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Obagi Medical Products, Inc. (NASDAQ:OMPI)

Q3 2007 Earnings Call

November 13, 2007 4:30 pm ET

Executives

Ina McGuinness - Integrated Corporate Relations

Steve Carlson - President, Chief Executive Officer

Steve Garcia - Chief Financial Officer

Analysts

Donald Ellis - Thomas Weisel Partners

Adam Greene - JPMorgan

Elliot Wilbur - CIBC World Markets

Angela Morison - SIG

Tyler Bruce - YX Funds

Operator

Good day ladies and gentlemen. Thank you for standing by. Welcome to the Obagi Medical Products Third Quarter 2007 Earnings Conference Call. At this time all participants are in a listen-only mode. Following the presentation, we will conduct a question-and-answer session (Operator Instructions). I would like to remind everyone that today’s conference is being recorded.

I’d now like to turn the conference over to Ms. Ina McGuinness with Integrated Corporate Relations. Please go ahead ma’am.

Ina McGuinness

Thank you, Tony. Earlier this afternoon, Obagi Medical Products released financial results for the third quarter ended September 30, 2007. If you’ve not received the press release, it is available on the Investor Relations section of the Obagi Medical Products website at www.obagi.com. This call is being webcast and a replay will be available on the Company’s website for 30 days.

Before we begin, we’d like to remind you that today’s remarks contains forward-looking statements within the meaning of federal securities law. These statements do not guarantee future performance and therefore undo reliance should not be placed on them.

We refer all of you to the risk factors contained in Obagi Medical Products 10-Q filed on August 7, 2007 for more detailed discussion of the factors that could cause actual results to differ materially and those projected in any forward-looking statement.

All information provided in today’s call is as of the date of a live broadcast, Tuesday, November 13, 2007. And Obagi Medical Products assumes no obligation to update any such information. Participating in today’s call from the company are President and Chief Executive Officer, Steve Carlson and Chief Financial Officer, Steve Garcia.

And with that I’d like to turn the call over to Steve Carlson. Steve?

Steve Carlson

Thank you, Ina. And good afternoon, everyone. I’m very pleased to report another quarter of rapid sales and one of the strongest quarters of operating performance in our company’s history. This success was fueled by double-digit increases in U.S. sales in every one of our product lines, as well as continued account penetration of our broad and CLENZIderm M.D. System’s product.

Our U.S. sales continues to have strong momentum increase in 43% Q3 2007 versus a year ago. Importantly, we’re able to eliminate much of the seasonality that typically slows our business during the third quarter as we marked the seventh consecutive quarter of top line growth.

Globally, our net sales were up nearly 38% from a year ago to a record $26.3 million exceeding last quarter’s sales of $26.1 million. Operating income rose 87% to $6.7 million and net income was up 284% to $3.9 million or $0.18 for fully diluted shares. Excluding the dilutive effect of our October secondary offering and a write-off of differed financing cost, earnings per share would have totaled $0.20.

Now, let me discuss in more detail, we’ve contributed to our continued success during this third quarter. Sales from our core product lines, which includes Nu-Derm, C Rx, Vitamin C and tretinoin continues to have strong momentum increasing 20% versus last year.

Further with regards to our flagship product Nu-Derm just a few weeks ago at the Fall Clinical dermatology meeting in Las Vegas, we announce results from a study evaluated in the use of Nu-Derm to improve the scar cosmesis following electrodesiccation and curettage in patients with superficial truncal basal cell carcinoma.

Lead investigator David Pariser, who is President-elect of the American Academy Dermatology Eastern Virginia Medical school presented photographic assessments that demonstrated 72% of the lesions achieve treatment success with the Nu-Derm regimen versus 63% of the lesions receiving standard therapy.

Additional results from our blinded dermatologists and plastic surgeon panel showed that is 61% of lesions treated with the Nu-Derm regimen achieved treatment success versus 29% of the lesions achieving treatment success with standard therapy.

With these results, we will continue to conduct clinical studies to support the science of our penetrating therapeutics technology and the clinical efficacy of Nu-Derm and Nu and expanded applications.

