Cyberonics, Inc. F3Q08 (Qtr End 1/25/08) Earnings Call Transcript

Feb.27.08 | About: Cyberonics, Inc. (CYBX)

Cyberonics, Inc. (NASDAQ:CYBX)

F3Q08 Earnings Call

February 20, 2008 9:00 am ET

Executives

Daniel J. Moore - President and Chief Executive Officer

Gregory H. Browne - Vice President, Finance and Chief Financial Officer

David S. Wise - Vice President, General Counsel and Secretary

Analysts

Thomas Gunderson - Piper Jaffray

Keay Nakae - Collins Stewart LLC

Steven Lichtman - Banc Of America Securities

Anthony Petrone - Maxim Group

Andrew Cowen - Tricadia

[Avi Danitar - RHO Capital]

Operator

At this time I would like to welcome everyone to the Cyberonics Investor Conference Call. After the speakers remarks there will be a question and answer session. (Operator Instructions) Mr. Dan Moore, President and CEO, you may begin your conference.

Daniel J. Moore

Thank you Constance. Thanks to all for joining and welcome to all to our third quarter conference call. I will be joined by Greg Browne. To begin I will ask David Wise our General Council to read the Safe Harbor statement.

David S. Wise

Thank you, Dan. This presentation includes forward looking statements. Forward looking statements may be identified by the use of forward looking terminology including; may, believe, will, expect, anticipate, estimate, plan, intend, forecast and other similar words. Statements in this presentation are based on information presently available to us and assumptions that we believe to be reasonable. Investors are cautioned that all such statements involve risks and uncertainties. Forward looking statements in this presentation concerning maintaining cash flow positive operations and achieving GAAP profitability, growing our epilepsy sales including full commercial launch of the demipulse generator by the end of Q4 FY ‘08, executing the plan to set and fund a separate TRD entity, conducting new clinical studies in TRD, developing new indications and collaborations with partners, resolving legal and financial issues, and improving communications with external stake holders. Our actual results may differ materially. For a detailed discussion of the factors that may cause our actual results to differ, please refer to our most recent filings with the SEC including our form 10-K for the fiscal year ending April 27, 2007.

Daniel J. Moore

Thanks, David. For those of you who need a printed out presentation or are viewing the presentation from the website, I will be starting on page 3 with the topics. I will review the progress on our strategic priority and give an overview of the sales analysis and then I will ask Greg to highlight the financials for last quarter and for the year to date before we move into our direction going forward for the rest of 2008 and into 2009. Then we will open it up for the usual questions and answers.

It was about a year ago this time when the new board came together and [Quinton] gave us 5 strategic priorities. I joined the company on May 1 to address those 5 strategic priorities. Those were first and foremost to achieve cash flow and GAAP positive P&L. Second, to grow our core epilepsy business. The third was to figure out what our depression strategy should be going forward. The fourth was to look at our intellectual property and explore partnership opportunities. The fifth was to build a new company for the future. I am pleased again to report significant progress on all of those objectives. I trust that by the end of this call you will agree. Let me start with the leadership team. As I said, I joined the company in May. I was fortunate enough to be able to get Greg Browne to join in July as our chief financial officer. In August we were joined by James Reinstein who has lead Sales, Marketing, and International.

I also want to report with mixed emotion the retirement of Richard Rudolf. The mixed emotion comes because before Richard came to Cyberonics he had an objective to be able to retire within 5 to 7 years. I am happy to say that he is able to do that and happier to say that he has agreed to stay on with us part time to help us in any areas of his expertise including depression. The four of us will be joined by George Parker, Randy, and David to make up the senior management team as we search for Richard’s replacement. The leadership team remains strong, growing and getting stronger.

The second objective around profitability. We are ahead of plan when it comes to profitability and I am pleased to report our operating profit in the last 3 years. Also, we achieved positive cash flow from operations, again the first in 3 years. We are on the road to profitability and our goal for Q4 remains GAAP profitability as well. Third area is epilepsy. We have talked about the need to grow the epilepsy business and I am pleased to report that James Reinstein and his sales team have grown US unit sales in Q3 by 9% over the prior year. We also witnessed again strong international unit sales growth of 17%. In the last month of the quarter in January we took our first price increase in 3 years. While that price increase had minimal impact on Q3, we do expect significant benefit from that price increase in future quarters.

Fourth, in the area of depression. We told you in the last call that we would provide more color to our strategy. We have made significant progress in 3 areas. First the clinical pathway. We believe we have solidified the approach by working with both our physician advisors and our external consultants. We have identified a path to reimbursement. Second, we analyzed the situation as a management team, we came up with a recommendation and the board agreed that the best thing to do is to consider a standalone entity and to seek a financial partner for the execution of the plan that we put together. Third we have chosen an investment banker to work with us on this process. So, good progress in depression overall. The demipulse generator remains in limited release and we are still on our goal of full commercial release by the end of this quarter.

