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Cyberonics Inc. (NASDAQ:CYBX)

F2Q08 (Qtr End 10/26/07) EarningsCall

November 19, 2007 10:00 am ET

Executives

Dan Moore - President and CEO

Greg Browne - VP Finance and CFO

David Wise - VP, CorporateCounsel and Secretary

Analysts

Tom Gunderson - Piper Jaffray

Brian Wong - Broadpoint Capital

Andrew Cowen - Tricadia

Jonathan Block - SuntrustRobinson and Humphrey

Anthony Petrone - Maxim Group

Keay Nakae - Collins Stewart

Alex Arrow - Lazard CapitalMarkets

Charles White - Banc of AmericaSecurities

Herb Stein - Private MentalHealth Advice Advocate

Operator

Good morning. My name is Valerieand I will be your conference operator today. At this time, I would like towelcome everyone to the Q2 Results Conference Call. All lines have been placedon mute to prevent any background noise. After the speakers' remarks, therewill be a question-and-answer session. (Operator Instructions). I would nowlike to turn the call over to Mr. Dan Moore, Chief Executive Officer. Sir, youmay begin.

Dan Moore

Thanks, Valerie. Welcome,everyone and thanks for joining us this morning. This morning I will be joinedby Greg Browne, our CFO and David Wise, our Corporate Counsel, who will readthe Safe Harbor Statement before we begin.

David Wise

Thank you, Dan. This presentationincludes forward-looking statements. Forward-looking statements may beidentified by the use of forward-looking terminology, including may, believe,will, expect, anticipate, estimate, plan, intend and forecast or other similarwords. Statements in this presentation are based on information presentlyavailable to us and assumptions that we believe to be reasonable. Investors arecautioned that all such statements involve risks and uncertainties.Forward-looking statements in this presentation include statements concerningachieving cash flow and GAAP profitability, growing our epilepsy sales,including for commercial launch of the DEMIPULSE generator, continuing todevelop the TRD opportunities, developing new indications and collaborationswith partners, resolving legal and financial issues and improvingcommunications with our external stakeholders.

Our actual results may differmaterially. For a detailed discussion of the factors that may cause our actualresults to differ, please refer to our most recent filings with the SEC,including our Form 10-K for the fiscal year ended April 27, 2007.

Dan Moore

Thank you, David. For those ofyou who have joined on the website as well and have access to the presentation,I am beginning on slide 3, the topics that we'll cover today. There are fourtopics before we move to the Q&A. The first one is around a review of thefiscal year 2008 strategic priorities and our progress towards thosepriorities. We'll focus on profitability and epilepsy growth to the first twopriorities.

The second topic that we’ll coveris the sales analysis, and this quarter consistent with last quarter we'llprovide even more detail on our sales results.

In the past, we traditionallytalked about our business by geography. Last quarter, we made some estimatesaround our epilepsy business and separating that from our TRD, ourtreatment-resistant depression VNS business.

This quarter, you will see thatwe've added to the analysis much more detail around our product lines, to giveyou a view of revenues, units and average selling prices for both generatorsand leads.

The third topic we'll cover is Q2and our year-to-date fiscal 2008 results. And I think you'll agree that we madegood progress in Q2. Finally, I'll close with our fiscal year 2008 managementexpectations and touch on objectives three and four at that time as well,before we move to Q&A.

Moving to slide 4, the strategicpriorities that were outlined by our new Board of Directors earlier thiscalendar year. There are basically five objectives. Keep in mind that over thelast couple of years, last two fiscal years, we've lost in excess of $50million on a GAAP basis. The first objective and obvious objective, we came tobecome cash flow and GAAP positive earnings as soon as possible to get theprofitability.

The second objective is to growour core epilepsy business, after three years of a decline in that business, aswe moved away from epilepsy and really focused on TRD. And I think the numberstoday will show that we’ve grown over the last two to three quarters,quarter-on-quarter, and we'll cover that in more detail.

The third strategic priority isaround rightsizing our efforts against the exciting TRD business opportunity.We must remember that today, this is a business without reimbursement, and ourgoal is to get to reimbursement, and we want to ensure that we do that right.Obviously, we want to do it as quick as possible, but it's much more importantthat we get it right this time.

The fourth objective is to look atthe strength of the company's intellectual property and all the other potentialindications for VNS and try to find partnerships where we can take thattechnology and get it to patients quicker.

We've been very active in sortingout those priorities, and we are in discussions on how to best obtainshort-term and long-term value for some of that IP for our shareholders.

And the fifth and certainly notthe least, is to build the company for the future. And there has been a lotgoing on behind the scenes for us, as a company, as we attempt to reengineerthe culture of the company and to build our quality systems.

So, those are the five strategicobjectives the Board gave us earlier this year. And I'm pleased to say thosehaven't changed, and we're making good progress against them.

If you go to slide 5, just tohighlight some of that progress in quarter two. First, our progress towardsprofitability. Again, during the quarter, we saw significant expense reductionsin Q2, as well as we did in Q1. I want to say that we're not done there andwill never be done. We will constantly look for ways to more efficiently spendour monies.

Number two, on epilepsy. USunit sales growth quarter-to-quarter from Q4 2007 to Q1 2008, and again from Q12008 to Q2 2008; unit growth in both quarters, as well as on revenue growth. Wealso continue to see strong international growth over prior year.

Objective number three, progresson depression. Our sales obviously continue to be negatively affected by theCMS decision. It's important that we recognize that we will continue to pursuethis objective to find reimbursement that will go a long way in helping usbuild this business.

And one of the first steps wetook was to build a separate, smaller business unit that could focus on TRD.Keep in mind that that business unit was just formed halfway through thequarter in August of this year, and also keep in mind that this technology canbe life-changing for thousands of patients who don't have another good option.

On the organization side, wecompleted another workforce reduction during the quarter, and we also realignedour sales force into two groups, one for epilepsy and one for TRD. And again, Icaution that those two groups have only been in place for a couple of monthsthis quarter.

