor and stay close to.

Tom Gunderson - Piper Jaffray

Josh, you probably, we all want to take one fact, and one assumption, and put it together, but can you give us a sense of how many times in the past you've seen those one-month slowdowns and they didn't portend anything for the future?

Josh Levine

Yeah. It's a good question and I've answered this question a lot over the course of the last, probably four to six weeks, given the economic, the broader economic trends. I have personally, in the last 11 years, had two experiences with what I'll call: “broader economic trends” or “macro trends” that have impacted the basic demand of the business.

The first was associated with the .com meltdown in 2000 and the second was really associated with post-9/11 environment. And in both of those cases, as the market, as the economy, started to slow and consumer confidence was impacted, there's no question that the intrinsic demand for our products and our procedures was impacted.

The interesting thing about both of those cases was that the impact wasn't a lengthy impact. I mean there were a couple quarters in both of those situations, at the outside, and then within three quarters, or so, after we started to see the demand return to historic levels.

And when you start talking to the physicians in both of those cases, and getting whatever kind of empirical feedback you could get, one of the things that you found was that patients were just, from a psychological standpoint, the purchasing psychology around going forward with our procedure, or cosmetic breast surgery, was really a different type of an impact than other large consumer purchase type of decisions.

Patients were considering and looking at this as: “an investment in themselves” and, as an investment, they were still willing to go forward with over time. So, again, probably a little bit different psychological profile of your patient than of your typical consumer product type of a purchase.

But, I guess in summary, what I would say is that if we are going to have a real problem in the broader economy, the likelihood is that we are not going to escape that. We will see some impact from it, but I don't project it will be a long range, long term kind of a hit to the demand.

Tom Gunderson - Piper Jaffray

Okay and then just one quick last one for Loren. I'm assuming, Loren, there were no sales for Perouse in Q1? Is that correct?

Loren McFarland

That's an easy one, that's correct.

Tom Gunderson - Piper Jaffray

Okay, thanks.

Operator

Thank you. We'll go to our next question from Greg Gilbert of Merrill Lynch. Go ahead, please.

Greg Gilbert - Merrill Lynch

Thanks. Good afternoon, guys.

Loren McFarland

Hi, Greg.

Josh Levine

Hi, Greg.

Greg Gilbert - Merrill Lynch

Just following on your comments about the economic situation: are you speaking mostly to the demand overall or do you think there's something to be said about the choice of saline versus silicone within that?

Josh Levine

I guess I'm referring to demand overall. I mean the truth is that while there is a difference in price point in the products and therefore, when you look at the quotes that are being made to patients from a total procedure fee, the choice between saline and gel, I mean our research Greg shows that from a price gap standpoint, there's a fair amount of resiliency there in terms of the difference in price point. I was referring to really kind of intrinsic demand overall.

Greg Gilbert - Merrill Lynch

That's what I thought. And your convergent rate up to the 40s seems to be in line with what you were expecting anyway, right?

Josh Levine

It is.

Greg Gilbert - Merrill Lynch

Loren, any other negative factors in gross margin, other than amortization and mix from Perouse? Smaller things that you didn't mention?

Loren McFarland

We did mention the amortization, it was just to be recognized that at our slow quarter. So, there's some fixed cost impact on just the slower base of business.

Greg Gilbert - Merrill Lynch

Right.

Loren McFarland

And then, we talked about the non-cash amortization expenses, which until we get ramped up particularly on the HA business, it'll have a little larger effect on the gross margin.

Greg Gilbert - Merrill Lynch

So, there was nothing unexpectedly negative in gross margin for you?

Loren McFarland

No.

Greg Gilbert - Merrill Lynch

Okay. And lastly, Josh, on business development: how would you characterize both your appetite at this point, as well as the environment? Thanks.

Josh Levine

Appetite is there. It hasn't changed. Again, we are looking for and have been looking for opportunities that are strategic opportunities for enhancing our core business strengths or core business positioning. So, I'd say that the appetite hasn't changed over time. As far as what the environment is like, I think that it's consistent with what we've seen over the last several years. The valuations in the marketplace for things especially on the facial aesthetic side are still fairly robust maybe more robust quite frankly than they deserve to be in some sense.