Next area, partnership. As you saw on the quarter we out-licensed the obesity patents and we in-licensed on an exclusive basis patents for VNS around stroke and traumatic brain injury. Finally, when we look at the team, the entire Cyberonics team, it is coming together as one team to work on the strategic business plan that we have in place. Let’s not forget the most important thing that we do. We return quality of life to patients. Like a 58 year old woman in Boston who was having up to 20 seizures per day, was on up to 20 medications per day, and had VNS. Her life is simply changed significantly since being implanted with VNS last August. Stories like that will allow us to continue to have a strong replacement business going forward.

What I would like to do now is get into more detail on what James Reinstein and the global sales marketing teams have been able to accomplish from a sales prospective. I am moving to slide 8, the generator unit sales by indication and geography. As I mentioned we had 9% growth in domestic units, 17% international, double digit 11% epilepsy growth overall. PRD continues to have issues on the commercial inside with 41 implants for the quarter.

Moving to slide 9, Total Revenues. You will see a 13% increase in the domestic business for epilepsy. That was $4.2 million in new epilepsy dollars for the quarter versus the prior year. You will see a 34% growth in the international business which was helped by the impact of currency exchange, however that strong double digit growth that we have been looking for and talking about is becoming a reality as you see a total of 17% growth in our epilepsy franchise, the key to our overall company. We also witnessed an overall $6.7 million decline in quarter 3 of last year in TRD, however going forward we expect our top line quarterly comparisons should become easier due to the steady declines in TRD implants that we have seen during the past quarters.

Let’s look at unit sales by product line. Moving to slide 10, in generators overall for epilepsy overall we saw an 11% growth and in leads we were down 5% versus last year yet up 5% versus prior quarter. One of the reasons we have looked at these unit sales by product line is that with the assumption that these numbers now could provide an indication of the replacement business by taking the difference between generators sold less leads for the quarter. We have come with a second approach to look at end of service as well. I am looking at slide 11 now. When we look at the models and the factors that might impact the service, when we look at the 3 models that we have marketed in the past, there are several factors that contribute to end of service. Factors like battery life. You will see that there are 2 different battery lives, 3 to 8 years with the model 101.02 and 5 to 11 years with the model 101. Obviously the parameters that are set on each device will also have an impact on the actual life of the battery. As we attempt to estimate end of service you can see overlaps in the shipment periods between models and only the model 100 is through its full product life cycle. Also I want to caution that we don’t get all of the implant cards. Although we are providing more data in an effort to be able to predict end of service it is far from being an exact science and investors should exercise caution in using this data or the data on the previous slide in estimating the replacement generator potential.

As I talked about in the last call we are excited about end of service because that means that those are patients who are coming back and have benefited from the VNS therapy enough that they are willing to go through another surgical procedure to have another implant. However, we think it is just one small part of our growth going forward. Future growth should be driven by new patients, average selling prices, international expansion and improved efficacy, improved clinical results, more R&D, new indications, new patients. I don’t want to get out of proportion here on the importance of end of service, but we did want to provide some more visibility to how you could make some assumptions around the end of service.

Let’s move on to ASP by geography and product line. As mentioned ASP is another way that we can grow our overall revenues. When you look at the last 4 quarters for our domestic generator business you can see significant increase quarter to quarter and more importantly year over year an 11% increase in our average selling prices. The international business, the 13% increase is driven by currency exchange as well. We do think that there is more room on the average selling price. With that sales overview I would like to turn it over to Greg who will discuss our progress to profitability.

Gregory H. Browne

Thanks Dan. We are going to discuss the financial results for our fiscal third quarter compared to the second quarter and the third quarter of last fiscal year as well as the year to date results, balance sheet and cash flow. Dan has already provided the rationale behind the revenue changes over the last year and the last quarter. Turning to slide 14 comparing ourselves with the second quarter of this fiscal year, I would like to say that we are very pleased with the progress we have made with respect to our overall net loss. It has declined from $8 million in the first quarter to $4 million in the second quarter, and now to approximately $1 million. This was also the first quarter in several years when the increase in epilepsy revenue offset the decline in TID revenue. Due to continued strong growth our international revenue now comprises 24% of total revenue. You will see that our expenses were some $4 million lower than in the second quarter, driving s Dan said, our first operating profit in over 3 years. The major components of this reduction were the headcount reductions announced last quarter and reduced marketing expenditure, particularly on the depression indication.

