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Volcano Corporation (NASDAQ:VOLC)

Q4 2007 Earnings Call

February 12, 2008 5:00 pm ET

Executives

John Dahldorf - CFO

Scott Huennekens - President and CEO

Analysts

Mike Weinstein - J.P. Morgan

Tom Gunderson - Piper Jaffray

James Foster - Bear Stearns

Jason Mills - Canaccord Adams

Operator

Good afternoon and welcome to Volcano Corporation's fourth quarter 2007 conference call. During the presentation all participants will be in a listen-only mode. Following the formal comments, we will conduct a question-and-answer session (Operator Instruction)

As a reminder, this conference call is being recorded Tuesday, February 12th. A replay of this call will be available through February 19th by dialing 719-457-0820 and using the pass code 2432162 or via the company's website at www.volcanocorp.com. I'd now like to introduce Mr. John Dahldorf, Volcano's Chief Financial Officer. Please go ahead, sir.

John Dahldorf

Thank you and good afternoon everyone. With me today is Scott Huennekens, Volcano's President and Chief Executive Officer. Volcano ended 2007 with very strong momentum marked by impressive revenue growth, fourth quarter profitability excluding acquisition charges and important technology acquisitions, excellent positioning to continue executing our three-pronged growth strategy.

Scott will review the key operating highlights of the quarter and provide some perspective on our plans for 2008. I will then follow with review of our financial results and guidance for 2008 before we open up the call to your questions.

Before turning the call over to Scott, let me remind you that our prepared remarks contain forward-looking statements as defined under the Private Securities Litigation Reform Act of 1995. These include statements related to the guidance about anticipated financial results, growth strategies, product development and clinical trial programs, the timing and receipt of regulatory approvals, market acceptance of our product offerings, the functionality and capabilities of our products, any merger or acquisition activities as well as forward-looking statements that we may make in response to your questions.

Factors that could cause Volcano's actual results to differ materially from those forward-looking statements are described in our filings with the SEC including our 10-K for the year ended December 31, 2006, and our 10-Q for the quarter ended September 30, 2007. Volcano cautions you not to place undue reliance on forward-looking statements that speak only as of the date that they are made. Volcano undertakes no obligation to update publicly any forward-looking statements to reflect new information with events or circumstances as of the date they are made. Scott?

Scott Huennekens

Thank you, John and hello everyone. 2007 was a great year for Volcano and 2008 promises to be even better. As we have discussed Volcano's revenue and profitability, growth strategy consists of three key elements. Number one, growing our combined base of IVUS and FM business more than 20%, number two, expanding our technologies into new markets to increase our growth rate and access to available markets, and third, broadening our technology and market opportunities through acquisitions. During 2007, we achieved all of our major goals in these three areas and are very well positioned to continue the successful implementation of our strategy in 2008 and beyond.

For the seven straight quarters, since our IPO a year and a half ago, Volcano generated strong revenue growth that exceeded Wall Street consensus recording a 35% increase in year-over-year revenues and ending 2007 with a 27% increase in annual revenues over 2006. While John will describe our results in more detail, we benefited from the strong IVUS console placement and disposable revenue growth across all of our four major geographies.

As we have emphasized in the past, our ability to expand our installed base of IVUS consoles is a key driver in our growth. We believe that we are winning the majority of the integrated lab placements in the IVUS market. We also continue to maintain a roughly 50-50 split between revenues in the US and outside the US during the year, as well as 78% disposable and 22% capital.

In addition our FM business during the year showed solid growth of 19% bolstered by Europe, where FM revenues grew 45% and we see positive trends for this business segment going forward. We also completed our first acquisition as a public company during the quarter, CardioSpectra which I'll speak of in more detail shortly.

Our ability to grow the IVUS market and market share continues to occur despite a sluggish environment for PCI's globally. The global number suggest that PCI volume was down slightly in 2007 and declined about 10% versus the fourth quarter of last year in the United States.

However, in the fourth quarter, we generated IVUS growth globally in excess of 30% as mentioned earlier and Boston Scientific reported earlier this quarter IVUS volume growth in excess of 20%. These numbers will suggest that IVUS grew more than 25% in the fourth quarter year-over-year and is one of if not the fastest growing area of interventional cardiology.

The major players are indicating that the drug-eluting stent market has stabilized and with FDA approval of the Medtronic's Endeavor DES a couple of weeks ago and the projected approval of the Abbott’s Xience DES shortly we would expect to see renewed interest in the DES technology and hope for a return of growth to the PCI market generally.

