Obagi Medical Products Q3 2007 Earnings Call Transcript

Nov.13.07 | About: Obagi Medical (OMPI)

Obagi Medical Products, Inc.(NASDAQ:OMPI)

Q3 2007 Earnings Call

November 13, 2007 4:30 pm ET


Ina McGuinness - Integrated Corporate Relations

Steve Carlson - President, Chief Executive Officer

Steve Garcia - Chief Financial Officer


Donald Ellis - Thomas Weisel Partners

Adam Greene - JPMorgan

Elliot Wilbur - CIBC World Markets

Angela Morison - SIG

Tyler Bruce - YX Funds


Good day ladies and gentlemen. Thank you for standing by.Welcome to the Obagi Medical Products Third Quarter2007 Earnings Conference Call. At this time all participants are in alisten-only mode. Following the presentation, we will conduct aquestion-and-answer session (Operator Instructions). I would like to remindeveryone that today’s conference is being recorded.

I’d now like to turn theconference over to Ms. Ina McGuinness with IntegratedCorporate Relations. Please go ahead ma’am.

Ina McGuinness

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

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

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

All information provided intoday’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 suchinformation. Participating in today’s call from the company are President andChief Executive Officer, Steve Carlson and Chief Financial Officer,Steve Garcia.

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

Steve Carlson

Thank you, Ina. And good afternoon, everyone. I’m verypleased to report another quarter of rapid sales and one of the strongestquarters of operating performance in our company’s history. This success wasfueled by double-digit increases in U.S. sales in every one of our productlines, as well as continued account penetration of our broad and CLENZIdermM.D. System’s product.

Our U.S. sales continues to have strong momentum increase in43% Q3 2007 versus a year ago. Importantly, we’re able to eliminate much of theseasonality that typically slows our business during the third quarter as wemarked the seventh consecutive quarter of top line growth.

Globally, our net sales were up nearly 38% from a year agoto 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 $3.9million or $0.18 for fully diluted shares. Excluding the dilutive effect of ourOctober secondary offering and a write-off of differed financing cost, earningsper share would have totaled $0.20.

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

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

Lead investigator David Pariser, who is President-elect ofthe American Academy Dermatology Eastern Virginia Medical school presentedphotographic assessments that demonstrated 72% of the lesions achieve treatmentsuccess with the Nu-Derm regimen versus 63% of the lesions receiving standardtherapy.

Additional results from our blinded dermatologists andplastic surgeon panel showed that is 61% of lesions treated with the Nu-Dermregimen achieved treatment success versus 29% of the lesions achievingtreatment success with standard therapy.

With these results, we will continue to conduct clinicalstudies to support the science of our penetrating therapeutics technology andthe 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 largepart of the successful launch in CLENZIderm MD, Acne Therapeutic System for anormal to dry skin.

Coupled with our CLENZIderm system for normal to oily skinthis now gave us physician to greater flexibility for effectively andcomfortably treating Acne across the wide spectrum of skin types andconditions.

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

The symposium was carried by Dr. James Wade andpresentations were made by key opinion leaders in the Dermatology medicalcommunity. Dr. Suzanne Bruce, James Del Rosso and Jouni Uitto supportingCLENZIderm, ELASTIderm and condition in enhance.

We also presented three posters on CLENZIderm, the pursuingdata indicating significantly greater lesion reduction and lesion clearance inthe 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 inclearance using CLENZIderm, BPO gel alone without the systems cleanser or poretherapy versus BenzaClin gel.

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

Additionally, in October at the Fall Clinical dermatologyconference in Las Vegas, James Del Rosso, Dermatology Resident Director for theValley Hospital Medical Center in Las Vegas, skin cancer clinics in Las Vegaspresented results from pooled analysis of three randomized, investigator-blindtrials totaling a 169 patients evaluating the solubilized benzoyl peroxide BPOfor the treatment of acne. This analysis suggest monotherapy with solubilized5% BPO or CLENZIderm M.D product may provide dramatic reductions in acnelesions within four weeks.

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

For CLENZIderm these clinical study results continue tostrengthen the creditability of our CLENZIderm systems in the treatment ofacne. During the third quarter, we also enjoyed continued penetration of theELASTIderm product into a significant portion of our existing customer base aswe 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 weexpand potential application beyond the eye to other areas of about includingneck, chest and arms.