Into the comparisons with the third quarter of last year, with our increasing epilepsy revenue which was up $4.2 million or 17.3% on the prior year. Our overall revenue declined compared to last year with 7.4%. When we reported last quarter this decline was at 15% and we are therefore starting to overcome the negative drag of declining TID sales. Our gross margin declined modestly this quarter due to increased amortization of reserves and additional production costs associated with our new model. We expect to see improvements in this number in Q4 and into next fiscal year. We continue to look at all areas of the business for expense reductions in the third quarter. As we announced last time we restructured the lease on our headquarters. We will expect to reduce our lease expense by over $500,000 in fiscal year ‘09 as a result. During the third quarter we terminated our line of credit, as we believed our cash position had continued to improve and the facility was unlikely to meet our ongoing needs. The current quarter included costs of $400,000 relating to the termination of the facility and a write off of deferred line costs of $260,000. These were one off items. The quarter also included payments on regular interest of $175,000 through the termination date of January 14th.

Our third quarter also included the benefit of reduced interest costs of about $200,000 when compared with the prior quarter. With respect to our year to date results our epilepsy revenue is up 9.4% year to date. When we reported this number last quarter it was at 5.7%. You will also note as Dan mentioned earlier the significant drag on revenue comparisons from the decline in TID related sales. This decline is over $90 million on a year to date basis. As we stated on our last call, we expect our fiscal fourth quarter revenues to be at the highest level of the year. Included in that are our expenses for the current quarter are our equity compensation costs of $2.7 million, expenses directly attributable to the depression indication of $2.5 million. This comprises the reduced spending on commercial activity and the cost of the ongoing post approval trials. We also had the benefit of some insurance receipts and other credits totaling $600,000 during the quarter. Our expectation is that expenses will rise modestly in Q4 and into next year. Having achieved one of our major goals this quarter, that of positive operating cash flow, we are now planning for consistent and growing profitability.

Turning to the balance sheet and the cash flow, as you can see our balance sheet continues to improve with cash balances increasing due to positive operating cash flow for the quarter of $2.5 million. This was achieved even without the impact of the $9.5 million license fee received in December and note that we also repaid $7.5 million on our line of credit during the quarter plus related costs. We are pleased with the continued reduction in inventory levels down by $3.9 million this year as well as maintaining our DSO at reasonable levels. Capital expenditure remains at low levels and well below the depreciation and amortization expense of $700,000 for the quarter and $2.4 million on a year to date basis. I am now going to turn it back to Dan for his closing comments on our ongoing focus for both the current fiscal year and our early thoughts on next year.

Daniel J. Moore

Thanks Greg going to slide 21 where we talk about our management focus for the rest of this year and into ‘09. First thing that we need to think about is to continue to search for partnership opportunities. Those will be around the neuro call point and we are open to various forms of collaborations beyond the IP deals that you have seen in the last quarter. Also we expect to complete a transaction around the TRD business. When we look at that continued depression effort, other neuro-modulation players have recently acknowledged a market of some 4 million patients. We believe there is significant potential market here and we believe we have the clinical pathway to reimbursement and that we need to finish our discussions with [Pares]. We also believe that depression is at a different stage in its development cycle that epilepsy.

Depression for us is a bit unusual. It is far from being a start up in its early development. The product is designed, developed, manufactured, it is through clinical and regulatory and we have one key milestone left to achieve, yet there is a lot of work to be done to grow that into the business it can be to help some of those 4 million patients. Very different from epilepsy where we expect continued double digit growth that will also require its own set of unique investments. With that in mind this management team made a recommendation to the board, and the board agreed, that we should consider a standalone entity and seeking a financial partner to help us execute on that plan. Also speaking to the board as outlined in the press release, the board has authorized a stock buyback of up to 1 million shares using open market purchases. Clearly this management team believes and the board agrees that the stock at current levels is significantly undervalued. As Greg said, now that we have achieved a position of operating cash flow, we believe the timing for such activity is right.

Let’s come back to the core business, the growth in epilepsy. Our goal remains to get demipulse into a full commercial release by the end of this quarter. We expect consistent growth in all markets. There are at least 2 to 3 million patients with epilepsy in the US and we believe there are 400,000 who could benefit from VNF therapy. Seizures and epilepsy are the second most serious neurological condition after stroke. Recent publications suggest that those numbers are on the rise. 125,000 new epilepsy patients appear in the US each year according to the NIH. Hospitalization increasing from 2000 where there are 47,000 hospitalizations due to epilepsy to 2005 where there were 71,000. This is a significant condition and VNS will play a key role in neuro-modulation for epilepsy going forward. We believe we still have a lot of opportunity in the international front and have recently increased our representation in the Middle East. We believe that there is a lot of development that can be done to improve the efficacy of VNS therapy for epilepsy and we intend to make those investments as well. Bottom line is that we expect continued growth in epilepsy as we reach more patients and change their quality of life. Also, be assured that we are focused on more improvements to the operating results. While we are excited about getting close to profitability, we are only close and we expect to grow our profitability from Q4 and well into 2009 and beyond. The bottom line is that we have identified a plan, we are executing against that plan and the key to this will be to continued execution. With that I would like to turn it over and open up for questions and answers.