Fifth DEMIPULSE generator, inlimited release and we're seeing very encouraging results with the DEMIPULSE.And we'll be furthering the launch of that product at the upcoming AES meeting.And number five, we continue to aggressively explore possible IP partnerships.

Let's move to some of the numberson slide 6. I want to start-off by reminding everyone that as we've attemptedto split out our numbers, both by indications in epilepsy and TRD, and bygeography that there are some estimates here. Obviously, the geographicalnumbers we have are as hard numbers. The indication numbers for epilepsy andTRD, we need to back into those numbers as we outlined last quarter.

What I want to highlight isstarting on line one, Q2 2008 unit sales of 2,126 units, being up almost 3%over the prior quarter. If we look at the components of that, most important,the domestic epilepsy business, last year from Q2 to Q3, we saw a decline inunits which is consistent with this time of year, as we go into theThanksgiving and December holidays.

Coming from Q3 to what'straditionally our strongest quarter to Q4, we did see a 5% increase on theunits. And then again, from Q4 the 1,316 units to Q1 fiscal year '08, we sawanother 5% increase in the units. And in Q2, we're happy to report we sawanother 8% quarter-on-quarter increase and that's 1,489 units is 7% higher thanlast year, but the biggest part of our business, the domestic epilepsy businessis growing. As you look at the TRD, obviously a disappointment, we're leaving patientsbehind here and we know that.

We did make one correction to thenumbers. Last quarter, the Q1 fiscal year 2008, when we made the first attemptdefining these numbers, we reported 159 units. We'd inadvertently included 24units that were non-revenue units that were part of the studies. So, we backedthose out for this quarter and we're showing a 135 units from Q1, declining to88 units in Q2.

I'm going to move to slide 7. Therevenues; if you look at the revenue side, we're essentially flat, Q1 to Q2.But when we look at the epilepsy business, again looking at the domesticepilepsy business, you can see we've had our best revenue quarter in at leastthe last six quarters that we are analyzing.

Inversely, when we look at theTRD business, we've had our worst quarter, probably no surprise, given thedecision to CMS in February and again in May, down to $1.6 million overall forTRD, with very little of that coming from international. Again, I do want toexercise caution, whether we are looking at units or revenue when we startlooking by indication.

Now moving to slide 8, we decidedthat it was most beneficial for us to be looking at our business by geography,by product line, by indication. We wanted to understand, how we are growing,where we are growing, so that we can address the business in a more planfulway. We split out for the two indications, epilepsy and TRD generators andleads, and what you will see is that our generator business continued to growfrom Q3 last year onto Q4 for 1,890 units to Q1 1,935 to Q2 2,020 units. Thatincrease from Q1 to Q2 represents almost a double-digit increase of 9.9%.

Obviously, more work to do there.We think we can do better, but we are on our way to showing growth in our mostimportant business. Historically, if you look back over the last severalquarters, we sell 1,400 to 1,500 leads per quarter.

In this quarter, Q2, the leadsdid drop down to 1,300 units and after some concern it's a single quarternumber. One assumption we are using is that there might be a link to be able tounderstand end-of-service versus new sales, new units by subtracting the leadsfrom the generators, because we know in every new case, our lead will be used.

So, as we've concluded here inincrease in the epilepsy generator sales relative to the sales of leads ispresumptive of an increase in the number of replacement units. But again, Ineed to exercise caution, as we attempt to split-out our business and whereit's coming from. Overall, strong growth in generators, nearing double-digits.

Moving to slide 9, we have alsotalked about the desire to provide additional transparency in our business. Inthe past, when we look at our average selling prices, we are pretty muchlooking at one or two numbers. We would look at our ASP overall quarter-to-quarter.We might even split it out by domestic and international. But what's mostmeaningful is to split it out by product line, so that we can see forgenerators and leads, domestic and international, what’s happening with ouraverage selling prices.

And I won't go through all thenumbers on slide 9, but if you look at the domestic generators, we are seeingfour quarters of growing ASP and the same for the leads, a slight decline inthe lead price in Q2, but overall growth in our ASP.

In international, we see fivequarters of growth. When we start looking at the mix, there are some declinesin the business and that’s due to more of our business being sold ininternational and in the domestic, as a percent of our total business.

I am going to turn it over toGreg, our CFO, who will go through the important reportings of incomestatement, balance sheet and statement of cash flows. Greg?

Greg Browne

Thanks, Dan. I am going tocomment on the financial results for the second quarter, as compared to boththe second quarter of last year and the first quarter of this fiscal year, aswell as briefly on the year-to-date results.

Dan has already provided therationale behind the revenue changes that we’ve seen as of the last quarter andas of the last year. And as he mentioned, we expect that our US sales will besomewhat lower in the third quarter than in the second quarter, due to theseasonal factors that we see, although, generally speaking, our fiscal yearfourth quarter reflects the higher sales levels of the year.

We’re pleased that our grossmargin has improved to 84.2% in the quarter, higher than the 80.9% seen in Q1,although still lower than last year's second quarter. This improvement has beenpredominately driven by improved product mix, better efficiency on theproduction line and more consistent sales and production volumes, resulting inimproved overhead absorption.

Our operating expenses dropped byapproximately $3.5 million from the first quarter run rate to $28.0 million inthe second quarter, as a result of both lower legal and stock compensationexpenses, as well as some impact from the headcount reductions announced lastquarter. We also made significant progress in reducing the rate of expenditureon marketing activity.

As discussed, the quarterincluded $2.6 million of workforce reduction costs, although as thesereductions took place in the first month of the quarter, some of the savingsalso occurred during this quarter.

On a go-forward basis, our stockcompensation expense should not be substantially different from the $2.6million recorded in the current quarter. Legal costs however, will vary fromquarter-to-quarter until the various matters reach a conclusion.