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

Last our condition and enhance system saw a significantincrease in new physicians purchasing the system in the third quarter. As youknow, we reintroduce a new Obagi condition and enhance brands with two newsystems.

One design specifically for use with non-surgical proceduresand the other designs specifically for use for surgical cosmetic procedures.This new branding in customization re-systems give us a more branded anduser-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 ofSeptember 30, 2007 we had approximately 5,000 active accounts. Our newlyfocused dermatology sales force is now doubled to 24 representatives as ouroverall field sales force totals 88 physicians up from 71 a year ago.

Looking to the remainder of the year, we’re confident in ourability to benefit from what is historically been a seasonally strong fourthquarter as we capitalize on our growth opportunities in both the domestic andinternational markets.

We built a strong sales organization and invested in ourproduct portfolio, which will position our company for a stable future growth.We also continue to successful leverage our infrastructure and establish atrack 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 ofthe typical seasonality we just historically experienced in the summer monthsof ours sales continue to grow at a record pace. We saw a net sales increase38% to $26.3 million.

And as a result of our continues focus on improvingoperating efficiencies, we achieved a very strong operating margin of 26% aftergiving effect to 1,873,000 in cost related to our recent offering and the writeoff of $78,000 in deferred financing cost and extinguishment of debt. Last yearin the third quarter operating margins were 19% and they were 29% in thepreceding quarter.

Now turning to earnings, net income totaled $3.9 million upfrom $1 million in the third quarter last year. Its worth noting, that ourreported diluted earnings per share of $0.18 reflects 873,000 in cost arisingfrom our secondary offering completed in October and a write off of 78,000 ofdeferred financing cost upon the extinguish of debt in the third quarter aswell.

Excluding that effect our diluted earnings per share wouldbe $0.20 per share, which is line with our expectations. Now in the brieflydiscuss our third quarter 2007 operating metrics compared to the third quarter2006.

Gross margins were consistent on both year-over-year andsequential basis at 82.5%. While, gross margins benefited from an increase inthe core product sales, this was offset by the sales of CLENZIderm, which willburdened by production on manufacturing and startup cost during the first ninemonths of the year.

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

As a percentage of net sales, SG&A expenses in the thirdquarter decreased to 52% from 56% a year ago. R&D expenses were $1.4million versus $1.5 million a year ago, essentially reflecting very similarlevels 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 incomedecreased to 26% from 19% a year ago. And if the secondary costs are removedand the cost related to the extinguishment of debt, the deferred financingcost, the percentage increase to 29% in 2007.

Interest expense decreased substantially to approximately350,000 in the quarter compared with $1.9 million for the third quarter of2006. This is primarily due to debt repayments of $35 million from net proceedsof our initial product offering, a mandatory prepayment we made in the firstquarter at $1.3 million, and an optional prepayment of $16.5 million during thenine-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 ofthe effective tax rate applied on a higher net income performance. This wasslightly offset by a decrease in our effective tax rate to 39.2 compared with39.5% a year ago.

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

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

The $14.3 million raised through our secondary offering inOctober allowed us to repay the security credit facility, senior secured creditfacility 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 forgeneral operating needs.

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

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

Despite modest gross margin compression, we expect to achieveprojected growth in earnings through our top line growth and leveraging out ourinvestment in SG&A that will drive operating margin improvements comparedto 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 resultto the secondary offering completed in October and the write-off of thedeferred financing cost on extinguishment debt.

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

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

Steve Carlson

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

Market acceptance of the conditioning and systems combinedwith the increase in clinical support from numerous studies provide theopportunity to extend Obagi’s existing product technologies into the largemarket of cosmetic procedures.

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

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

Obagi is focused on product innovation and diversificationcombined with our intellectual provide property provides us numerousopportunities in our target markets and will continue to support our efforts toremain a market leader.

With that, operator would please open the call forquestions.

Question-and-Answer Session


(Operator Instructions) We go first to Donald Ellis withThomas 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 oninvestment with new sales people in that six plus month range, which we thinkis more efficient and is historically seen in pharmaceuticals. And I think withthe 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, Iassume most of those are plastic surgeons versus dermatologists or it’s heavilyweighted towards plastic surgeons, is that correct?