Question-and-Answer Session

Operator

(Operator instructions) The first question comes from Thomas Gunderson of Piper Jaffray.

Thomas Gunderson - Piper Jaffray

Good morning. I am going to focus on epilepsy for three questions if I could. On the price increase you took in January, could you put a number on that?

Daniel J. Moore

It is close to double digit price increase on the Model 102.

Thomas Gunderson - Piper Jaffray

Thanks. One the US sales force, Dan, do you think you have a good geographic spread right now and that your are catching all of the major metros and you have the territories focused the way you want?

Daniel J. Moore

Yes Tom, I think in the last call I mentioned we have approximately 70 reps. I think that is plenty to cover the number of centers we have. The key to growth will be to penetrate those centers that are already performing VNF. I do think we have the coverage we need.

Thomas Gunderson - Piper Jaffray

Sticking with the US sales force, since last spring can you give us some sense of how the sales incentives have changed so that the sales individual territory managers are focused on epilepsy?

Daniel J. Moore

I think that the first focus was to get a team of people focused on epilepsy instead of depression plus epilepsy. As we have spoken about in past calls, I think there was much more emphasis on depression. The key factor here is that as we pay reps to sell product and bring revenue to the company. The commission models have been simplified around epilepsy and revenue for epilepsy.

Thomas Gunderson - Piper Jaffray

Sorry to get into this in detail but I think it is important to look forward and I am curious about the incentives. Do they have special incentives for new users and for growth year over year?

Daniel J. Moore

No, we don’t have special incentives for new users but for growth they get paid to achieve a plan. Those plans include growth and the expectation of growth.

Thomas Gunderson - Piper Jaffray

Okay, then the last question I will get back in queue for this. You gave a couple slides on retention and re-implants. Do you have a historic number? Is it north of 90% of patients who get VNS receive a re-implant eventually?

Daniel J. Moore

We don’t know the actual number but tom if you use the numbers that were provided in the slide where we worked though the Model 100 it is about two thirds of patients.

Thomas Gunderson - Piper Jaffray

Okay.

Daniel J. Moore

Via our implant cards, but again that is an imperfect science.

Thomas Gunderson - Piper Jaffray

So it is at least two thirds?

Daniel J. Moore

We know of two thirds.

Thomas Gunderson - Piper Jaffray

Got it, thank you.

Operator

Your next question comes from Keay Nakae of Collins Stewart.

Keay Nakae - Collins Stewart LLC

Good morning. My first question is on demipulse. What is left to do there before you commence with a full launch and as far as pricing on that, you just took an increase on the 102. Will we still look for a premium for demipulse over the new higher price for the 102?

Daniel J. Moore

On the demipulse I would say yes we still fully expect to get a premium for that product. It does things that the Model 102 doesn’t do and we are preparing for full launch by the end of this quarter in which we would put accounts into waves and release the product wave by wave to the various accounts in the US and international.

Keay Nakae - Collins Stewart LLC

Versus this most recent increase on the 102, how muchof a percentage higher are we looking for on a price on the demipulse?

Daniel J. Moore

What we said is that we expect a double digit premium on demipulse over the Model 102 and we expect that spread to still be there.

Keay Nakae - Collins Stewart LLC

Okay, what is your spec 2 depression? Can you give us more detail about where you are at with your plans for a new randomized control study?

Daniel J. Moore

I think the thing that has changed since we last talked is that not only have we had additional meetings with our external consultants who are experts in the area of reimbursement, we also convened a meeting with our physician advisory board and locked in on the clinical path that we think will be required and will help us get to reimbursement.

Keay Nakae - Collins Stewart LLC

So what are looking at in terms of the timing of doing this clinical work and completing it?

Daniel J. Moore

I think we are going to continue on the path we were on so the next thing for us is just to solidify meetings with payers to share that plan that we developed with those external experts and our physicians and once we have done that, we will continue on the path of putting a clinical study together. You still need to go through the IRBs and everything that is require for a randomized control trial with the center, so first would be meet with payers and second would be start getting up to speed and ready to go in the sites themselves.

Keay Nakae - Collins Stewart LLC

Is that something that we should expect you to commence this calendar year?

Daniel J. Moore

I would say yes it should be done this calendar year.

Keay Nakae - Collins Stewart LLC

Finally with respect to the structure, can you give us some thoughts of some of the different types of structures that you are at least thinking about at this point for the depression enterprise?