As we have discussed with you in the past, we believe that there are two primary factors behind the growing use of IVUS, beginning with the increasingly positive clinical data demonstrating the value of IVUS. As a result, we believe that a growing number of interventional cardiologists are using IVUS to provide enhanced diagnosis and therapy guidance to prevent placement related complications that are believe to contribute to stent thrombosis and restenosis.

Secondly, the increasing ease of use and technology enhancement such as Volcano's and Boston's integrated IVUS systems that are simpler, faster and easier to use are facilitating adoption within the clinical community.

We have achieved some important regulatory milestones since our last call beginning with last week's announcement of FDA 510(k) clearance of our Revolution Catheter and FFR or Functional Flow Reserve technology on the s5 family of IVUS consoles. With these approvals physicians for the first time can choose among three powerful tools all available on the same integrated hardware platform.

These offerings make Volcano unique in terms of providing this level of integration, functionality and convenience on a single platform. Not only does this represent a benefit for the diagnose and treatment of patients, but we also believe it simplifies the buying decision for cath lab managers as they can now address any physician preference. We are initiating a limited market release of these offerings during the current quarter and we will ramp to a full launch in the next quarter.

Other key events in the regulatory area include the CE mark for the s5 family with our Rotational Catheter and FFR clearing the way for marketing in Europe. We are initiating our European effort again a limited market release this quarter and a full market release next quarter. So far the market reception has been very positive. In addition, we have submitted for approval for Revolution, our new s5 consoles in Japan and expect to have approval by the end of the second quarter.

During 2007, we placed 597 Volcano IVUS systems including 280 integrated systems versus 404 IVUS systems and 46 integrated systems in 2006. This represents growth of just under 50%. As we have emphasized, placing these new consoles in integrated systems is critical to our long-term success. With more than 6000 cath labs in the US, Europe and Japan, we are at the very beginning of the transition of the market from roll around consoles to integrated systems. We expect the rapid adoption of integrated systems that we saw in 2007 to accelerate in 2008.

We have pursued a three-pronged distribution strategy for hardware consoles including one in direct sales, two, partnering with [big irony] and geography companies and three, partnering with DES companies.

During the quarter, we announced the collaboration with Cordis Europe that will enable Cordis to offer their customers Volcano IVUS for use in Cypher DES procedures. We are delighted to be partnering with Cordis, as they have a major presence in Europe and this partnership is off to a great start.

Additionally, we have recently signed two new agreements in Japan. The first was with GE at the end of December. Also at the end of January, we reached an agreement with Siemens Japan, under which Siemens will begin selling their Artis and Angio Systems with our s5i IVUS. This agreement follows our market alliance in the third quarter with Philips, Japan to promote our s5i IVUS system with their cardiovascular x-ray equipment.

At the January CCT, the largest interventional cardiology meeting in Japan, all three companies exhibited Volcano systems in their booths. At this point, we have strong relationships established with [big iron]; relationships that Boston Scientific does not have.

As I referenced a minute ago the release of positive clinical data around the use of IVUS continues to be strong and we are driving hard on that front in a number of areas. As we announced last quarter, we are sponsoring the first major study to design to examine the role of IVUS and accurate stent placement and reduction of clinical event. The study is called ADAPT or Assessment of Dual AntiPlatelet Therapy with Drug-Eluting Stent.

This is a multi center registry of between 11,000 and 15,000 patients with coronary artery disease under going stent-assisted PCI using drug eluting stent. Enrolment has been initiated in the study; its main objectives are to determine the frequency and correlation of DES thrombosis and the relationships of aspirin and/or clopidogrel hyporesponsiveness and general platelet reactivity to early and DES thrombosis and late DES thrombosis.

There are eight centers in the IVUS protocol which will be a 3000 patients sub-study exploring the potential benefits of IVUS guided PCI to reduce clinical event. This is a major commitment by Volcano and there is a great deal of interest in the study. We believe the findings will help advance the field of interventional cardiology and more importantly patient care and confirm on a significant scale the findings of the stellar study and worked by other clinicians. We look forward to reporting on the trials progress going forward.

In addition to launching ADAPT, we are also initiating the new trial called BLAST or Bifurcation Lesion Analysis and Stenting of Thin Cap Fibroatheroma. This study will involve approximately 220 patients and we expect to enroll at five sites in the United States and 10 in Europe. Its primary objective is to demonstrate the great skill in VHIVUS our superior diagnostic technique to provide pre-interventional knowledge of the amount, composition type and location of atherosclerotic plaque in both our arterial branches of bifurcations when compared to information provided by pre-procedural angiogram.

There will be a blinded and non-blinded arm in the study and the data we look at 30 days, one year and two year follow-ups. We are now going through a center certification process and hope to begin enrolling patients in the trial by the third quarter. The lead investigator is [Dr. Terry Lafaye] of Institute Cardiovascular in France.