Equally exciting the CLENZIderm MD brand experience 71% sequential sales growth to $1.8 million during the third quarter due and large part of the successful launch in CLENZIderm MD, Acne Therapeutic System for a normal to dry skin.

Coupled with our CLENZIderm system for normal to oily skin this now gave us physician to greater flexibility for effectively and comfortably treating Acne across the wide spectrum of skin types and conditions.

These results also reflect the positive response form physicians to a growing clinical database. Example of this clinical data (inaudible) are as follows. In August, as the American Academy Dermatology conference in New York, we sponsored a symposium entitled skin through the ages.

The symposium was carried by Dr. James Wade and presentations were made by key opinion leaders in the Dermatology medical community. Dr. Suzanne Bruce, James Del Rosso and Jouni Uitto supporting CLENZIderm, ELASTIderm and condition in enhance.

We also presented three posters on CLENZIderm, the pursuing data indicating significantly greater lesion reduction and lesion clearance in the first two weeks using CLENZIderm then BenzaClin gel, a combination drug, which contains 5% BPO and 1% clindamycin antibiotic.

The second, poster showed going greater lesion reduction in clearance using CLENZIderm, BPO gel alone without the systems cleanser or pore therapy versus BenzaClin gel.

And lastly, the third poster showed clinical data with a tolerability study comparing CLENZIderm with another leading 5% BPO clindamycin combination drug therapy and CLENZIderm was found to be equal to yet statistically more comfortable at the week two time point than the competitor.

Additionally, in October at the Fall Clinical dermatology conference in Las Vegas, James Del Rosso, Dermatology Resident Director for the Valley Hospital Medical Center in Las Vegas, skin cancer clinics in Las Vegas presented results from pooled analysis of three randomized, investigator-blind trials totaling a 169 patients evaluating the solubilized benzoyl peroxide BPO for the treatment of acne. This analysis suggest monotherapy with solubilized 5% BPO or CLENZIderm M.D product may provide dramatic reductions in acne lesions within four weeks.

Further the analysis showed a reduction in inflammatory and non-inflammatory lesions was greater with Obagi CLENZIderm regimen then jar gel formulation of BPO/clindamycin combinations. Patients also reported greater overall satisfaction and comparable tolerability with the CLENZIderm solution.

For CLENZIderm these clinical study results continue to strengthen the creditability of our CLENZIderm systems in the treatment of acne. During the third quarter, we also enjoyed continued penetration of the ELASTIderm product into a significant portion of our existing customer base as we generated $1.6 million in the ELASTIderm sales.

Reorder rates also remained strong at 67% in the quarter. ELASTIderm continues to represent a tremendous growth opportunity for us as we expand potential application beyond the eye to other areas of about including neck, chest and arms.

While, it will take time to develop the appropriate formulation and clinically evaluate those new market niches. We are actively marketing and selling ELASTIderm to our existing physician network as such new physicians are adding ELASTIderm eye cream or gel as a specific eye therapy to those patients, who are already using the Nu-Derm and C Rx systems.

Last our condition and enhance system saw a significant increase in new physicians purchasing the system in the third quarter. As you know, we reintroduce a new Obagi condition and enhance brands with two new systems.

One design specifically for use with non-surgical procedures and the other designs specifically for use for surgical cosmetic procedures. This new branding in customization re-systems give us a more branded and user-friendly identity for other applications.

Overall sales progress on all fronts resulted in 18% year-over-year increase in the number of active U.S. physician customers. As of September 30, 2007 we had approximately 5,000 active accounts. Our newly focused dermatology sales force is now doubled to 24 representatives as our overall field sales force totals 88 physicians up from 71 a year ago.

Looking to the remainder of the year, we’re confident in our ability to benefit from what is historically been a seasonally strong fourth quarter as we capitalize on our growth opportunities in both the domestic and international markets.

We built a strong sales organization and invested in our product portfolio, which will position our company for a stable future growth. We also continue to successful leverage our infrastructure and establish a track record of achieving improvement in our operating performance.

With that, I’d like to turn this over to Steve Garcia.