In the second quarter, thecompany also recorded approximately $600,000 of credits to expenses in the formof insurance proceeds, clinical trial refunds and reduced property tax costs.These are expected to be one-off items.

We are in the process offinalizing a restructuring of our lease on the headquarters building to reducethe amount of space we occupy. This process is expected to be finalized in thethird quarter, and may involve restructuring costs, and we cannot be moreprecise at this time.

We will continue to work, as Danmentioned on other cost saving measures, in order to better align our overallexpenses with current revenue, including reducing our insurance costs.

Our goal remains of returning theorganization substantially closer to achieving one of our primary objectives, thatof GAAP profitability.

With respect to the balance sheetand the cash flow, as disclosed in our press release, our cash position remainsrelatively stable at $85.3 million at quarter end, compared with $85.8 millionat year end. Although somewhat lower than at the end of the first quarter dueto an ongoing reduction of our payables.

Our inventory level has beenfurther reduced this quarter, and is now lower by some $2.1 million than yearend. Day sales outstanding at 56 days was slightly higher than the 53 daysreflected at the end of the first quarter, although comparable with the 55 daysreflected at the end of the fiscal year.

Our depreciation and amortizationexpense remains consistent at approximately $850,000 per quarter, well abovethe $250,000 approximately of our quarterly expenditure on capital equipment.We have chosen this time, as Dan mentioned, to put out more complete sales dataon the accompanying slides, including more detailed information on sales byproduct line and ASP.

As always, we are open todiscussion of any further expansion of this disclosure. I'm now going to turnit back to Dan for his closing comments.

Dan Moore

Okay. Thank, Greg. As we look atthe remaining two quarters in fiscal year 2008, what are we expecting to do;well first and foremost, we're expecting further improvements to the operatingresults. I do want to note that Q3 sales historically have been lower than Q2,due to seasonal factors with the November and December holidays.

However, we will continue topursue our goal of a breakeven P&L as soon as possible, so that we can gointo the next fiscal year setup for a profitable year.

Second, growth in epilepsy, quietfrankly, I don't care if that growth comes from end-of-service, new patients,international, or wherever, we expect to grow the business.

One of the first things we'vedone is realigned our sales force to put our sales force back to the neurologycall point where we can work with our physician customers on behalf of ourpatients to bring VNS technology to patients whose drugs have failed them.

We are in the midst of launchingthe DEMIPULSE generator, which, as a reminder, is 43% smaller and 36% lighterthan the current generation. It provides battery indicators to let you knowboth when the battery is ready to stop and also a fuel gauge type meterthroughout the life of the product.

The third thing it does is itlooks at lead impedance and checks thatevery 24 hours and also provides faster interrogation and has a parameterretention feature.

Overall, the next generation and I'll remind you that this is the fourthgeneration in 10 years of VNS history for epilepsy. We are excited aboutthat product.

Number three, continuing thedepression effort. We have set up a domestic sales force that's been on thestreet for approximately two months. We expect to continue with that presenceas we work on our clinical and most important our coverage and reimbursementplans with both CMS and private payers, because the key to depression isobviously for us to get the coverage and reimbursement.

Number four, we expect continuedprogress with other VNS applications and define partners as we've begun sortingthrough the indications. And the obvious one is the obesity indication. Itdoesn't really fit within the call point we have, and others might help get theanswer on VNS for obesity quicker than we can do it alone.

And number five, we want tocontinue to expand our communication with our external shareholders. We'llcontinue to share what we're seeing, whether it's dollars and revenues, units,ASPs, geographies by product line. We plan to tell you what we are planning todo and then go out and do it to increase shareholder value.

The bottom line is, I believe weare making solid progress. We are on our way to profitability. We're seeing someepilepsy growth. We work hard each day on TRD and sorting out the plans there,as we are looking for partners for our fourth objective, and finally as we arebuilding a solid company.

Now, with that, what I'd like todo is at this time open it up for questions. And please, state your name andyour affiliation, and we'll take some time for questions now. Thank you.

Question-and-Answer Session

Operator

(Operator Instructions). Yourfirst question comes from Tom Gunderson with Piper Jaffray.

Tom Gunderson - Piper Jaffray

Hi. It's Tom Gunderson from PiperJaffray. Just to follow my instructions here, Dan, can you clarify a little biton what's going on with the sale force realignment. I think in the last quartercall you identified that 20 people were going to be dedicated to TRD andeverybody else would focus 100% of their time on epilepsy? Has that changed atall?

Dan Moore

No, Tom, it hasn't. In fact, wehad a fewer people we put in place in May that were still covering both. Andthen in August, we both reduced the size of the sales force overall and splitit into two groups so that there are two groups today, as a result of thatAugust split, one specifically and only focuses on epilepsy and the other groupof approximately 18 individuals who will focus on TRD.

Tom Gunderson - Piper Jaffray

The size of the US sales force at this point,actual territories, peoples selling to docs?

Dan Moore

For the epilepsy side about 70,with management over that just over 80 people.

Tom Gunderson - Piper Jaffray

Okay. And then, it seems you'vegot your growth and you said you didn't care where growth comes from and that'sa healthy attitude. But, it seems as though a lot of it, at least in thisquarter, is coming from end of use, if we are interrupting the new numbersright. Dan, are you giving a sense that maybe the sales forces, their focusingon epilepsy is going for the low-hanging fruit first, going with knowncustomers who have known patients and replacing the VNS unit and may be notlooking as hard as you'd like them to on building the business and growth withnew patients?

Dan Moore

Yeah, Tom. After being away fromthe neurologist, we are not really focusing on the neurologist for a couple ofyears and really focusing on psychiatry and TRD. You could see that couldhappen, our sales rep either new coming into a territory or coming back intothat epilepsy call point, and may start there with the low-hanging fruits.That's probably a valid assumption. I just again, need to caution on ourprocess. We've looked at this every way we can and we think the best way, as anindicator is probably, generators less leads would equal that number. But,again, the concern here is this quarter-to-quarter variations, people who'llbuy lead, how many are sitting in hospitals, at par levels. Our par levelschanging so there are a lot of factors there but, it's probably the bestindicator that we have at this point to separate out new from end-of-service.