We are looking forward to the publication of data also from the IBIS-2 study in the next couple of months and possibly presentation of it at the American College of Cardiology Meeting next month. The PI of the study is Professor Patrick Serruys. IBIS-2 is a study done in conjunction with GlaxoSmithKline and uses IVUS VH tissue characterization to estimate the effect of Glaxo’s novel anti-inflammatory compound Lp-PLA2 inhibitor in patients with coronary artery disease.

Our IVUS technology was used to measure the impact of the drug on plaque burden, necrotic core and the numbers of thin-cap fibroatheroma plaque phenotypes. We are hopeful that the results will share the value of VH in monitoring plaque progression in total by tissue type and by plaque type. Positive results will lead to unique product labeling for GSK’s drug, future involvement of Volcano technologies and other major drug studies and a new paradigm, where understanding the plaque leads to different systemic therapy decision. We are very excited about these possibilities.

Based on information from outside sources and our internal numbers, we estimate the IVUS and FM markets finished 2007 in excess of $400 and grew approximately 15% during the year. At a $130.6 million in sales, Volcano has slightly more than 30% market share of revenues in the IVUS and FM markets. With the continuing market growth and market share gain, there is significant headroom for Volcano to continue to grow its based IVUS and FM business in excess of 20% for years to come.

I want to take a couple of minutes to update you on the second leg of our growth strategy. Expansion of our technologies into new markets, this includes our newly acquired OCT technology, image guided therapy products, vulnerable plaques and ICE, Inter Cardiac Echo.

I'll start with the CardioSpectra acquisition that we completed at the end of the year. We are very excited about the potential combination of OCT technology as a complement to IVUS technology. We believe that expanding our presence into clinical situations with extremely high resolution imaging or smaller catheter size is important.

As we announced at the time of the transaction, our long-term goal is to integrate the OCT functionality directly into our s5i integrated imaging suite of products as well as standalone OCT systems. We will be able to offer clinicians a complete multifunctional capability that seamlessly provides phased array and rotational IVUS functional measurement and OCT all in one system.

The imaging capabilities of this technology are truly remarkable, and provide significantly greater resolution in the near field than conventional IVUS, 10 microns versus 100 plus microns for IVUS. The Volcano OCT system consists of a console with advanced custom software, a pullback device and disposable catheters, much like IVUS.

We completed GLP animal studies in January and our plan is to have our first-in-man in the next quarter and live cases at PCR in May. Additionally, we expect to file for appropriate U.S FDA and European CE regulatory approvals this year and have product sales in these geographies in 2009. For Japan, we expect regulatory submissions in late 2008 or early 2009 and commercialization in early 2010.

Our initial focus with this technology will be in the area of stent placement, but we believe the technology has applications for other indication such as thrombus identification, pulmonary optical and cancer diagnosis and treatment. John will discuss the financial implication of this transaction during his comment.

Our image guided therapy development program is progressing on schedule. Our first product will be a balloon on IVUS on the same catheter. This family of products will have coronary and peripheral applications. Future plans will include a catheter with IVUS bare metal stents and balloon. We have met with the FDA on clinical trial design for the balloon IVUS catheter. During 2008 we expect to perform the necessary animal and human trial to submit for regulatory approvals in the United States, Europe and Japan with plans to begin commercialization of this first product in the US and Europe in 2009 and Japan in 2010.

Much like the other companies with product lines comprised of proprietary capital equipment and disposable such as intuitive surgical, we see our installed base of multi functional hardware systems being a key asset that we can leverage with additional disposable diagnostic and therapeutic devices. We will be using visualization and tissue characterization rather than robotic to guide faster, simpler and more effective therapy delivery. The installed base also represents a significant barrier to entry in the field.

Our vulnerable plaque program continues to be focused primarily around the PROSPECT trial, as we have discussed previously the results of two year patient follow-up in this study will be presented at the TCT in October. With the addition of OCT Volcano has solidified its position as the technology and clinical leader in invasive diagnosis of vulnerable plaques.

Given the results of PFO clinical trials and the market adoption of other minimal invasive structural heart therapies, we have slowed our investments in intra-cardiac echo in favor of the afore-mentioned program. We are continuing with the development of an ICE catheter and system and in the future, we plan to have an integrated systems with IVUS functional measurement OCT and ICE capability.

Before turning the call over to John, I’d like to highlight the key elements of the growth strategy for 2008 and beyond. In the IVUS area, we expect that stenting volumes will rebound based on new data and new devices, such as Endeavor and Xience. Helping us to grow the market share will be the continued rapid adoption of integrated IVUS systems and the launch of our Revolution Catheter and FFR Fractional Flow Reserve on s5 platforms in the US, Japan and Europe.