Steve Garcia

Thank you, Steve, and good afternoon, everyone. In spite of the typical seasonality we just historically experienced in the summer months of ours sales continue to grow at a record pace. We saw a net sales increase 38% to $26.3 million.

And as a result of our continues focus on improving operating efficiencies, we achieved a very strong operating margin of 26% after giving effect to 1,873,000 in cost related to our recent offering and the write off of $78,000 in deferred financing cost and extinguishment of debt. Last year in the third quarter operating margins were 19% and they were 29% in the preceding quarter.

Now turning to earnings, net income totaled $3.9 million up from $1 million in the third quarter last year. Its worth noting, that our reported diluted earnings per share of $0.18 reflects 873,000 in cost arising from our secondary offering completed in October and a write off of 78,000 of deferred financing cost upon the extinguish of debt in the third quarter as well.

Excluding that effect our diluted earnings per share would be $0.20 per share, which is line with our expectations. Now in the briefly discuss our third quarter 2007 operating metrics compared to the third quarter 2006.

Gross margins were consistent on both year-over-year and sequential basis at 82.5%. While, gross margins benefited from an increase in the core product sales, this was offset by the sales of CLENZIderm, which will burdened by production on manufacturing and startup cost during the first nine months of the year.

Selling, general and administrative expenses, which include depreciation and amortization and non-cash compensation expenses increase $2.9 million to $13.6 million This was a result of increased staffing, primarily in the areas of sales, marketing and administration, as well as, expenses related to the secondary offering, increased legal fees and SOX compliance.

As a percentage of net sales, SG&A expenses in the third quarter decreased to 52% from 56% a year ago. R&D expenses were $1.4 million versus $1.5 million a year ago, essentially reflecting very similar levels of spending to support new product development in both periods.

Income from operation rose 87% to $6.7 million compared with $3.6 million a year ago. As a percentage of net sales, operating income decreased to 26% from 19% a year ago. And if the secondary costs are removed and the cost related to the extinguishment of debt, the deferred financing cost, the percentage increase to 29% in 2007.

Interest expense decreased substantially to approximately 350,000 in the quarter compared with $1.9 million for the third quarter of 2006. This is primarily due to debt repayments of $35 million from net proceeds of our initial product offering, a mandatory prepayment we made in the first quarter at $1.3 million, and an optional prepayment of $16.5 million during the nine-months ended September 30, 2007.

Income tax expense increased to $2.5 million compared to $0.7 million for the same quarter. This significant increase is a function of the effective tax rate applied on a higher net income performance. This was slightly offset by a decrease in our effective tax rate to 39.2 compared with 39.5% a year ago.

Turning to the balance sheet, as of September 30th, 2007 our cash and cash equivalents total $2.5 million. Working capital totaled $19.4 million and stockholder's equity totaled $29.8 million. In addition, we generated $2.5 million of positive net cash flow from operating activities for the quarter.

On October 17th, we closed a public offering of $6.3 million or 6.3 million shares rather of common stock at $20 per share. 800,000 shares of common stock were sold by Obagi for net proceeds of the company of $14.3 million, after deducting underwriting discounts, commissions and estimated offering expenses.

The $14.3 million raised through our secondary offering in October allowed us to repay the security credit facility, senior secured credit facility in total resulting in no outstanding debts subsequent to quarter end. This transaction also allowed us to retain $5.1 million in proceeds in cash for general operating needs.

Based on the current trends in our business and our success in leveraging our infrastructure across a growing revenue base, we continue to guide toward 2007 sales in the range of $102 to $106 million, which would represent growth in the range of 31 to 36%.

As per gross margin although we continue to anticipate gaining efficiency in our manufacturing processes for CLENZIderm we believe our gross margin percentage will decline slightly toward in the year due to expected increases in sales volume with CLENZIderm.

Despite modest gross margin compression, we expect to achieve projected growth in earnings through our top line growth and leveraging out our investment in SG&A that will drive operating margin improvements compared to last year.

We are revising our estimates for 2007 EPS to the range of $0.72 to $0.75 to reflect the cost and increase shares outstanding as a result to the secondary offering completed in October and the write-off of the deferred financing cost on extinguishment debt.