But I mean our view is that, if there were an opportunity to come down the pipe that made sense for us, we'd be interested in considering it.

Greg Gilbert - Merrill Lynch

Thank you.

Operator

Thank you. We'll go to our next question from Alex Arrow of Lazard Capital Markets. Go ahead, please.

Alex Arrow - Lazard Capital Markets

Hi, good afternoon, Josh.

Josh Levine

Hi, Alex.

Alex Arrow - Lazard Capital Markets

The new policy for the post-approval study, in which you've allowed it to be voluntary, can you describe what benefit you are perceiving and perhaps if you could quantify in market share gains or how is that affecting your competitiveness versus [reselling] it?

Josh Levine

It's an interesting question. I think I'm going to answer your question, but I think I'm going to take this opportunity probably, to give you or give everyone a little bit broader sense about the PAS discussion or the post-approval study discussion in general.

Just to clarify the question, we went back to the FDA after we had launched the post-approval study with mandatory patient enrollment requirements and physician enrollment requirements based on input from IRBs, and the IRBs were giving the agency the same feedback that there were concerns on their end about mandating patient enrollment for a FDA-approved device.

So, just to clarify that, had we known that this was going to be a sticking point before we locked down the protocol, we certainly would have addressed that upfront. So, a change wouldn't have been necessary. But I think that, at the end of the day, the adjustment that we made and the agency agreed to was the right one based on what patients and what patient safety advocates were asking about.

In terms of competitive advantage or market share gains, I mean, I think in general, this topic about the post-approval study requirements hasn't gotten the kind of visibility and the discussion level that it really deserves. And I guess the 21,000 patients as of yesterday that we have enrolled, puts us about halfway to that total patient commitment.

And I think that the progress we've made there, Alex, truthfully is a direct result of the philosophy and the effort that we've applied to this thing from the very beginning. We've been consistent in our comments, both internally with our own people as well as externally with physicians and the investment community, that patient enrollment in the PAS is one of the most important initiatives our company has on its plate, and we've been really consistent about that.

We set our goals to get patients enrolled as quickly as possible and that we wanted to do that with a minimum of burden on patients and surgeons, and I think we are executing on that.

Alex Arrow - Lazard Capital Markets

Well, but presumably, it must have slowed down a little bit since if you're relaxing the requirement? There must be some surgeons who are opting out, even if it's only a few of them, right?

Josh Levine

I can tell you that, in all honesty, we have not seen any major shifts in ongoing enrollment rate on average over the course since we launched the study. And I think the fact that we're now a halfway to the commitment speaks to that. The FDA told us that their expectation was that they wanted completion of enrollment within two years of approval. And we took that input really seriously. And as a result, we put very high expectations on our salespeople and our clinical studies personnel to get this done and we're executing against that goal.

Alex Arrow - Lazard Capital Markets

Okay. Thank you. If I could ask about the stats you gave on gel versus saline: does that apply to the US cosmetic market or does that include the reconstructive part of the US market?

Loren McFarland

That's the entire US market, reconstructive and augmentation.

Alex Arrow - Lazard Capital Markets

Okay, thank you. And then finally your comments on liposuction being light: can you say, does that have anything to do with the smart lipo devices competition or is that independent?

Josh Levine

It's independent, I mean again, the smart lipo device, and some of these “less invasive” technologies, have certainly been out in the last several quarters and I think patients are, and physicians are, taking a look at these things.

The practical reality is this: For your typical patient in a typical multi-site lipo procedure that gets done, the amount of that post-tissue that gets removed is dramatically more than what can be done with the technologies like the ones that you're talking about: these “less invasive” technologies.

So, while there may be patients trying those new technologies, if they want lasting results, many of them end up coming back for traditional lipo procedures, which is really the only sure fire way to provide a guarantee that the amount of tissue that needs to be removed can be extracted, because it's a fool proof mechanical extraction. So, while there may be some impact from some of these new technologies, I think these patients will come back; at least that's what we are hearing from the docs that are seeing the patients.