We'll also continue our aggressive console placement effort, as a vehicle to increase adoption in disposal revenue. This effort will be aided by both our partnerships with [big iron] and stent manufacturers as well as our initiatives to expand our US sales force and our direct sales effort in Europe and Japan. Complementing this product technology in sale and marketing effort will be our expanding clinical programs including the ADAPT and BLAST trials, I discussed earlier. In addition, we expect a growing volume of data from other trials to be available in the market during the course of the year.

As I mentioned earlier, we are also looking for continued strong growth from our FM business. We are getting ready to launch our new FM wire offering next quarter. As we have incorporated significant improvements in these wires during the past year. In addition, our ability to offer FM capabilities on the s5 family beginning next quarter in the US and Europe and in Japan in the third quarter will make the technology faster, simpler and easier to use.

Finally, we'll continue to explore potential strategic opportunities, the third-prong of our growth strategy. As we have made clear today, Volcano's growth prospects are excellent on their own and we do not need to make an acquisition to continue our growth, track record and achieve our future growth and profitability expectation. But, we'll look to expand our offerings where it makes sense, including coronary and endovascular therapies that can leverage our proven capabilities and product development, regulatory, manufacturing, sales and marketing.

We have been very clear since our equity offering last October that we are going to be very disciplined in our approach to acquisitions, including growth rates, gross margins, valuation and accretion criteria. Thank you again for joining us today. And I look forward to speak with you during the Q&A. John?

John Dahldorf

Thank you, Scott. Revenues for the fourth quarter were $40.0 million, a record for the company, and a 35% increase over revenues of $25.5 million in the same period a year ago. This brought total year revenues to $130.6 million, a nearly 27% increase over revenues of $103 million in fiscal 2006. As it has been the case in the more recent quarters, the growth in IVUS disposable revenues continued to be very strong, 46% versus the fourth quarter a year ago, including a 28% growth in the US. In addition IVUS system sales increased 18% in the fourth quarter of 2007 compared to the fourth quarter of 2006. I should note that our results benefited favorably from the release of revenues associated with prior stocking orders for the Revolution Catheter and Revolution upgrade kits in Japan. These revenues accounted for approximately $2.5 million of fourth quarter revenues.

With respect to revenue breakup for the quarter, consolidated sales of IVUS systems and related equipment were $8.8 million versus $7.4 million a year ago. In the US, IVUS systems revenues were $5.8 million versus $3.5 million a year ago. In Japan, they were $1.3 million versus $2.2 million and in Europe they were $1.5 million versus $1.5 million a year ago.

Scott mentioned the value of our growing installed base and during the quarter we placed 177 IVUS consoles compared to 150 in the fourth quarter year ago. It is also important to note that 107 of our console placements this quarter were the integrated unit versus just 44 in the first quarter of 2007.

Total IVUS console placements were 597 in 2007, a 48% increase over the 404 IVUS console placements in 2006. As we discussed in our last call, the market continues to move towards the integrated IVUS console and we would expect that trend to continue in 2008. By the way, we now have more than 3200 IVUS and FM consoles installed worldwide.

On a consolidated basis, IVUS disposable revenues were $25.9 million versus $17.7 million a year ago. In the United States, IVUS disposable revenues were $11.4 million versus $8.9 million. In Japan, they nearly doubled to $10.1 million versus $5.8 million and in Europe they were $3.8 million versus $2.5 million a year ago.

FM revenues in the quarter were $4.1 million versus $3.8 million in the fourth quarter year ago. In the United States, FM revenues were $1.8 million versus $1.5 million a year ago. In Japan, they were $332,000 versus $919,000. Please keep in mind though that we released some deferred revenue last year related for the ComboMap, and ComboWire, and in Europe they were $1.7 million versus $1.2 million a year ago.

Other revenues on a consolidated basis were $1.2 million versus $593,000 in the fourth quarter a year ago. Gross margin in the fourth quarter was 60% versus 61% a year ago and in the most recent quarter. Margins in the quarter were impacted versus a year ago, as a result of the onetime sale of Revolution upgrade kit for the IVG console in Japan.

Operating expenses in the quarter were $50.4 million, which includes $26.2 million of in-process research and development and other charges related to our CardioSpectra acquisition. Without these charges, operating expenses would have been $24.2 million. This compares with $17.5 million a year ago and $21.6 million in the third quarter.

Aside from the acquisition related charges increases in operating expenses year-over-year reflect our investments in our direct global sales force, marketing programs, research and development initiative, SOX compliance related costs and increased stock-based compensation expense. The growth in operating expenses from the third quarter is related to increased sales costs plus expenses associated with the TCT meeting in October.