Tom Gunderson - Piper Jaffray

Okay and then just one last minorone. International TRD units popped up, sort of surprisingly. Is thereinventory build in there somewhere?

Greg Browne

Tom this is Greg Browne. We choseto put number out there for completeness. We don't see an inventory build, wedo have reimbursement in several countries in Europe and slowly we're beginningto introduce that for that particular indication in Europe.So, we're hopeful that we'll see a little bit more as time goes on.

Tom Gunderson - Piper Jaffray

Okay, thank you.

Dan Moore

Thanks Tom.

Operator

Your next question comes fromBrian Wong with Broadpoint Capital.

Brian Wong - Broadpoint Capital

Good morning and thank you somuch for all the details. I just have a couple of follow-ups. Kind of jumpingon Toms question about your international sales, I was wondering if you couldtalk about to what initiatives you're taking. If I remember correctly, a coupleof quarters ago or maybe it was last quarter, you mentioned that that was anarea of focus for you. What sort of initiatives are you taking in that area?

Dan Moore

I would start with the leadershipof the company and the reason for that. I've got a lot of internationalexperience as does James, and when you look around on medical devices, eventhough, we've been very happy with our double-digit international growth, it'sstill not providing the right mix ratio of international to total business thatwe'd like to see. So, I think it starts with the management team really gettingoff of the growth and starting to think about what should international is andwhen you start with that, we should be pushing international to be 40% to 50%of our sales. I think you start fundamentally thinking differently about theopportunity, the next logical thing to do would be to consider some expansionsworth figuring out, where we can spend our money. It doesn't make sense to betrying to run the world from Europe or other opportunities better served inLatin America and Asia and other areas bybringing in additional people to help in those areas. So, I think that thesecond thing would be around expansion of people and leadership in the companyto go out and bring VNS to other areas of the world where it probably hasn’tbeen. So, I think that’s number two on getting the international focus.

Number three, I think when you goback to that framework of what should it be instead of thinking about numbersthat are $20 million, $25 million a year, you start thinking about largernumbers and planning your way towards those numbers.

And James has only been onboardfor a few months. He's over in Europe now forhis second trip over and I think he started to work with the team to figure outways to get additional growth in international.

Brian Wong - Broadpoint Capital

How big is your internationalpresence in terms of sales force right now?

Dan Moore

Beyond what we said in the 10-K,we got roughly 50 people overall in international. But in the mix of directversus distributor down to sales rep level, I don’t know, I don't have it.

Brian Wong - Broadpoint Capital

Okay and has is it been growingor is that pretty much status quo for now?

Dan Moore

We've kept it flat. The idea waswhile we go after that first objective of profitability, one of the mindsetchanges within the company is don’t grow international at all costs because wedo think we can grow international revenue and at the same time growprofitability.

And if you are throwing a lot ofpeople at it, as you increase your revenues. If you are just throwing morepeople into it, you probably won't increase your bottom-line. So, there is somefocus on running international as a separate profitable P&L just like we'vebegun to split out TRD.

Brian Wong - Broadpoint Capital

Got you. Okay. And then in termsof your headcount, obviously you finished-off the last headcount. I was justwondering if that headcount reduction was over and whether or not you arepretty much at, again, a steady state for your overall employee headcount or isthat going to go down further?

Dan Moore

Brian, I'd never say never, but Ithink after the last couple, since we've been here, we've taken 25% cumulativeaway from our overall headcount. So, I think we're at a point now where we needto reorganize with what we have and see if we can do what we think we can,which is to grow the epilepsy business and grow our way into the headcount wehave.

Now, there is some attritionalong the way. And as we see attrition, we see that as an opportunity to eithernot replace or to move people around. I wouldn't say within our existingheadcount of roughly 470 people that we've got them all in the right places todo what we want to do for 2009, '10 and '11.

So, I think the two things willbe: one, watch the attrition; and number two, move people fromfunction-to-function as we lose people.

Brian Wong - Broadpoint Capital

Okay. And since you brought itup, the attrition rate, turnover and sales force, how has that been?

Dan Moore

I don't know the actual numbers,but I go to a meeting every Monday and we talk about how many open headcountswe have, and it's low for the 470, it's low 10’s, like 13 people. So, it's nota big number.

Brian Wong - Broadpoint Capital

Okay.

Dan Moore

And keep in mind, since May, whenwe put that sales force in place in May, we didn't drastically change it inAugust. We took out some of the redundancy, but the sales rep, it was beforethe customer in May. For the most part, we've left those epilepsy people thatwere handling both in front of that epilepsy call point.

So, there hasn't been a massiveshift from May to August with our sales force. We wanted this facility there.

Brian Wong - Broadpoint Capital

Okay. And one last question maybefor Greg. Obviously, nice pick-up on the gross margins, where do you think thatcould - obviously, you mentioned that there is room to grow but where do youthink that might go?

Greg Browne

Well, last quarter we said thatwe would expect the gross margin to increase either the rest of this fiscalyear. It probably moved up a little bit quicker than we expected at that timeto the level of 84.2. And, at this stage, I would not expect significantincreases for the rest of this fiscal year.

Brian Wong - Broadpoint Capital

Okay. Thanks again.

Operator

Your next question comes fromAndrew Cowen with Tricadia.

Andrew Cowen - Tricadia

Hi guys.

Greg Browne

Hi.

Dan Moore

Hi, Andrew.

Andrew Cowen - Tricadia

Couple of questions, first, itsaid in the release on the G&A front, you had some one-time costs with thereductions in headcount in this quarter but then, there are some one-time gainsor some insurance offsets. Just trying to get an idea of should we count onG&A on a quarterly basis being below $10 million going forward?