Daniel J. Moore

I don’t think the structure would be much different than what we have in place. An all commercial team supported by a clinical group that would help conduct the study.

Keay Nakae - Collins Stewart LLC

The entity itself in terms of splitting it off, you bring in a financial partner and I think obviously the goal is to try and offload some of the expenses off your balance sheet. Is that the primary aim there?

Gregory H. Browne

If I could interject, I think it is still very early in the process. As Dan mentioned, we have appointed an investment banker and we are embarking on a process to seek a financial partner. It is likely that it would involve the establishment of a standalone entity, the transfer of our depression indication and related commercial activity to the standalone entity and investment by a financial partner in that entity. As we said in the press release, we would expect to maintain at least a minority interest and obviously that would have an impact from a cash standpoint and perhaps more significantly from the burden on their income statement. That is the general force but as I said this is very early in the process and it will take some time to bring to fruition.

Daniel J. Moore

We remain equally excited and optimistic about what can be done in depression, but the other side of the businesses as we have looked at it over the last 9 months and planned our business going forward we come to the table with even more confidence around the potential with epilepsy. We have suggested that we thing that business should be able to grow by double digits not only in the short term but in the medium term and the long term. To keep it growing in the medium and long term we recognize that we need to improve the efficacy of VNS therapy for epilepsy to get further penetration. That is going to require some clinical work and that is going to require some R&D work. There is investment required on the epilepsy side of the business and we think that is a standalone business that will do quite well and there is investment required on the TRD side. If we were a billion dollar business perhaps we could afford to do both right, but given our situation as a $120 million to $130 million company, you look at that and we can do one and a half of those well or we can choose to approach each with a three quarters effort. We don’t think that is the right thing to do to maximize shareholder value. We think it is the right move to split the two and really find a financial partner to help in TRD.

Keay Nakae - Collins Stewart LLC

I don’t disagree with the logic. Does that structure need to be in place before you commence your new depression and study?

Daniel J. Moore

No, we are going to keep going. We haven’t stopped from the day I came in here on May 1st. I know the team was spending a lot of time on TRD. Although we haven’t talked a lot publicly about TRD, we have spent a lot of time on the depression indication while we are managing the epilepsy business and preparing that for mid and long term growth. We have kept our eye on sorting through the opportunities in TRD. That is actually how we ended up with the recommendation to the board that we consider splitting the indications in the company.

Keay Nakae - Collins Stewart LLC

Okay great thank you.

Operator

Your next question comes from Steven Lichtman at Banc Of America.

Steven Lichtman - Banc Of America Securities

Following up on that last question relative to the clinical work on TRD, you mentioned completing this year, was that the entirety of the clinical work or just the plan or what were you referring to?

Daniel J. Moore

Completing the start up, getting the protocol out to the centers, getting IRB approvals and beginning enrollment.

Steven Lichtman - Banc Of America Securities

Over on epilepsy, is there any way they give us a sense in terms of the unit growth, to what extent would these new customers versus same-store sale growth in current customers qualitatively?

Daniel J. Moore

If you look at the one technique we used last quarter to look at the end of service versus the new units, you would see from Q3 to Q4 that the end of service units via that estimate would have decreased. We don’t want to spend a lot of time trying to sort out… There was an earlier question about commissions and do you pay on new versus end of service, it is too easy to get wrapped up in that one area, that one point, we are looking at this as management team and the fuller group of the sales force and saying there is an opportunity here to grow this business in so many ways that we are not spending a lot of time Steve on the end of service thing. That is why we laid out what we know about it and we are optimistic that as we grow implants and VNS therapy works for patients where their drugs have failed them, overall that number is going to go up. Looking at it quarter to quarter, we would rather be coming back and just showing a growing business overall. That business is growing overall because of international expansion, ASP, penetrating accounts further. We are not going to spend a lot of time trying to track the replacement business.

Steven Lichtman - Banc Of America Securities

Actually I was referring more to the new business and trying to get a sense of maybe perhaps more qualitatively where the focus is. Is it really re-doubling efforts on previous or current customers and getting deeper, or have you been able to pull in new customers? It is really on the new business that I was referring to.

Daniel J. Moore

It is focusing on the customers that we have and trying to improve the penetration with those customers. By definition that would be new patients. There is an emphasis on just don’t take the low hanging fruit, go out and find and help customers find the patients that would benefit from VNS therapy. The woman I referred to earlier had her first episode, her first seizure when she was during her first pregnancy at 21. She is 58 today. 37 years later she got her VNS device after being up to 20 pills a day. We think that when you hear stories like that and now she is down to 2 seizures a day, we think we need to get to more of those patients. She would be considered a new patient because she hadn’t had VNS. We have got to do a better job of helping physicians get to those types of patients earlier in their treatment cycle.