Alex Arrow - Lazard Capital Markets

Okay. Thanks, Josh.

Operator

Thank you. We'll go ahead to our next question from Frank Pinkerton of Banc of America Securities. Go ahead, please.

Frank Pinkerton - Banc of America Securities

Hi, good evening. Thanks for taking the question. I'll throw one out to start off with here: You didn't give much data on your botulinum toxin product. Can you give any specifics regarding: “compared” or maybe: “between” what we know about either Reloxin or Botox that are already out there? So, as you look at these Phase II studies: how it stacks up with those two products?

Josh Levine

Well, you're right. We didn't give any specific dosing data but the fact that all safety and efficacy endpoints were met in our Phase II study I think was a positive. I think one of the product attributes that was worthy of mention was a relatively rapid onset of action that we saw in Phase II and we are very strongly expecting to confirm that observation, Frank, in Phase IIIb and IIIc of the trial. So, I would say, that's one data point or one area in terms of potential product attribute that may be differentiated.

Frank Pinkerton - Banc of America Securities

Okay and then can I ask, Loren, two questions for you? First of all: the Perouse acquisition was that basically for the entire quarter, did that close for about the beginning of July?

Loren McFarland

It did. It closed on July 2nd.

Frank Pinkerton - Banc of America Securities

Okay. So, even though it's probably a seasonal edition that's kind of the -- if we think of seasonally that's kind of the full contribution it would have put to the quarter for what you guys talked about, correct?

Loren McFarland

Right, that $4.9 million is indicative of a full quarter of sales.

Frank Pinkerton - Banc of America Securities

Okay. And then lastly, you are kind of reserved for product warranties that have been in a range somewhere between $12 million and about $14.5 million, $15 million, but it looks like it's moving towards the bottom part of the range there. Are you seeing anything different with the assumptions you need to make regarding now that you're doing the larger percentage of silicone or is this just natural fluctuation on the balance sheet or on the recording of the accounting for the warranties? Thank you.

Loren McFarland

Yeah. A couple of things, in general, are helping the product warranty reserves: one is that the shift to gel is a favorable shift. The gel products perform better than the saline products over the long run. And then secondly: our improved quality has allowed a lower rate of claim from our customers for product problems. And so, both of those where these are claim rates, our historic claim rates to predict our future ones have been beneficial.

Frank Pinkerton - Banc of America Securities

Okay. Thank you.

Operator

Thank you. We'll go to our next question from Jonathan Block of Suntrust Robinson Humphrey. Go ahead please.

Jonathan Block - Suntrust Robinson Humphrey

Well, hey, guys, good afternoon.

Loren McFarland

Hi, Jon.

Josh Levine

Hi, Jon.

Jonathan Block - Suntrust Robinson Humphrey

Just first one: on the post-approval study expense, I think, Loren, you said $9 million for the year. And just taking the figure of around $21,000, $22,000, it seemed that you guys are tracking to a complete enrollment maybe early to middle of fiscal year '09. So, can you give us a feel for where this expense, where the expense run rate, what that might look like upon completing enrollment?

Loren McFarland

Well, we're not giving any guidance for fiscal year '09 yet. So, I think I will decline trying to kind of predict where that'll be next year. But when we first started the post-approval study in all the conditions, we said $30 million to $45 million over 10 years. And so, we had $3 million last year, fiscal year 2007, we have $9 million this year. So, you can kind of reverse engineer that $15 million out of the range, so $15 million to $30 million remaining over the remaining eight years.

Jonathan Block - Suntrust Robinson Humphrey

Okay. Great.

Loren McFarland

Talking too many numbers.

Jonathan Block - Suntrust Robinson Humphrey

No, that's helpful. And then, just in terms of the competitive landscape, if I normalize for the Perouse acquisition, I have you guys losing, maybe about 100 basis points, in terms of market share between you guys and Allergan.

So, is this maybe the normal swing of the pendulum if you would or are you seeing maybe a little bit more of an impact from Allergan's DTC program?