Greg Browne

Let me answer it this way, we arehaving a lot of moving parts over the last quarter.

Andrew Cowen - Tricadia

Right.

Greg Browne

With respect to the workforcereduction and with respect to some changes in the compensation expense and someunusual credits that play through, as well, I don't think it's necessarilyappropriate to reduce the G&A expenses solely by the cost of the reductionin force.

On the other hand as Dan said, weare continuing to work away at the expenses and it would certainly be asignificant disappointment for us if we saw them tick up from here. But, we arenot quite at the stage yet where we are prepared to put hard numbers out thereon a go forward basis.

Andrew Cowen - Tricadia

Okay. Just, is there, alright,fair enough, I guess, we'll see what it does next quarter. In terms of theleads, is there a competitive component to that, you think you're losing outsales to some better leads?

Dan Moore

I don't. I don't know thecompetitive lead that can be used for VNS.

Andrew Cowen - Tricadia

Yeah, that's why I was surprisedand if you see a big up-tick in generators that the lead would fall off likethat?

Dan Moore

Yeah, no, I don't expect. I wouldjust, again, put out the caution here. I think next quarter's numbers will bemuch more important, because I think if you have seen 1400 to 1500 quarterlythat's been pretty consistent.

Andrew Cowen - Tricadia

Right.

Dan Moore

I don't want to sit here and tryto go through and understand exactly how many leads were in hospital at thebeginning of the quarter, how much inventory did they burn-off? I just didn'tthink it was that much of a worthwhile exercise at this point, providing thetransparency around generators, leads, TRD and epilepsy.

Andrew Cowen - Tricadia

Okay. I'd definitely appreciatethe transparency there. Last question is where do you feel you are, in terms ofthe efficiency of the sales force. I know it require decent amount of almost,retraining of the sales force, going back to neurologist rather than thepsychiatrist. Are you 50% over there in terms of getting the sales force,selling on a per head basis or where do you think you are?

Dan Moore

When you ask the 50% number, ifyou are saying what I expect our sales reps volume per territory to doubleanytime soon the answer to that would be no. However, from an overall, how'sour sales force working with this customer that they really haven't focused onin the last couple of year, I would put as, probably that 50% number now and todifferentiate that Andrew, I think, to really be the therapy consultant that wewant them to be that they are working side-by-side with the physician on behalfof patients. What we haven't done yet, and I have mentioned this in past calls,is looking at our key centers deciding who we are going to work with and inwhich ways doing some data mining.

I think there is a lot more wecan do to work with our physicians who treat patient everyday using VNS toextract some of the parameters in some of those centers, put those into othertrials. That's the part we haven't done. We were back with the customer. Wehave been there for six months. We are doing the basic blocking and tackling.We are [backing] our units, here is DEMIPULSE.

What we really haven't done istaken it to the next level throughout the country in a real thoughtful way andthat's what James is working on with the sales management team.

Andrew Cowen - Tricadia

Okay. Well, great quarter, guys.Thanks.

Dan Moore

Thank you.

Operator

Next question comes from JonathanBlock with Suntrust Robinson and Humphrey.

Jonathan Block - Suntrust Robinson andHumphrey

Well, hi, guys, good morning.Just in terms of maybe an update on DEMIPULSE. In other words, when do youexpect the full release and any details you can provide us in regards to theASP?

Dan Moore

Okay. On the full release, Iwould say, definitely by the end of our fiscal year, over the nextquarter-and-a-half, I would want to be in full release. So, sometime betweenend of calendar year or a month-and-a-half from now, to that first quarter, Ithink we would be out in all of our centers. So, that's the objective.

On the price side, I think it'sstill a little bit too early to create expectations around price. We areoutdone as we bring this new technology to customers. I will say we haven'tseen a huge amount of resistance nor should I expect a lot of resistance giventhe next generation that we are bringing that's truly differentiated from ourprior generations. But, it is a double-digit increase on the ASP.

Jonathan Block - Suntrust Robinson and Humphrey

Okay, great. And then just toshift over to the TRD side, is there an update on the clinical trials just inregards to maybe the size and the timing?

Dan Moore

Yeah, the clinical trial thatwe’ve laid out has been there that what we’re calling D-22, and it is over acouple of hundred patients, randomized control trial, which I think weuniversally heard. Whether it's private payers or CMS public, everyone wants arandomized controlled trial.

That’s the clinical part of it. Ithink that’s the easier part. I think the more important part around how doesthat fit in with D-21 in the registry and what we’re doing I think as we’vesaid in the earnings announcement that we expect that in early calendar 2008,we would be providing some additional color on that.

Jonathan Block - SuntrustRobinson and Humphrey

Okay and just last one. I knowyou talked about maybe a smaller, but now at least a dedicated unit working onTRD, just when we look at the revenues this quarter I know there is still a lotof moving parts, but do you think it's safe to say that here in the US, TRDrevenues have likely bottomed?

Dan Moore

Yes, I'd love to say that. Iwould have loved to say that the last quarter and the quarter before. Jonathan,it's really too -- until we see an uptick, I don’t want to say yet that we'vehit bottom. At the same time, we've got 18 people, nine in the territories andnine people working side-by-side with them to try to get those case-by-caseapprovals where possible. So, I would hope our efficiency gets better than 88units per quarter, but we’re not there yet. It couldn’t get worse.

Jonathan Block - Suntrust Robinson and Humphrey

Okay. Now, I appreciate thehonesty there. I was trying just to go back to the DEMIPULSE for one second,just so I am clear, that double digit, is that generator and leads, if youwould, or just generator?

Don Moore

Just generator, we haven’tchanged the lead.

Jonathan Block - Suntrust Robinson and Humphrey

Okay. Perfect. Thanks, guys.

Operator

Your next question comes fromAnthony Petrone with Maxim Group.