On a GAAP basis, we reported a loss of $23.7 million or $0.53 per share. Again, excluding the acquisition related charges, we would have had income of $2.4 million or $0.05 per dilute share. In the fourth quarter of last year, we reported net income of $1.4 million or $0.04 per diluted share on a GAAP basis.

Excluding the acquisition related charges and stock based compensation expense, we reported net income of $4.4 million or $0.09 per diluted share. In the fourth quarter of 2006, excluding stock based compensation expenses of $901,000 we reported net income of $2.3 million or $0.06 per diluted share. Weighted average diluted shares in the quarter were $47.8 million versus $38.2 million a year ago reflecting the impact of our equity offering that was completed in the fourth quarter.

Turning to the balance sheet, we ended 2007 with a $189.1 million in cash, cash equivalents and short-term available for sale investments. This compares with $92.4 million at the end of the third quarter and $95.5 million at the end of 2006. Of course, two events impacted this balance. Our common stock offering in October that generated net proceeds of approximately $123 million and the $25.2 million cash outlay related to the CardioSpectra acquisition.

With respect to guidance for 2008, we'll provide the following metrics on an annual basis. Revenue, margin, operating expenses, GAAP earnings per share, earnings per share, excluded nonrecurring charges and stock based compensation and expected share counts. Also please keep in mind as we have discussed in the past, our IVUS system revenues can experience some lumpiness given that we may sell systems with features that will not be delivered until the future period. In these cases, we will defer the revenue until such time that the enhanced features are delivered and/or installed.

For fiscal 2008, we expect total revenues of approximately $158 to $162 million or an increase of approximately 21% to 24%. Gross margin for the year is expected to be in the range of 60% to 61%. We continue to implement manufacturing cost reduction programs to achieve our previously stated goals, annual margin improvement of 200 basis points to 300 basis points.

However, the gross margin percentage impact of these cost reductions will not be fully realized during the year, due to the sales of low to negative margin of Rotational kits for the s5 family consoles primarily in the second and third quarters. We expect to exit the year with margins in the ranges of 63% to 64% which should position us well heading into 2009.

We expect that operating expenses, which include our stock-based compensation expense an approximately $3.1 million of intangible amortization will be 64% to 65% of revenues. Our plan calls for increased SG&A spending, as we build out our sales and marketing programs in Japan and Europe and continue to make strategic additions to the US sales force.

In addition, we are planning to increase spending in research and development to fund the product development programs as well as new market initiatives and expanded clinical trial efforts that we discussed today. This includes $3.5 million to $4 million to support our OCT program, which accounts for about half of our R&D increase this year.

On a GAAP basis, we expect to report a net loss of approximately $0.02 to $0.04 per share. However, we expect to be profitable on a GAAP basis beginning in the fourth quarter. Excluding stock-based compensation expense of approximately $10.2 million Volcano expects to report net income of $0.16 to $0.18 per diluted share.

In addition to the margin expense issues, I just covered other factors impacting our outlook for 2008 including increased interest income resulting from our increase in cash balances and minimal interest expense. Weighted average shares outstanding at year end 2008 are expected to be approximately $47.4 million basic shares and $50.1 million shares on a diluted basis.

Before opening the call to your questions, I want to mention that we'll be presenting at the Cowen Healthcare Conference in Boston next month. Thank you again for joining us today. And now, we'll open the call to your questions.

Question-and-Answer Session

Operator

Thank you (Operator Instructions)

We'll hear first from Mike Weinstein with J.P. Morgan.

Mike Weinstein - J.P. Morgan

Thanks. Good evening, guys.

John Dahldorf

Hi, Mike.

Mike Weinstein - J.P. Morgan

Hi, John. Nice quarter, and maybe I just want to dive into it. First a little bit for return of 2008, some of the announcements you guys made here on the call. The strength that we saw, if we look at 2007 and the strength you guys saw obviously in placements, obviously your increased [MR] placements was pretty remarkable in '07 given all that what's going on in the cath lab. But we finally really started to see at the back half of the year, particularly in the fourth quarter, the disposable growth catching up with that. Can you just talk a little bit about what you think you are seeing in the cath lab, and where do you think utilization is [regardless] in the different markets?

John Dahldorf

Yeah. Mike if you look at Japan, the Yano Research numbers are showing that it's now growing to over 65%. Our estimates of the U.S. for that in 2007, it was 14%, but probably a little bit higher in the fourth quarter. And in Europe, it's such a dispersed market with Eastern Europe and Europe it's tough to get your hands around it. But it's probably still in the 3.5% and hasn't increased that much. We see increased use of IVUS. But we also see increased uses of FFR, and you saw that with our growth in the FM business, especially in Europe.