Steven Lichtman - Banc Of America Securities

I wasn’t sure if you touched on this. In terms of more clinical work being done on the epilepsy side, can you update us on that, any new plans on that front?

Daniel J. Moore

As we talk about partnering with our physicians, we talked about data mining. We didn’t talk about that on this call, but that effort remains as our sales reps have identified the top 100 accounts or so around the country, those aren’t top necessarily defined by revenues but top epilepsy centers. We have a data mining exercise that is still under way after having identified the accounts that we think offer something different in VNS for treatment of epilepsy, that is the first part. I think beyond that as we have been putting together our 2009 plan, there is not only an R&D component to that plan but there are clinical considerations as well to focus our dollars on clinicals around the epilepsy indication in addition. I think more on that will come out over time.

Steven Lichtman - Banc Of America Securities

I have couple financial questions for Greg. Can you give us what constant currency international in total growth was in the quarter?

Gregory H. Browne

Steve, I don’t have the precise constant currency growth numbers but clearly the total amount contributed to growth from the currency impact over last year was about half a million dollars. When we look at the international growth number of 33% about a third of that would be coming from the currency side.

Steven Lichtman - Banc Of America Securities

On the operating expense you mentioned credits of $600,000. What was that and was it in SG&A?

Gregory H. Browne

It is in SG&A and it reflects some insurance proceeds for some of the legal costs associated with the ongoing litigation and reflected approximately $100,000, some of the entries associated with restructuring our lease and deferred rent as well as some reduced accruals relating to past clinical commitments.

Steven Lichtman - Banc Of America Securities

So the messages on the operating expense side, we are expecting it to grow from an absolute level from here but you anticipate sales growing faster then?

Gregory H. Browne

We do expect it to pick up modestly from here as we go forward, yes.

Steven Lichtman - Banc Of America Securities

Lastly, gross margin goals, medium to long term, you mentioned that it should up-kick. Are we talking about getting it to the mid 80’s?

Gregory H. Browne

I think our expectation and obviously we haven’t finalized our plans for the next fiscal year but our expectation is that we will be back up around 84% for next year and obviously we will have to do better.

Steven Lichtman - Banc Of America Securities

Thanks guys.

Operator

Our next question comes from Anthony Petrone of Maxim Group.

Anthony Petrone - Maxim Group

I guess an all way around approaching the penetration of the market, I think Dan that you mentioned in previous calls a number of 30% penetration into existing neurologist accounts or I guess said another way; some of your existing neurologists are treating 3 out of 10 patients that would be potential candidates for VNS. Has that number changed at all in the past 90 to 180 days?

Daniel J. Moore

I can’t say that we have looked at it that way. I would say that our approach in trying to improve the penetration actually goes down to a territory, a hospital, and then a physician level. That is the approach we are using. By that we have started to look at who is prescribing on the neurologist, epileptologist side and how many are they prescribing per month, then working with our sales force to understand the denominator in each one of those equations. The denominator in each one of those equations. How many patients did that physician have that had epilepsy and is he or she prescribing more or less than what would be consider average? Bringing that up Anthony, to a global number, we haven’t done that. I think you build this business territory by territory, hospital by hospital, physician by physician. That has been more the focus with James and his team expecting them not only to hit plan but that given the growth in the global numbers of 125,000 new epilepsy patient in the US each year, we should be growing hospital by hospital, physician by physician.

Anthony Petrone - Maxim Group

Taking that into consideration penetration into starting going up the chain into the top tier hospitals you mentioned maybe 100 or so top hospitals. Are you in all those hospitals at this point? Are you still looking to get into some of those top hospitals?

Daniel J. Moore

We are adequately covering more than those hundred hospitals.

Anthony Petrone - Maxim Group

Moving quickly to depression. I think you still have some sales in clinical [inaudible] pending transaction.

Daniel J. Moore

We don’t expect it to change and it is true that if you are referring to a commercial team both regional access managers and case managers, we still have people devoted to that business and we expect to continue to have those teams in place because there are literally millions of patients out there that could benefit. You can see we aren’t reaching many of them.

Anthony Petrone - Maxim Group

Taking into consideration your outlook of double digit growth reached eventually for depression, can you give an indication as to the size of the minority interest at this point? Have you debated that internally?

Gregory H. Browne

I think that as I said earlier, it is very early in the process and I think it would be premature to comment on what that might be. Obviously we would like to have as significant minority interest as we could because we do believe that we believe the opportunity is there. Is it going to take some time to realize that opportunity but we believe it is substantial as Dan has said. We would like our shareholders to have as large an interest as possible.

Anthony Petrone - Maxim Group

Thank you for taking my questions.

Operator

The next question comes from Andrew Cowen of Tricadia.