Anthony Petrone - Maxim Group

Thank you, guys for taking myquestions. Just a couple on if we could focus in on maybe penetration intoneurology practices. The data that you presented between generators and leadsis very helpful, but can you disclose if you can, any indication of how manynew practices were penetrated during the quarter, specifically neurology?

Dan Moore

Alright, just to say, I don'tknow that number but when I talk about James working with the sales team, and Ihope that you can see and what we're presenting at this point. We are couple ofbusiness leaders who do go down into details because I think it's byunderstanding where your business is and where you want to take it, you'llactually make it happen.

So, we have provided the color ongenerators versus leads. When we are looking at our neurology call point, howmany neurologists are out there? And what are we getting in each center? I'veseen some older information that would suggest that almost 75% of our physicianbase prescribes on average one a year. So, I'm not as worried about newscenters because I think we have plenty of centers out there and plenty ofneurologists who understand or know of VNS. What we probably haven't done istaken what the best are doing and spreading the gospel here, on what thepossibilities are with VNS technology. And I think, as James and his teambegins understanding not only those territories that we have set up, but whichare the centers that are really the key opinion leaders that understand thistechnology and have taken it well beyond where we took it our initial clinicaltrials, and then we're able to take that message to other centers. I think thatwill the key to our growth overtime.

Anthony Petrone - Maxim Group

Sure, that's helpful and a coupleof follow ups to that. If we look at the focus on the sales force now that hasbeen restructured, how much I guess, the mandate is there to I guess and basedon your comments, I would say very little.

But if there is, is therecurrently a mandate for the existing sales force to say, go and penetrate newaccounts? Is there a breakdown among the epilepsy sales force right now, amongthose going after new accounts and those harvesting the existing ones?

Dan Moore

I would say the consistentmandate to the sales management team and down into the territories is, numberone, achieve plan. And number two, that plan should include growth. So, Ithink, just being that we're in a device business where we've implanted 42,000or whatever the number is, when we know there are, we're saying in the US alone400,000 patients out there with more being added everyday, we haven't done whatwe can do with this technology.

So, the mandate for the salesforce is that we intend, we believe, we see these numbers, we think like manyother device businesses, there is a lot of growth out there. And if you're hereto grow, you're welcome; if you're not here to grow the business, then youprobably not on the right edge.

Anthony Petrone - Maxim Group

Okay, I guess moving onto DEMIPULSE. With the new epilepsy studies that you've spokeabout in previous quarters, when you begin these studies, I'm assuming that DEMIPULSE will be the unit that's used in, kind of compared to theprevious results. And I guess, maybe will there be a focus on DEMIPULSE and howthat has improved, say over the last five years relative to the technologycurrently in the marketplace?

Dan Moore

I don't think we'll limit anystudy to DEMIPULSE, only unless we were looking at DEMIPULSEversus the prior generation and trying to learn something about the product. Wedo expect, as we go forward to offer both product lines, both the DEMIPULSE andto have the existing 102 for those who want to continue with that product.So, I don't see us moving into a study where we would force everyone over toDEMIPULSE.

Anthony Petrone - Maxim Group

Okay. And just on the SG&Aside, obviously the expenses are coming down nicely, but just noticing there onthe percent of total sales, it actually increased a little bit sequentially.And I'm just wondering, you mentioned the restructuring of the lease, but canyou at least give us an indication of what other fixed costs are currently inthere that you might be working on over the next several quarters to bringingdown?

Greg Browne

Well, apart from the leaserestructuring, as I indicated earlier and you mentioned on the lead that willbe finalized in the third quarter. We're also looking at particularly in ourinsurance costs, which were up for nearly in the current quarter, and we expectto see some reductions there. And we continue to refine some of those policies,regarding travel and other expenses.

And as Dan indicated also, wecontinue to look at ways to enhance the profitability of our internationaloperations, that grown very strongly enough. We want to [find this on] littlebit more on the bottomline. So, I think in terms of the expense reductions weprobably assume a vast amount and we will continue to work away at those thingsthat present themselves.

Anthony Petrone - Maxim Group

That's very helpful. And I havejust a final question here, just in terms of recent news on the marketplace onthe financial service side. Do you foresee any change in terms of the creditline, specifically as it relates to Merrill Lynch? Have you been in discussionswith them?

Dan Moore

We have had an ongoing discussionwith Merrill Lynch over the last two or three months with a view torestructuring that credit line. As yet, we haven't finalized those discussions.We would very much believe that we can do so in the current quarter.

Anthony Petrone - Maxim Group

Okay.

Dan Moore

Given our cash position, thatshould also assist us as we go through then to the fourth quarter.

Anthony Petrone - Maxim Group

Great. Thank you very much. Lookforward to continuing to watch the progress. Thank you, guys.

Dan Moore

Thank you. Next question please?

Operator

Your next question comes from KeayNakae with Collins Stewart.

Keay Nakae - Collins Stewart

Yes, good morning.

Dan Moore

Good morning.

Keay Nakae - Collins Stewart

First question is about theend-of-service units, notwithstanding the variability perhaps in this quarter,is there any correlation between the number of EOS units and what, your modelsinternally would have predicted, given how long previously sold devices havebeen implanted?

Dan Moore

I think that trying to model thatend-of-service is a big challenge with just too much variability. You havedifferent model numbers with different battery lives. You've got physicians whoare programming to different rates with patients over years, where they maychange the power requirements on the battery overtime, because of programmingparameters.

I think, there is just too muchvariability to try to predict anything, other than we would expect our totalnumber of end-of-service units to grow year-on-year. Beyond that, as a percentof the total, I hope that end-of-service becomes a smaller part of the total,because we do want those new patients. As we've looked at that market, there ishundreds and thousands out there where we penetrated 42,000 or whatever thenumber is over 10 years. I know you guys have been on that. We've looked at itevery which way we can and I just think it's not a real good indicator of whatour growing business should be, if we do the job with our epilepsy businessthat we expect to do.