Josh Levine

Jon, I'll take that one. I think it's a multi-part answer. We clearly, again excluding the Perouse acquisition, your number is accurate in terms of the share hit that we took. I'd say that was primarily domestically. During the quarter, I will tell you that we saw some, what I'll call, targeted competitive activity focused on our largest domestic accounts, an activity for whatever it was worth it was primarily focused on price discounting.

I wouldn't characterize that as an across the board kind of national situation, but really more selectively targeted at specific accounts of ours. At the end of the day, it had little impact on our ASPs, because we didn't respond to any of those situations with price matching. But as a consequence, we did give up some volume.

And we take the share, a share discussion and a competitive positioning conversations very seriously and people that follow the company and our business for a long time know that while we said very clearly we've great respect for Allergan. In our core business, we're not going to take a back seat to anyone and in my mind nothing has changed in that regard. So, I'm not in a state of panic over the quarter. I don't think that people should read a lot into the share shifts on a short-term basis. The real story is what happens from a relative share position over time.

On the DTC discussion, it's difficult to say whether the DTC campaign is actually getting traction or not. I'll tell you what it is doing. The fact that Allergan is making -- the kind of investment that they're making allows them to go to plastic surgeons and say that they're doing the kind of things that help to grow their practices and that's probably getting some leverage.

But it is more difficult to quantify: if what they spend promotionally is actually getting any traction? I see a couple of disconnects quite frankly that are worth, I guess, pointing out if nothing else between the DTC activity that they're talking about and other things. If their DTC campaign was really driving patients, one question I have would be: why would there be a need from a tactical standpoint to cut prices where they are in some of the larger accounts that I mentioned? So, that was one point.

And, I guess, the second I would say is a disconnect for me is, if you look at the DTC effort and the patient enrollment levels with their post-approval study, I would have thought that there would have been more positive correlation between the two. In other words: if they were really driving a significant number of patients, some of those patients would have spilled over into patient enrollment activity into their dip study, and I don't think that's happening.

So, the whole discussion about DTC, and that it's getting traction, is interesting. Just as a point of reference: we have some personal experience with DTC advertising on our own. We ran the first consumer direct response marketing campaign in the cosmetic breast surgical back in 2000. We ran another one again in 2003. And what we learned from those experiences is that in terms of its impact on surgical procedures, DTC investments draw patients into the marketplace to find out more about the procedure and even to consider a surgical consultation with a plastic surgeon of their choice.

But what it wasn't very effective at was: “driving brand preference”. It's not the same type of model as a topical skin or injectable facial procedure. And when you start talking about physician mindset on these things the aesthetic outcomes that are at stake along with the doctor's reputation and even legal liability, if a patient aesthetic outcome expectation isn't met is something that the doctor thinks about quite a bit.

So, as a result, most of the plastic surgeons that I know won't relinquish responsibility for product selection in the patient in those situations. So, in my mind, while DTC may be a very cost-effective means to drive demand and brand preference on the facial product side, I think, from personal experience, it's a lot less effective in the surgical aesthetic segment.

Jonathan Block - Suntrust Robinson Humphrey

Okay, great. Thanks for the color, guys.

Operator

We'll go to our next question from Amit Hazan of CIBC. Go ahead, please.

Angela Waddell - CIBC World Markets

Hi, this is actually Angela [Waddell] speaking on Amit's behalf tonight. I just have a quick question, actually to follow up on the market share. What about the long term? How can we be confident that the share loss is not going to continue? And do you assume any US market share decline in your FY '08 guidance?

Josh Levine

Yeah. I mean all of what we've communicated vis-à-vis guidance, [Andrea], has been baked in. All of those elements have been baked into the calculations. So, the guidance that you've got encompasses all of that.

As far as the longer term look again, I'm going to go back to what I said before which is we, I'm not panicked about the quarter. I don't think that there is a lot to read into share shifts of 100 basis points on a quarter, a short-term basis. I think the real discussion is, let's see where we are three or four quarters from now and what the momentum in the business is in the market overall.

Again, I think that the advertising and the DTC investment that's being made may be having a positive impact in terms of drawing patients into the market to find out more about the procedure. But I don't necessarily think that, as a brand preference driver, that again, from our experience, that it has all the impact that you'd hope it would. So I guess, I just have to say: “stay tuned”.