Mike Weinstein - J.P. Morgan

The U.S. market right now, just to focus on the U.S. business, that you said 14%. I guess our math is saying that's probably maybe actually higher than that. Do you think that -- is there a number that, as you exit the year, you think is more achievable then maybe we thought about six to nine months ago in terms of where that penetration can go, seeking obviously no change in reimbursement? As your thinking on that changed at all?

Scott Huenneken

No. No, I mean as we've talked about consistently without them, Boston is blocking and tackling its more advantageous, clinical data. Its increased speed on the street. Its more integration to eliminate the barriers to use train IVUS from the 15-minute procedure of the roll-in consoles to the integrated IVUS.

And so, we continue to see increases in IVUS usage in accounts that move to integrated platforms of the 20% to 25% range. So, we want to get our old systems converted. We want to get new customers converted, and all that leads to the IVUS market growing. So, if you do those things, you are going to have PCI growth we hope next year in the 2% to 3% range in the U.S, and then on top of that, just the roll-in effect of where we are at the market penetration wise, and if you add a couple of percentage points, you are going to have the IVUS market growing overt 10% in the U.S., and then we view it as we'll grow more than 20 as we continue to take share.

Mike Weinstein - J.P. Morgan

Your deferred revenue number actually went up this quarter, which we are assuming that it would come down at the end of the year. You can maybe just comment more on that?

John Dahldorf

Yeah, Mike. As we get closer to the introduction of the s5 with FFR and Rotational, we just saw an increased number of deals come across that included those advanced functionality. And so again the strength was in the pipeline of deal. We shift those. We invoice those customer started wearing catheters paying form, but we had to defer the revenue.

So, I mean, if you look across the entire year, we probably have deferred in excess of 50 consoles, and we've probably about $5.5 million what I'll call product revenue sitting on the balance sheet related to future elements that we'll be delivering next year related to this advanced functionality.

Scott Huennekens

So, Mike, our invoice revenue for 2007 was actually $135 million. So the growth was really from an invoice sales side even higher than the GAAP side pretty significantly and is a nice lead into the year.

Mike Weinstein - J.P. Morgan

Yeah, I understood - understood. Are you going to let me ask you -- as Revolution moves out, have you thought about disclosing to the street as Revolution becomes the bigger part of your disposable mix with that percentages?

Scott Huennekens

At this time, like we have --

Mike Weinstein - J.P. Morgan

The [average] right now, it doesn’t matter but in the year it will.

Scott Huennekens

Yeah. And I think that we kind of cross that bridge as we come to it, as we look at the business, and as we're seeing the markets developing, and as we kind of understand the market adoption.

Mike Weinstein - J.P. Morgan

One more question, John, and then I'll jump back in the queue. The one part that I want to make sure we understood better was the keyed into your referencing on the gross margin outlook for 2008. We've gross margins ramping up obviously over the course of the year along with revenues, but you are seamlessly suggesting that there is going to be a dip in the second and third quarters. I just want to make sure we are capturing that?

John Dahldorf

Yeah. You are absolutely right, Mike. I think what you'll is you will the first-quarter kind of at what I'd call our target margin of 200 to 300 basis points improvements. Then you are going to see the second, third quarters as we introduce upgrade kits to the marketplace. You'll see that margins get depressed a bit, and then in Q4 you'll see a kind of bounce back up. And then as I spoke, as we lead into 2009, we really expect it to be for the fourth quarter at the 63% to 64% range.

Mike Weinstein - J.P. Morgan

Okay, perfect. Thank you, guys.

Operator

Our next question will come from Tom Gunderson with Piper Jaffray.

Tom Gunderson - Piper Jaffray

Hi, guys. I'll continue on the gross margin side. But, for Q4, you said that it was a little bit lower as anticipated because of upgrade kits in Japan. John, I think we were talking about maybe 200 upgrade kits that you are doing to do in Q4 Goodman and Fukuda how did that turn out?

John Dahldorf

Yeah, we didn't quite do the 200 in the quarter. And we probably did about -- I think it's about a 125 to 150. We've got some of those bleeding into the beginning of 2008 really just from a material logistics perspective. So, but, the margin impact in Q4 was definitely driven by the upgrade impact in Japan. The impact of it in Q1 will be that it’s almost immaterial compared to everything else that will be going on in Q1.

Tom Gunderson - Piper Jaffray

Okay. And then sticking with Japan with Revolution approved on the IVG was there -- were there stocking orders with distributors in Japan for Revolution?

John Dahldorf

Yeah, in the quarter, between upgrade kits and the stocking order of Rotational Catheters, we estimate that it was about $2.5 million and of that about $1.1 million related to the catheters, just them filling up their distribution channel and their pipeline with catheters.