Excluding the effect of the offering the right down to deferred financing cost; the guidance range would have remained unchanged from our previous guidance of $0.76 to $0.79 per share.

That concludes my comments on the company’s financial performance. Now I’ll like to turn the call back over to Steve Carlson.

Steve Carlson

Thank you, Steve. Our financial achievements continue to demonstrate that our key achieve growth initiatives are all in place and provide significant future upside potential as follows. The growth in a number in the number of new account positions provide significant new opportunities for our core products to continue to grow at double digit rates.

Market acceptance of the conditioning and systems combined with the increase in clinical support from numerous studies provide the opportunity to extend Obagi’s existing product technologies into the large market of cosmetic procedures.

And last we continue to penetration and strong reradiates for elastin and CLENZIderm a proof that we’ve successfully launch two new technologies that give the physician to stunt the model very well.

Looking forward, we believe that each of our current product lines are well positioned for meaningful growth. We remain committed to invest in research and development and have a very strong product pipeline with a commitment to introduce two new products every year.

Obagi is focused on product innovation and diversification combined with our intellectual provide property provides us numerous opportunities in our target markets and will continue to support our efforts to remain a market leader.

With that, operator would please open the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions) We go first to Donald Ellis with Thomas Weisel Partners.

Donald Ellis - Thomas Weisel Partners

Thank you, and good afternoon.

Steve Carlson

Good afternoon, Donald.

Donald Ellis - Thomas Weisel Partners

Couple of questions, regarding the additional sales reps, have they been in the field long enough to be fully productive in your opinion?

Steve Carlson

I think as we discussed before Don, we find return on investment with new sales people in that six plus month range, which we think is more efficient and is historically seen in pharmaceuticals. And I think with the U.S. growth that we’ve seen over the last two quarters in access of 40%, and we’re seeing that incremental leverage out of those sales people.

Donald Ellis - Thomas Weisel Partners

Okay. The next question is, over the 5,000 accounts, I assume most of those are plastic surgeons versus dermatologists or it’s heavily weighted towards plastic surgeons, is that correct?

Steve Carlson

Yes. As we’ve reported before it is weighted towards plastic surgeons. But we’re seeing substantial new growth in dermatology and new accounts largely fueled by the clients of Derm System.

Steve Garcia

We’re also seeing some growth in the other category, which is the non-traditional skin care physicians, the FPG, the OPG as well some cycle growth within in that categories as well.

Donald Ellis - Thomas Weisel Partners

So with respect to adding new physician groups in the plastic versus dermatologist, how would rate the opportunity adding one additional plastic surgeon or adding one additional dermatologist. Which creates you greater revenue opportunity for you guys?

Steve Garcia

I think in the short-term because we have a broader portfolio and anti-aging in aesthetics plastic cells historically continues to be the strongest revenue platform that in new accounts. Having said that though as we continue to generate the additional clinical data surrounding CLENZIderm if they huge opportunity to compete in that act in space for roughly $1 billion with a current prescription products generated in that category. So dermatology is certainly is a large growth driver for us going forward based on CLENZIderm.

Donald Ellis - Thomas Weisel Partners

Okay. Great. Those are my questions. Thank you very much.

Steve Garcia

Thank you very much.

Steve Carlson

Thank you.

Operator

And we’ll go next to Adam Greene at JPMorgan.

Adam Greene - JPMorgan

Three questions, first I don’t think I heard, but why cells of ELASTIderm why were they down sequentially in converse to why would Nu-Derm so strong in the quarter versus the second quarter whereas I think third quarter typically a year as you said seasonally low and third question on a trend now in that the contract is up in 2010 with Triax what happens when a contract ends, what happens to the revenue stream?

Steve Carlson

Let me take them each in order, ELASTIderm were actually pleased with the sales were on a sequential basis is relatively flat. ELASTIderm continues to see very strong reorder rates and with Q3 you can appreciate the focus we had on CLENZIderm in a launch of Condition and Enhance which in fact really answers question two of why do we see such strength in Nu-Derm and that’s what the Condition and Enhance system is being launched and that improved branding in user-friendly identity to that. To your question regarding rationing and we have an option to renew that agreement we don’t anticipate that revenue stream will go anywhere but continued to grow with us.