Angela Waddell - CIBC World Markets

Okay. And, also, do you have any marketing plans yet for the facial filler products in terms of building a stern sales force?

Josh Levine

Yeah. We spent a lot of time on the “go-to-market” strategy on the derm side and I can tell you that given the timing of the launch of our Prevelle Plus product, we're in the final stages of a thought process around that. I think, that you will undoubtedly see, probably towards the first quarter next fiscal year, a ramp up, the start of a ramp up in infrastructure build for that. But past that, I don't think, at this point, I want to get too specific as to expense ratios or what our specific plans are.

Angela Waddell - CIBC World Markets

Okay. Great. Thanks. And also do you have any updates on the progress on your CPG and have you received sufficiency letter?

Josh Levine

Yeah. Our CPG filing is still active. We're still in active conversations with the agency. During the quarter, we did receive a request for additional information and clarification on certain parts of our submission. But I would say or characterize those as pretty routine in terms of the nature of the questions.

Angela Waddell - CIBC World Markets

Okay. Great. Thank you very much.

Operator

Thank you. We'll go to our next question from Jayson Bedford of Raymond James. Go ahead, please.

Jayson Bedford - Raymond James

Hi, good evening, guys, just a couple questions. First: you just talked about the kind of the procedural slow down and drop off in September. Is it fair to say that you haven't seen a snap back in October or at least the first week in November?

Josh Levine

Jayson, no, we're not going to comment on the current quarter. I mean we've been pretty consistent about that. The comments that we are going to make are specific to Q2, which was the financial release.

Jayson Bedford - Raymond James

Okay. I guess maybe for Loren. Loren, is there any way you can kind of quantify the impact of Perouse? I guess we're assuming: it's lower than corporate gross margin average, but is there anyway you can? If you were to parse out Perouse, what would have been gross margins?

Loren McFarland

Well, the Perouse gross margin, you have to remember Perouse operates entirely in our international channel and primarily through distributors. So, that has an impact on the gross margin. It doesn't mean it's not good gross margin. And as a [comfort], we also have lower SG&A and so, the key is to get as much as possible to the operating line.

And so, you have to kind of remember that gross margin isn't the entire story when it comes to that. Well, we talked about the different channels, but there's also a negative influence on the non-cash amortization impact of Perouse and it's actually somewhat of the Genzyme agreement as well.

The Perouse numbers are, I think, $300,000 a quarter. And so, that's about 30 basis points at our current run rate. And then the Genzyme one adds about another $400,000, $450,000 a quarter and so the combination of that non-cash amortization gets you in the 80, 90 basis point range of our total business.

And so, that's probably the most color I can give on that. The $2.4 million number has a pretty big impact as well, of course, because it's going through cost of goods sold. But that's kind of a non-cash item. I'd have you think about that as a one off.

Jayson Bedford - Raymond James

And the Genzyme impact has been there for a few quarters, though?

Loren McFarland

It has.

Jayson Bedford - Raymond James

Okay. The inventory build in the quarter, is that just Perouse?

Loren McFarland

Primarily, yeah, it is the Perouse. I forget the exact number that it was. I think Perouse we acquired $9 million and so, our inventory would have been $37.5 million, thereabouts, and so that's almost flat with the June quarter.

Jayson Bedford - Raymond James

Okay. And then lastly, I guess, for Josh. Josh, in terms of timing of a new CFO: what are your thoughts there?

Josh Levine

In the release, we put out we said we're kind of in final stages of the decision making, and again, I refer back to that. I'd say: “we're rounding third, heading towards home”. I don't expect this to be a very long transition window. So, again, pretty soon.

Jayson Bedford - Raymond James

Fair enough. Thanks, guys.

Operator

Thank you. We'll go to our next question of from Gary Nachman of Leerink Swann. Go ahead, please.

Roy - Leerink Swann

Hi. This is Roy in for Gary. On the CPG study, that you had to submit additional data: do you have a timeline of when the FDA is going to get back to you? Or: when they might approve it? Or: if they're going to go panel? Or: anything like that?