Andrew Cowen - Tricadia

Congratulations on profitability on the operating line. A real quick question, getting out of that credit facility. Where were those costs? Were they in SG&A or were they in the interest expense line?

Gregory H. Browne

That would be in the interest expense line.

Andrew Cowen - Tricadia

I guess that makes sense. You are very, very close then to profitability on a net income basis for Q4 or are you not speaking to that idea?

Gregory H. Browne

We are not speaking to it as we have said all along that as you know the dollar as GAAP profitability in Q4. As you can see we were fairly close in Q3. Having said that we also said that our fourth quarter sales will be the highest for the fiscal year so I think that would lead us to the conclusion that we think that goal is achievable and that we are not yet in the business of giving guidance.

Andrew Cowen - Tricadia

The R&D line came down pretty significantly this quarter, is that a trend that we should see or is this a onetime dip?

Gregory H. Browne

This really reflects some changes we made to the clinical support group surrounding the depression indication in Q2 and part of the headcount reduction that occurred that quarter. In fact, we would expect the R&D line to start to pick up in dollar turns as we start to re-invest in the epilepsy business on a go forward basis as Dan discussed.

Andrew Cowen - Tricadia

Is there a percentage of sales target for this?

Gregory H. Browne

I think it is a little bit really to talk about hat. Certainly we plan on spending more money next year on our engineering and on our R&D activity. It will also depend of course on the timing of new clinical trials as it relates to depression. I think it is a little premature to talk about a [inaudible] percentage but we do expect to have quite a number in double terms next year.

Andrew Cowen - Tricadia

Clearly whatever compensation plan or organization you have put in place for the sales forces have been very effective and you have certainly been reducing your costs as well as improving productivity on the sales line. Are you releasing what your commission costs are, your selling costs. Are you breaking that out from G&A?

Gregory H. Browne

We haven’t traditionally done that and I think in balance we probably would not. It has been fairly consistent over the last few quarters. I haven’t gone back and had a look into last year but they have certainly been consistent over the last 3 quarters of this year.

Andrew Cowen - Tricadia

On a dollar basis?

Gregory H. Browne

On a percentage of revenue basis but I think that as Dan discussed the change in the focus of the plan is now more towards revenue and away from other metrics and we are seeing the results.

Andrew Cowen - Tricadia

On the up G&A line if you expect the dollars to go up that would be a mix of having some increased commission sales which are variable with sales, right?

Gregory H. Browne

That’s correct.

Andrew Cowen - Tricadia

Okay thanks.

Operator

The next question comes from [Avi Danitar from RHO Capital].

[Avi Danitar - RHO Capital]

I was wondering if you could share with us any perspectives you have on international. Clearly that has been the star performer as far as growing right through. Any potential declines in the TRD business? Are there any unique features of that business in as to why it is growing so strongly versus the domestic business?

Daniel J. Moore

I don’t think it is unique compared to other device businesses in that our international team continued to focus on epilepsy throughout the year even though they had TRD approvals, where in the US the focus really went over to TRD and I don’t want to take anything away from the sales team that was in place because they were compensated to go out and get prescriptions for depression and they got some 17,000 within a couple years. Meanwhile the international teams stayed focused on the epilepsy business and continued to grow quarter after quarter, meeting plan and achieving growth. They continued to do that and as we came in and I brought James here in August, we said lets learn from the international team and do what we have done in the past which was to split the sales force so that you have a sales force focused on a call point. The international team was doing that. If you keep in mind that the sales force is not that old, we did this in August, yet you can see the uptake in our epilepsy sales in the US because you take a team, you tell them your call point is the neurologist, the epileptologists, the neurosurgeons, the other surgeons who are implanting these devices and oh by the way, we are going to compensate you when you sell a device because that brings revenue into the company. The prescription doesn’t. I don’t think that there was a magic formula there consistent with what you would see in other device companies. That also leads to when we look to the neuro call point versus the psychiatry call point, versus the depression versus epilepsy. We are seeing 2 businesses there, both that we are bullish on, both that we want to invest in. We are the kid in the candy store with overall not being that billion dollar company, we don’t feel that we have the amount of money we would need overall to invest in epilepsy for not only the short term but the medium term and the long term and invest in depression for the short, long and medium term. That is where we said, lets restructure this thing. Coming back to the sales force, there is no magic here. It is basic execution.

[Avi Danitar - RHO Capital]

The second question I have is based on some of the forward looking features that I have in my model. It certainly looks like based on where you are this quarter and your guidance of continued revenue growth, that you should have fairly significant contribution margins from every incremental revenue dollar going forward. Are you able to share with us what those contribution margins are that you are expecting?