Steve Carlson

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

Steve Garcia

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

Donald Ellis - Thomas Weisel Partners

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

Steve Garcia

I think in the short-term because we have a broaderportfolio and anti-aging in aesthetics plastic cells historically continues tobe the strongest revenue platform that in new accounts. Having said that thoughas we continue to generate the additional clinical data surrounding CLENZIdermif they huge opportunity to compete in that act in space for roughly $1 billionwith a current prescription products generated in that category. So dermatologyis 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.


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

Adam Greene - JPMorgan

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

Steve Carlson

Let me take them each in order, ELASTIderm were actuallypleased with the sales were on a sequential basis is relatively flat.ELASTIderm continues to see very strong reorder rates and with Q3 you canappreciate the focus we had on CLENZIderm in a launch of Condition and Enhancewhich in fact really answers question two of why do we see such strength inNu-Derm and that’s what the Condition and Enhance system is being launched andthat improved branding in user-friendly identity to that. To your questionregarding rationing and we have an option to renew that agreement we don’tanticipate that revenue stream will go anywhere but continued to grow with us.

Adam Greene - JPMorgan



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

Elliot Wilbur - CIBC World Markets

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

And may be just give us a little bit of color or perspectiveon what’s going on with respect to the launch of ELASTIderm and CLENZIderm andbe 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, werecently announced we are restructuring surrounding our international strategyin their business and providing increased focus to the fundamental changes of thatrefocused is one, we’ve internally promoted an individual Curt Hanson, the VicePresident of International Sales.

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

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

As you can appreciate it takes sometime to one evaluatethose market opportunities, identify the right distributors, because we arestill looking at the distribution model that’s the most efficient way to drivethat business.

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

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

Steve Garcia

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

Elliot Wilbur - CIBC World Markets

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

Steve Carlson

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

Elliot Wilbur - CIBC World Markets

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

Steve Carlson


Elliot Wilbur - CIBC World Markets

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

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

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

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

Steve Carlson

I appreciate the free radical and speculative nature of thequestion 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-Dermstudies together greater and greater levels of safety and efficacy data.

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

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

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

But we think we’re well positioned with the data we’vegenerated in the ongoing additional data we are generating that will have afairly robust dark C of information will provide the FDA is free radically whenthey 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 fromyou.


(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 onSG&A leverage. Noting that third quarter was higher than the normal spendrate due to the offering. Should we be expect in fourth quarter to be down ordo you have bonuses that get paid to the sales force or how should we belooking 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 theoutlook, which we’ve provided on an adjusted basis for EPS. We’ve always seenfourth quarter to be a strong leveraged in growth, both on top and bottom. Wedid see extraordinary expenses in Q3 because of the offering.

We also had the launch of the condition in enhance and atsame timeframe and we do have bonuses that we accrue for in the fourth quarterbased on the companies performance. So, we think we’re going to have a verystrong 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, thegrowth that’s been seen sequentially this year even though in 2006 it wasdownstream around a little bit under licensing line?

Steve Carlson

The licensing line effectively is tied to our Japanesedistributor Rohto Pharmaceuticals, which sells essentially our Vitamin Cs in5,000 retail pharmacies under the Obagi brand. What you notice, you lookquarters-over-quarters the reflective sales are kind of bare cycles of productlaunches and their seasonality in Japan.

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

Angela Morison - SIG

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

Steve Carlson

What we understand is this was a pending OTC monograph thatnever got finalized and simply sat for 18 plus year. And the FDA some one intheir staff pulled that filed and indicated that they should finalize thatmonograph.

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

So that’s what we understand they were doing and we are notaware of anything that prompted as a President to issuing that register otherthan a desire to bring that monograph to a close. And as you know and we'vepreviously reported they were over 700 responses and they were no indicationsof safety that would cause the FDA any incremental concerns that would promptthem to take any additional or aggressive actions as it relates to withdrawalsof cosmetics in the marketplace.

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

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

Angela Morison - SIG

Thank you for all the information.

Steve Garcia

Thanks Angela.

Steve Carlson

Thank you.


(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.


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

Steve Carlson

Thank you all. Bye, bye.

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