Josh Levine

No. It's an interesting question, Roy. We really have not received any indication from the agency vis-à-vis their intentions on a panel poll for this or a turnaround time on the additional data we're providing.

I get the sense, and again, I've learned the hard way, over a long period of time, to not try to predict what the FDA will, or won't, do, especially around breast implant PMAs. But I get the sense that there's really not a lot of urgency on their part, or strong desire, to see this go to panel. So, I mean, you might look at that and say: “well, that's a positive”.

Again, that's just conjecture on my part. I don't have anything that confirms that, or refutes it, but I think that the general topic of breast implant PMAs in the world that the agency is living in right now, at CDRH is, I can't imagine that that's high on their hit list in terms of desires is to see a panel called for it. And again I don't have any indication in terms of turnaround time.

Roy - Leerink Swann

Okay. And in your prepared remarks, I may have missed this, but did you say that you won't be presenting peer tax Phase II data for competitive reasons?

Josh Levine

Well, there are certain elements that we won't be presenting. I mean I think we've been much more expansive on the protocol specifics, the protocol design, but if you're asking specifically about dosing specifics, I think our view is that we probably would rather not get public with dosing specifics.

Roy - Leerink Swann

Okay. And then my last question is with Anika and Galderma: they recently announced that they're going to be terminating their agreement for Elevess, and how does that maybe change, or affect, your plan for launchings the Puragen Plus, Prevelle Plus?

Josh Levine

It doesn't.

Roy - Leerink Swann

It doesn't. Okay. Thank you.

Operator

Thank you. We'll go ahead and take our last question from the line of Peter Bye of Jefferies & Company. Go ahead, please.

Peter Bye - Jefferies & Company

A couple of questions, I guess, Josh, first: why are you so defensive on the quarter and then still reaffirming guidance? Our numbers is the breast implant (inaudible) just your numbers in (inaudible) grew 21% in Q1, 22% in calendar Q2 and 25% in calendar Q3. So, to assume it's actually accelerating. Can you just explain the dichotomy between the two? You beat the numbers on the top line of consensus, you reaffirmed it: why the pessimism?

Josh Levine

I think, well let me fully back up, first of all, if I communicated that I'm defensive on our quarterly results, clearly that isn't the message I want to send. I mean: I'm pretty proud and pleased with what we did in the quarter and I recognize that we did beat the Street in term of the top line number by almost $1 million.

I think that when I look again at some of the data, and some of the trend that we started to get visibility on towards the latter part of Q2, I think you have to ask: is there a continuing trend there going forward into Q3 and later in the year?

Again, every time I look, the backdrop from an economic standpoint doesn't look like it's getting better and I just think that it's prudent to recognize that if there is a broader melt down, if you want to call it that in terms of the economy, the likelihood that we're going to be able to avoid that or side-step it with our products and our procedure, I think the answer is, we would probably be affected to some degree by that.

Peter Bye - Jefferies & Company

Then: why would you reaffirm guidance on that front, just take down the top end?

Josh Levine

This is kind of “pick your poison”, right? If I take down guidance, I'm going to get a bad report card on that, if I…

Peter Bye - Jefferies & Company

Well, put it this way: the trends you're seeing now, is top kind of guidance still realistic?

Josh Levine

Yes. I think it is.

Peter Bye - Jefferies & Company

That's fair enough, thanks. And then on Prevelle Plus and Puragen Plus: if you look at '09, and I know Josh and Loren, you've not given any guidance, but the market for dermal fillers in '07 certainly exceeded most people's expectations.

Our numbers show it grew 38% in the first half of '06, '07 and then it looks like it's actually growing north of 40% in Q3 '07. So, when you look at those launch numbers, you're getting very little credit for that, I think and your numbers in '09 in consensus. What's a realistic share? If you just look it that way? What's the share of the market? You launch out there from a competitive standpoint, who the injectors are, is it 2%, 5%, 50%, 20%, I mean, can you give us any range?

Josh Levine

Peter, I don't think I'm going to give you any specifics in that regard. I think a way to be thinking about the share is this: I think the share discussion is a hybrid discussion. I think there's a share discussion in the plastics channel and then I think there's a share discussion in the cosmetic derm channel.