Tom Gunderson - Piper Jaffray

Okay, and with that new in the…..

Scott Huennekens

This is Scott; they are selling and flowing through the channel.

John Dahldorf

Yeah, they are not buying and holding.

Scott Huennekens

They are not buying and holding that’s…

Tom Gunderson - Piper Jaffray

I'm just trying to figure out -- maybe you can give color, Scott, as to the international growth on catheters was much higher than U.S., and I'm just trying to see if there is any, is that just through greater usage, or was there something else that added into that?

Scott Huennekens

No, it's the usage increase, and it's the installed base increase as well the Japan effect of having Revolution selling through ion the IVG's in Q4. So, we've taken share from Boston. We probably have 40 to 50 new accounts in the fourth quarter in Japan. They were using our products versus Boston.

Tom Gunderson - Piper Jaffray

Okay, thanks. Two more quick questions. One is, I just want to understand on ICE, that's going to the backburner, and OCT will be what you are putting more emphasis on for structural heart disease?

John Dahldorf

Not for structural heart disease, but in general relative to R&D priorities higher priority on the image guided therapy products as well as OCT. So, they will still have…

Tom Gunderson - Piper Jaffray

Okay.

John Dahldorf

…..have coronary and peripheral vascular application and we feel like they have higher revenue possibilities and pretty much in the same timeframes that ICE was and ICE were kind of moving back one year, slowing down some of our investments.

Tom Gunderson - Piper Jaffray

Okay. But I may have misunderstood when you are explaining this. But you are not substituting something else for PFO or AF ablation type procedures you are just pulling that down to take a greater opportunity with OCT in other areas?

John Dahldorf

And the image guided therapy products absolutely right.

Tom Gunderson - Piper Jaffray

Okay, and then…

John Dahldorf

Any confusion no they are different application, yeah.

Tom Gunderson - Piper Jaffray

Got it. Last question, and that is, Scott, you've mentioned in some of your presentations that when you get an integrated unit, your usage goes up by 25% as you've sold more integrated units is that percentage still holding?

Scott Huennekens

The percentage holds true for units that we sell. For units that our corporate partners sell is not as high.

Tom Gunderson - Piper Jaffray

Why is that?

Scott Huennekens

I think is the case of the hospital is in the buying mood of a new cath lab, and they want to buy with a warrant and need versus when we sell an IVUS system there is a motivated buyer, who is adding that to their system.

Tom Gunderson - Piper Jaffray

Got it.

Scott Huennekens

Just that settled different.

Tom Gunderson - Piper Jaffray

Thank you.

Scott Huennekens

Okay.

Operator

Our next question will come from Bear Stearns, Rick Wise.

James Foster - Bear Stearns

Hi good morning guys. It's [James Foster] filling in for Rick. Congratulations on the quarter. I just had one question. Scott, I know you touched on the potential acquisition in the cath lab. And I was hoping maybe you could expand a little bit on maybe timing, or is that something you should expect in 2008 and its potential impact on your fourth quarter guidance or GAAP profitability?

John Dahldorf

We've talked since the time we did our acquisition that we kind of have a two-year window relative to doing something, and we are six months into it. We're actively looking -- we're actively discussing things there is no way to put timing on it though.

James Foster - Bear Stearns

Okay. And I guess on the guidance, do you said this I mean obviously an acquisition would have, it doesn't include anything in your mind at the moment?

John Dahldorf

That's correct.

Scott Huennekens

No, the guidance does not consider any acquisitions.

James Foster - Bear Stearns

Okay. And also one other follow-up on the guidance, this is I'm assuming if I heard you right that this includes no pipeline products in terms of OCT or IGT products?

John Dahldorf

That is correct.

James Foster - Bear Stearns

Okay, I appreciate it. Thanks guys.

John Dahldorf

You welcome.

Operator

Next up is Canaccord Adams, Jason Mills.

Jason Mills - Canaccord Adams

Hey guys, congratulations on a good quarter. I want to follow-up on Mike's question. John, on the gross margin side: First, could you help us out with respect to the Cadence, if we are looking at the first quarter on a year-over-year basis? You had a really strong first quarter of '07. So I'm hesitant to sort of balance 65.5% gross margins unless you are comfortable with that, so may be help us there?

And then the back part of the year as you expect to exit in the 63 to 64 range? When you look at 2009, we are modeling that, and you are talking about 200 to 300 basis points -- are you talking perhaps 200,300 basis points on a pro-forma gross margin, assuming that the year would be sort of what the fourth quarter would be excluding these upgrades? And therefore we're looking sort of mid-60s, or should we be looking at 200 to 300 basis-points on what you actually report?