Adam Greene - JPMorgan

Thanks.

Operator

We’ll go next to Elliot Wilbur at CIBC World Markets.

Elliot Wilbur - CIBC World Markets

Thank you. Good afternoon. Question for you Steve, knowing you in a company as well a site, I think I do, I’m going to venture guess at your non-Obagi satisfied with the growth rates in the international market and I’m just wondering perhaps if you can provide us with an update as to what you’re doing at a kind of reinvigorate the growth rates and particularly might what seems to be pretty significant opportunity?

And may be just give us a little bit of color or perspective on what’s going on with respect to the launch of ELASTIderm and CLENZIderm and be at some your international distribution channels?

Steve Carlson

Thanks, Elliot and I appreciate that. U.S. International, has not shown as robust growth as the United State. As you are aware, we recently announced we are restructuring surrounding our international strategy in their business and providing increased focus to the fundamental changes of that refocused is one, we’ve internally promoted an individual Curt Hanson, the Vice President of International Sales.

He has very strong track record with us as we refocused our Canadian business approximately two years ago. He was also a very strong sales manager force in United States. He knows our business well.

So with that we are also looking to place and have placed our first dedicated international sales manager. In Europe we are looking to add additional dedicated people to focus on key regions of growth for us and we think that business model in organizational structure will result in substantial growth for international going forward.

As you can appreciate it takes sometime to one evaluate those market opportunities, identify the right distributors, because we are still looking at the distribution model that’s the most efficient way to drive that business.

ELASTIderm and CLENZIderm we’ve seen great enthusiasm for their products by our existing distributors and interest by new potential distributors. They are both working we’re seeing great enthusiasm for through the import and pretty statistical sale process.

And we believe we’ll start to see some of the early pick-ups of those product launches in the first quarter, and two quarters of ’08, as we sign up new distributors and launch those new products into existing structures.

Steve Garcia

I think one thing is important to noticed as well is just with the ELASTIderm and CLENZIderm now in our pocket. The speeder markets is market quicker with the prescription base products we saw with Nu-Derm and so on and it took much closer to a year to two years, Whereas now, we’re talk in months in order to access the markets and get through the regulatory process within the various new market we’re trying to enter into.

Elliot Wilbur - CIBC World Markets

And Steven, that’s equally thrill of the CLENZIderm versus ELASTIderm?

Steve Carlson

Yes, both ELASTIderm and CLENZIderm are regulated as OTC or Chaismatics. International the only country we’re aware of that has restructured some benzoil peroxides is in Japan.

Elliot Wilbur - CIBC World Markets

Okay. I had a follow-up question for you…

Steve Carlson

Okay.

Elliot Wilbur - CIBC World Markets

…as you will on the regulatory front that gets you it wouldn’t be in Obagi, NHQ question. The many tested variety of regulatory issues, 30 years later and you say, okay, retired, I guess.

So, since you have so many new shareholders, I guess the question I am going to pose to you is just free radical one.

Lets say the FDA would come up tomorrow and say we now want NDA’s from all marketers of 4% hydroquinone. Assuming they give you some grace period whatever it maybe.

I mean what would you have to do in terms of putting together an NDA that you think its going to satisfy what they are looking for, I mean have you already compiled ample safety data and do you think you just have to run a small efficacy study and sort of what kind of timeline we’ll be talking about, if you had a put to together an NDA and then sort of what do you think it would run you on the cost side?

Steve Carlson

I appreciate the free radical and speculative nature of the question as we don’t anticipate and we have heard nothing from the FDA on those. There is as you know Elliot we continue with the condition enhance in Nu-Derm studies together greater and greater levels of safety and efficacy data.

The process its been laid out by the FDA Cedar its relates to Douzy (ph) two drugs as they would file a federal register and invite us to come forward with all our data and provide that to the FDA for their evaluation.