We should get nice uptick fromend-of-service, but we also need to get it from new patients as well, byworking with those centers, to determine which patients could benefit from VNSthat currently are getting VNS who are in that 20% to 30% of patients who areon drugs, but the drugs is just not doing it for them.

Keay Nakae - Collins Stewart

Okay, second question regardingthe randomized controlled study for depression? What is left to be determinedbefore you can move forward with that?

Dan Moore

Brian, you have got a number ofprivate payers out there, who look at Tech Assessments Groups and you've got onthe public side at least CMS that represents a certain percent of the patientpopulation overall. So, I think it's how do you put together D-21 in the postmarket registry, that we have agreed to do with FDA as part of the approvalwith a randomized controlled trial called D-22 and meet the needs of thosepayers.

So, I think it's getting into thespecifics, with each of the payers to say, here's the study we are going to usegoing forward, in combination with these other two studies to hopefully giveyou an indication of where VNS brings benefit to your patient population.

Keay Nakae - Collins Stewart

And where would you assess youare, in terms of completing that process? Are you halfway there or 75% of theway there?

Dan Moore

It's a hard marker to give. We'vegot trials designed but, until we've got agreement it's -- and I am notcontrolling the agreement side. It's hard to say, how long it will take us tocome to an agreement with and how long will it and again, they are not goingto, I don’t think any of the private payers or CMS is going to say, if you dothis and that comes out, okay you will get your coverage and yourreimbursement. However, I do think it's important that we're alignedfundamentally with the direction we're going that it's going to answer some ofthe deficiencies we've seen in the past and I can't easily assign a number to that.

Keay Nakae - Collins Stewart

Okay, fair enough. With DEMIPULSEcan you give us some qualitative feedback as to how well that's being receivedand then also in a similar way, what is left to be determined there before yougo to full launch?

Dan Moore

I think the qualitative sidewould be consistent with the other things we see in our lives with electronicsor medical devices. Usually smaller is better. So, it starts when you put thetwo devices side-by-side, that smaller device obviously has appeal and thenwhen you talk about the capabilities of what this one does, that the other onecouldn’t do, whether it's a battery indicator or programming capabilities thatare better than what we have with the existing device, I think the appeal isnatural.

Keay Nakae - Collins Stewart

Okay. And what is left to be donefrom your end to feel comfortable with the full scale launch?

Dan Moore

I think it comes back to again,James and the sales management team. We're doing things in a very methodicalway to have a plan that brings the product out to our customers in waves. So,we're into wave one, we're in to wave two, what do waves three, four and fiveand six look like, who's in them and what timing.

Now a plan like that doesn't takelong to put together, but I think it's based somewhat on the findings that youhave during your limited launch. So, I think at this point it's to get a littlemore feedback on the product, a little more time and that put together the planto actually launch it. So, that by the end of the fiscal year we are fullylaunched.

Keay Nakae - Collins Stewart

Okay and finally, can you give usa sense of roughly what the one-time charge might be related to therestructured lease of the facility, and any potential one-time chargeassociated with your financing with Merrill?

Greg Browne

Let me start with the second onefor a minute. We are conducting a range of discussions with Merrill Lynch,which would include restructuring the facility and I suppose one of the optionson the table would be to cancel the facility. We haven't reached a decision onthat and should we chose to terminate that facility towards the end of thisquarter, there would be a fee associated with that of approximately $400,000.So, we are looking at a range of options there and we'll certainly have itconcluded by the end of this quarter.

With respect to the leaserestructuring, we have mostly renegotiated the position with respect to ourlease on the headquarters building. I can't at this stage put a number on whatthe charge might be. I can tell you that there would be approximately $250,000write-off of lease held improvements, but over and above that it would dependon the final terms of any sub-lease, and so it's just a little hard to tell.

Keay Nakae - Collins Stewart

Well, closer to a couple ofhundred thousand as opposed to $1 million?

Dan Moore

I would not expect it to go over$1 million at this stage, but it's still possible, but I think that's unlikely.

Keay Nakae - Collins Stewart

Okay. Very good. Thank you.

Operator

Your next question comes fromAlex Arrow with Lazard Capital Markets.

Alex Arrow - Lazard Capital Markets

Thanks. Unless I missed it, didyou give the status of the other pipeline applications for VNS in terms of whattimeline you're going to commit on for things like anxiety, obesity,Alzheimer's, and then the other indications that you can comment on?

Dan Moore

Now, beyond the comment I madeabout obesity being the first one that makes sense I think to find a partnerfor, Alex, you didn't miss it, we've made a lot of progress particularly in thelast three months of sorting out the various indications. And there are plentyof them.

More than 20 at last count, soand varying timelines on the IP, so which of those do we want to keep internally,and which ones do we want to consider for partnership, I think we made a lot ofprogress there. But when you are looking at a partnership obviously until thedocuments are signed, I assume we have nothing.

Alex Arrow - Lazard Capital Markets

Well, the previous managementteam had mentioned from time-to-time that there were first demand studies, thatsome of those indications have already progressed into humans, and somehaven't, would you be willing to tell us, which have gone into humans so far?

Dan Moore

Yeah, I mean, we've had a numberof IDEs, and I think we put some of that out in the past 10-Ks. In addition toepilepsy and depression, we've had patients enrolled in tremor, in obesity andanxiety and in migraine.

In addition to those, we've hadsome investigational sites who have done their own IDEs and some of the otherindications.

Alex Arrow - Lazard Capital Markets

Okay. And then, as a relatedquestion, because of your intellectual property portfolio around VNS for --essentially for every indication for VNS, can you comment on what your outlookis for other company that's pursuing the vagus nerve stimulation for obesitystrategy?

Dan Moore

Yeah, but the overall comment isthat, as far as I understand they are in clinical trials. They haven'tattempted to commercialize their product. And so, at this point we've reallybeen focused on our other five objectives. And we have not done the analysis tosee whether what they are doing, they really conflict with some of the IP thatwe have.