John Dahldorf

Yeah. Well first of all, you've asked a couple of questions in there. So let me kind of….

Jason Mills - Canaccord Adams

Sorry about that.

John Dahldorf

That's all right. I see Q1 of '08 being very similar to Q1 of '07. As you recall, Q1 of '07 was just an exceptional quarter for us from a margin perspective. So, I think Q1 kind of on par with that in '08. When I see, Q2 and Q3 again dipping down, and then Q4 again, as I mentioned exiting in the 62% to 63% range. So, then if you look at the 60% to 61% for the year so as I look at '09, I really kind of look at '09 as I'm exiting the year. So, if I'm exiting the year at 62% to 63%, I'm looking at 200 to 300 basis points on top of that 62% to 63%, and that's we would average for '09.

Jason Mills - Canaccord Adams

Well, okay, that'd be quite impressive, thanks. And then to follow up, Scott, on the top line. So help me with the math, just with respect to your IVUS business. I guess looking at the total revenue, a few invoiced revenue in '07 of $135 million, help me and you did $2.5 million, sort of, "non-recurring" or non-sort-of-procedure-related IVUS? If you kind of think about this in terms of what you are growing your business from a procedural standpoint, what was your guidance of a 158 to 162?

The first question would be out of that guidance -- what is included in there, and the 2Q, 3Q upgrade kits that you mentioned, and how does that relate to the invoiced revenue next last in 2007? And what does that imply for year-over-year sort of IVUS growth, because it seems like your guidance would suggest some conservatism if you're looking at growing your IVUS business over 20% and for using that 135 relative to say, an x upgrade of in the 155 range?

Scott Huennekens

Yeah, overall, Jason, you can expect that we're always going to have some of these deferred revenues. So, we're going to have software upgrades this year. We're going to have OCT coming out at the beginning of next year. There are constantly going to be some of those things. So, when we speak of growing the 20% it's, on the GAAP-to-GAAP revenue, and it may be that invoiced revenue again grows faster like it did this year, and we have a deferred number that grows a little better stays relatively constant, John, on the middle-of-the-year upgrade question.

John Dahldorf

Yeah, the upgrades -- and remember, in this year we probably had little over $2 million of upgrade kits in Japan this year between Q3 and Q4. Next year upgrade kits on worldwide basis revenue wise will be probably around $3.5 million, one the s5 family of products. And like I said that we'll see most of that I think in Q2 and Q3.

What Scott kind of mentioned is that you've got these things, and they happen, and again that's why I always go back, and I refer to the lumpiness that we've in IVUS systems business is that you have these upgrades, you have these timing of these deferrals. And like Scott said, these deferrals -- it's always very difficult to forecast them and how much you're going to be taking on as deferrals. Once it's deferred, we usually have a pretty good idea of when these are going to rollout, and they are part of our guidance here, but again it's very hard to determine.

So, the way we look at it, and the way we model it from the P&L perspective is that we factor some conservatism in it. We're trying to take a step back, and we think -- all things being equal -- we're comfortable with the 20% to 23% growth year-over-year. So, that's the guidance that we were given.

Jason Mills - Canaccord Adams

Right. So, my math is right, backing up $3.5 million and then the $2.5 in '07, you are modeling sort of 21% to 22%, so that makes sense?

John Dahldorf

Yeah.

Jason Mills - Canaccord Adams

Okay, last question, and I'll get back in queue. I wondered if you've received any feedback for your sales reps on the street with respect to drug-eluting stent-pricing in the cath lab of early days. I know but Medtronic did sign an agreement with the GPO, you are just curious anecdotally if you are hearing about what changes in pricing from a drug eluting stent perspective with what are the obvious implications being if they go down, there is more room in that bucket for [AVI's]?

John Dahldorf

I've not heard any feedback today to this point. But it's something I'm looking forward to hearing from our sales force. We have our global sales meeting this week; it started today. So, we'll be there the rest of the week, and it's definitely something I'm going to be asking about, and it something we think will probably happen that there will be some erosion in pricing with both Endeavor, Xience and Promus on the market this year.

Jason Mills - Canaccord Adams

I think you set yourself up for the lot of calls in the next week, Scott. Thanks a lot.

Operator

And that does conclude the question-and-answer session. Mr. Huennekens, I'll turn the call back over to you for any additional or closing remarks.

Scott Huennekens

Okay. Thank you again for joining us. We are really looking forward to a great 2008 and helping more patients until next time, we'll talk you then or see at different meetings. Thank you.

Operator

Again thank you all very much for joining us today. That does conclude the presentation. Have a great afternoon.

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