Based on that evaluation and safety and efficacy then they would make a determination whether that data was adequate and sufficient to meet their requirements or if there were deficiencies what those would be and what they were didn’t have.

So at this point time without having that dialog in presenting all of the data at that point in time, it's completely premature to speculate of what the requirements would be, what the size and scope of magnitude of that would be.

But we think we’re well positioned with the data we’ve generated in the ongoing additional data we are generating that will have a fairly robust dark C of information will provide the FDA is free radically when they ask for.

Elliot Wilbur - CIBC World Markets

All right. Thanks for entertaining the question Steve.

Steve Carlson

Thanks very much Elliot, I always like the question from you.

Operator

(Operator Instruction) Next to Angela Morison of SIG (ph).

Angela Morison - SIG

Hi, I was hoping if you give us a little bit more color on SG&A leverage. Noting that third quarter was higher than the normal spend rate due to the offering. Should we be expect in fourth quarter to be down or do you have bonuses that get paid to the sales force or how should we be looking at SG&A?

Steve Carlson

Thanks Angela. We don’t provide quarter-on-quarter guidance, and I think if you look at our topline sales and outlook for the year and the outlook, which we’ve provided on an adjusted basis for EPS. We’ve always seen fourth quarter to be a strong leveraged in growth, both on top and bottom. We did see extraordinary expenses in Q3 because of the offering.

We also had the launch of the condition in enhance and at same timeframe and we do have bonuses that we accrue for in the fourth quarter based on the companies performance. So, we think we’re going to have a very strong fourth quarter as we’ve indicated in our outlook for the year.

Angela Morison - SIG

Great. And could you walk us through a little bit, the growth that’s been seen sequentially this year even though in 2006 it was downstream around a little bit under licensing line?

Steve Carlson

The licensing line effectively is tied to our Japanese distributor Rohto Pharmaceuticals, which sells essentially our Vitamin Cs in 5,000 retail pharmacies under the Obagi brand. What you notice, you look quarters-over-quarters the reflective sales are kind of bare cycles of product launches and their seasonality in Japan.

In Q3 there was roughly 9% increase in royalty rates and that’s due to another product line that they launched under the Obagi brand that’s provided for under our agreement with them.

Angela Morison - SIG

That’s very helpful. And I know, you don’t like to ask the hydroquinone, sorry. When you think about what the federal and everything has asked for so far. What are they examining, what is the concern they are examining over the counter market that may or may not be addressed by having the product as prescription only?

Steve Carlson

What we understand is this was a pending OTC monograph that never got finalized and simply sat for 18 plus year. And the FDA some one in their staff pulled that filed and indicated that they should finalize that monograph.

They followed appropriate procedures after that extended period to time, which is to issue a Federal Register notice and do ask for an open commentary period to determine if there were any safety concerns or other concerns out there after that extended 18 plus years.

So that’s what we understand they were doing and we are not aware of anything that prompted as a President to issuing that register other than a desire to bring that monograph to a close. And as you know and we've previously reported they were over 700 responses and they were no indications of safety that would cause the FDA any incremental concerns that would prompt them to take any additional or aggressive actions as it relates to withdrawals of cosmetics in the marketplace.

Having and said that since you asked the question, now stay as we continue to do. We've been selling 4% hydroquinone as a prescription drug through physicians for that same period and we’ve never had a significant adverse reaction.

And we continue to GAAP their substantial clinical data to support not only safety, but efficacies surrounding the use of 4% hydroquinone drug. Albeit, in our market that is in the physician dispense channel but it is still a required prescription drug.

Angela Morison - SIG

Thank you for all the information.

Steve Garcia

Thanks Angela.

Steve Carlson

Thank you.

Operator

(Operator Instructions) Next Tyler Bruce at YX Funds (ph). Mr. Bruce your line is open. Please go ahead with your question.

Tyler Bruce - YX Funds

Hi, my questions already been answered. Thank you.

Operator

Thank you. And we're standing by with no further questions, see no at this time, therefore this does conclude today's conference. We do thank you very much for your participation. You can disconnect at this time.

Steve Carlson

Thank you all. Bye, bye.

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