Alex Arrow - Lazard Capital Markets

But is your position still, asthe previous management team said, is that you have all therapeutic uses of VNSor are there some exceptions to that?

Dan Moore

I'm not aware of any exceptionsbut, Alex, at the same time I haven't done the IP analysis.

Alex Arrow - Lazard Capital Markets

Okay. Great. Thank you.

Operator

Your next question comes fromCharles [White] with Banc of America Securities.

Charles White - Banc of AmericaSecurities

Hi guys. It's Charles White forSteve Litchman. Just one question on the epilepsy side, can you give us somemore details on the small size center study that you are working on tosupplement the IDE and maybe when we can expect to see some data from that?

Dan Moore

You said on the epilepsy side,right? So I am losing my voice but…

Charles White - Banc of AmericaSecurities

Right.

Dan Moore

We do have a couple of othertrials going. But when you talk about the small center, let me separate thetwo. We've got a couple going in Europe, onefor pediatric patients and another adjunctive VNS versus drug, as trials thathave been ongoing. As far as smaller centers, I think the need is to go, takethe single center experience and duplicate that experience in a multi-centertrial.

But that would not be one wherewe would duplicate it in a large randomized control trial like we would for newindication with FDA. It would be more to see if the positive results that wereobtained in one centre with VNS therapy for epilepsy could be duplicated inadditional centers in a trial.

Charles White - Banc of AmericaSecurities

And any sense of when we might beable to see some data out of that?

Dan Moore

No. Not yet. I mean, I thinkthose studies still need to be put together at the multi-center level being onthe single center. So, I think it would be much too early. And I think thatcomes back to being a device company and really looking at VNS as more, Ithink, the strategic direction of the company in the past was to look at thisis the platform and get into as many indications as we could.

We've had the approvals inepilepsy for 10 years and I think a fundamental shift in our strategy as wepursue growth in epilepsy is part of that longer term growth is workingtowards, being able to publish better results on the efficacy side for VNS, fortreating epilepsy. So, that strategic tactic, that tactic becomes part of whatyou would do in a device company where you intend to grow business overtime.

And I don't think it will be justa single center or a single trial with four or five, I think it’s more aclinical strategy where you look at showing where your device works better inpatients overtime. And it will probably take time, more the format of severalsmaller studies, as opposed to one where the company's milestone driven.

Charles White - Banc of AmericaSecurities

Okay. Great. That's it for me.Thanks.

Operator

The next question comes from HerbStein with [Private Mental Health Advice Advocate].

Herb Stein - Private Mental Health Advice Advocate

Good morning, Dan. It’s HerbStein, here.

Dan Moore

Hi, Herb

Herb Stein - Private Mental Health Advice Advocate

Mental Health Advocate andPro-activist. Dan, under the discussion about depression and getting it right,certainly the D-22 randomized study if and when it's ever implemented, would beone of the ways. Would you care to elaborate, more specifically what it isunder depression that you currently doing to get it right?

Dan Moore

No, I think today the answer tothat is no. I think I've gone as far as I would like to go in saying that wethink that there is more than one audience here that we need to be indiscussion with. Beyond FDA, where we have a commitment, there is also CMS andthere are private payers.

So, the specifics of whom we aretalking to, when and how those discussions are going I think it's a bit earlyto be talking about that publicly. But, those are the obvious audiences, if weintend to get coverage leading to reimbursement.

Herb Stein - Private Mental Health Advice Advocate

Okay. My other question is youindicated a staff of about 470 people currently?

Dan Moore

Yes.

Herb Stein - Private Mental Health Advice Advocate

I am just curious. Prior to thedepression launch I recall a number in the area of 250 to 300 people. Is thereany reason, why the staff is so much significantly higher, without depression?

Dan Moore

Well Herb, I think when we hitour profitable year back in fiscal year 2004, I think, we were few hundredemployees overall and we grew that as we were gearing up for depression to morethan 750. I think we peaked at 780 employees overall. So, today going from 780down to 470, I think we have done, we are more right-sized for a business thatis low hundred to millions than being at 780 people.

Specifically the breakout ofthose individuals, we’ve talked about the break out at the sales force level,what we haven't done is gone into the company and talked about the break outthroughout the company of how many fulltime equivalents do we have working onTRD versus epilepsy, but it is something we're looking at.

Herb Stein - Private Mental Health Advice Advocate

Okay thank you wish you all ahappy Thanksgiving and a peaceful one. Thank you.

Dan Moore

Thanks Herb. I think with thatwe'll end the call. We're just over an hour. I do want to just go back and saythat over the first six months that we've got the new management team in place,we have taken that direction that we've signed up for with the Board and madeconsiderable progress on those five objectives.

We can see profitability, butthat’s a breakeven profitability. And obviously into fiscal year 2009, '10 and'11 we expect this to be a growing business and that's gets into that secondobjective of growing epilepsy. We expect this to be a growing business andgrowing both on the top-line and growing the bottom-line by a greater amount.So, I think on those first two we're showing some good signs of progress.

To Herb and others I like to bemore transparent on objective number three around TRD and around the otherindications, that as all of you know until a deal was signed it's notappropriate for us to be talking about the specifics of what we're doing withbringing shareholder value to those other indications. We are focused andtrying to get VNS to as many potential patient populations as we can, to getthe answers to where VNS will be helpful and where it doesn't have a role.

So, I do think that internally,we're spending a lot of time on number three and four and as we do all four ofthose objectives, we're building a stronger company. So, in the first sixmonths and having Greg here for five of those months and James for four,whatever the numbers are overall and working with the management team, thesolid management team that was here, we have made considerable progress and welook forward to even more progress as we go out to Q3 and Q4.

And with that, I'll close out thecall by saying happy holidays to everyone; have a safe and great time with yourfamily and friends. And we'll talk to you next quarter.

Operator

This concludes today's conferencecall. You may now disconnect.

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