I think from a plastics channel standpoint, where we have our strongest relationships, a fair amount of relationship equity, if we want to call it that, the access to the physician from a surgical aesthetic franchise standpoint. I think, we're going to get a lot of support in the plastic surgery channel, with our products, our facial products.

Peter Bye - Jefferies & Company

Well, I understood, sorry about that, I understand that, Josh, I understand where you're going, everyone's conscious about what not loading up the expenses on flowing out a derm franchise and derms are bigger injectors than plastics. But obviously that bleeds in, you know, how many plastic injectors are and they're growing a little bit faster than derms, because they're coming from behind the curve a little bit. Give, is it 2 or is it 20, or somewhere in between?

Josh Levine

I think, again, I'm not going to give you an exact number. I think that the product lineup that we believe we're going to have, the portfolio of product we're going to have to compete with, is going to fair pretty well.

Again, I think that we're realistic in our view about the people that are currently, the primary competitors in the market, I think it would be unrealistic to try and get anyone to believe that we're going to supplant a Metafist or an Allergan in the channel that they have their best strength in, but I think that we will surprise some people with our products and the degree of support we get and the outcome in our core business channel.

And I think, we've got a number of things from a strategy standpoint, that will prove to be the best way for us to go to market in cosmetic derm in a way that doesn't completely dilute our P&L, and I think that's something that we need to be cautious of because I think that, to say that we're going to go out and do, add a dedicated group or dedicated sales force of the size and magnitude or headcount that our competitors have to call specifically on cosmetic derm would be a difficult situation for our income statement in the near term.

Peter Bye - Jefferies & Company

Sorry again, it is the last one. And on the plastics, our look there was it was really poorly attended so sort of saying what the data comes back on that whether it was location or guys doing procedures or not doing procedures, they want to come or lack of product flow, and you're saying sort of reaffirming guidance but also showing some hesitancy, we all appreciate the candor, but again, just trying to reconcile the two, can you just give us one synopsis for that?

Josh Levine

Let me be clear, if there was something to restate in terms of guidance, I'd restate it. So, the guidance that we have, and that Loren reaffirmed, is the guidance.

Loren McFarland

Peter, this is Loren. When you subtract Perouse from our guidance, just under the run rates that we've been talking about today, it gives you a range of growth in the second half of 15% at low end and 25% in the high end. So, I think that's a range that's very achievable.

Peter Bye - Jefferies & Company

I know but, Josh, I guess what people are trying to estimate is when you see slow down, is it mid, from mid-to-high or whatever how you're going to say it, you guys say mid-to-negative or is it sort of mid to like low double-digits?

Josh Levine

You've got business that in Q2 we projected was growing in the low-to-mid single-digits in terms of procedures unit volume, and that was for the entire quarter. Again, in the last part of that quarter, we saw some at the beginnings of some slow downs. This is not something that we're going to be able to project for on a long-term horizon.

If you're asking for what the impact is three months out, six months out, nine months out, we're going to have to see. I think that we gave up some share during the quarter domestically. We know where we lost the share. We know why we lost the share, and we're going to take these appropriate actions, and I think you'll see the appropriate competitor’s response from us going forward.

Peter Bye - Jefferies & Company

I appreciate that. And again, Josh, your candor is unprecedented. I appreciate it. Thanks.

Josh Levine

No problem.

Operator

Thank you. This does conclude our Q&A session. I'd like to turn it back over to Josh Levine, President and Chief Executive Officer, of Mentor Corporation.

Josh Levine

Thank you, operator. Before I conclude the call, I just want to take a minute and personally acknowledge Loren McFarland's 22 years of service to the company. Thank him for his many contributions to Mentor over that period of time. We'd always want the best for Loren in his future endeavors. And with that I guess I'd like to thank everyone for participating in today's call. We look forward to speaking with you when we report third quarter results. Thanks very much. Bye, bye.

Operator

Thank you. This does conclude our conference call for today. We appreciate everyone's participation, and you may now disconnect.

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