Gregory H. Browne

As I said earlier we are not really in the guidance business yet. What we have said is that our goal for next year is sustained revenue growth built on the factors that Dan discussed earlier on the epilepsy side both in units as well as pricing and clearly international. Second of all, we expect an uptick in our growth margin next year. We expect to be able to leverage our bottom line. We continue to focus on expenses and clearly we believe that the incremental earnings if you like operating earnings from the growth and revenue should be strong but I don’t think we are ready to put a percentage on it yet.

[Avi Danitar - RHO Capital]

As far as the stage that the company is in now, clearly you have reduced costs, you improved working capital, you have gotten epilepsy growing again now. It feels like you turned the corner on most of the restructuring initiatives, getting off the line of credit, announced the share repurchase. I am wondering if there is anything further to do amongst the restructuring initiatives?

Gregory H. Browne

I believe as Dan discussed earlier, the major focus for us now is to go through the process in respect to finding a partner to execute on our depression plan and that process is getting underway. I think it is obviously a bit early to talk about how long that will take because it is early in the process. I think that part would signal the end of the beginning, as it were and then we would move on to more exciting developments past the restructuring side.

Daniel J. Moore

I think an important point here. This hasn’t been the board or Dan or the Senior Management Team, this has been a combined effort of all the Cyberonics employees coming together under adversity and difficult circumstances, uniting around a plan that we laid out and continued to execute on that plan. Now I think as you manage a plan going forward we will be looking and we are looking day to day at all of the investment opportunities that we have because no matter what the size of the business I have been part of, there are always been more things that you would like to do than you could afford to do if you are managing the P&L with the idea of growing the top line and leveraging the bottom line so it is growing better and faster than the top line. We are in a mode now where we started to draft our 2009 fiscal year plan bringing teams together around the projects we are going to do. A key part of strategy is being able to have the guts to be able to identify the things that you are not going to do. We are underway with that as well and saying we can’t do everything we would like do to but we are very optimistic about epilepsy and the future growth of that business. Let’s ensure that we are placing the right amount of money against that business and finding a way to also finance a depression business that again has hundreds of thousands of patients for epilepsy and I am sure you have all been watching the press lately other significant players in the neuro-modulation business believe like we believe that there are literally millions of patients who could benefit from neuro-modulation for depression. We feel we are bullish, we feel that we have the best of both worlds because the thing that is different here is that every day we come to work and focus on neuro-modulation for epilepsy and we focus on neuro-modulation for depression. We impact the brain by being outside of the brain. We think that this provides some uniqueness in itself. We will continue to refine that plan quarter to quarter. We are creating a culture that does that and understands that this is the way you successfully grow a business.

[Avi Danitar - RHO Capital]

Terrific! Last question is for the share repurchase. Is the intent to essentially fund that with a flat cash balance over the course of the year or do you plan to draw down the cash balance partially to fund that?

Gregory H. Browne

I think that will depend on how the prices over the next few months and as we put that plan in place we would not be averse to drawing down our cash balance if it seemed appropriate at the time.

Daniel J. Moore

We also expect quarter after quarter to have an operating cash flow as well.

[Avi Danitar - RHO Capital]

Which is exactly what I was trying to understand, is how much of the optimism around that growth and the operating cash flow is reflected in your million share repurchased plan?

Gregory H. Browne

I think it is a combination of a number of things. First of all as I said we have a positive operating cash flow which is a situation we expect to continue and hopefully increase, second of all, we received a license fee in December of $9.5 million which was used to repay our line of credit. Thirdly, perhaps most importantly, we believe that the share price does not reflect the intrinsic value of what our shareholders deserve. If the price continues to be below the level of what we believe it should be and what shareholders should get then we will realize our cash resources to buy the million shares.

[Avi Danitar - RHO Capital]

Great, keep up the good work.

Operator

Our next question comes from Anthony Petrone from Maxim Group

Anthony Petrone - Maxim Group

Just a quick couple follow ups in regards to the buy backs. Are there any restrictions currently in place, are there any restrictions in terms of purchasing pattern? Also a couple follow ups on the demipulse. Has the company conducted any assessment runs within the market place and really keeping your mind on the price affecting that impacting any demand for the product at all and is the company seeing any delayed purchasing patterns due to the pending release of demipulse? Thank you.

Gregory H. Browne

Let me address the stock buying. I wasn’t quite sure I understood your questions.

Anthony Petrone - Maxim Group

Some other share buy backs had restrictions for initially out. In other words when it is initially announced is there any 24 to 48 lock up period when you cannot buy?

Gregory H. Browne

In the normal course of events we would not expect to commence a buy back before next week. After that it would be open to us to conduct the buy back.

Daniel J. Moore

On the demipulse we have had positive feedback about that product overall. Again on the pricing we haven’t gone into a lot of details there. There has not been a lot of push back on price. You have to keep in mind that people spend $15,000, $20,000, $25,000 on a car and we are talking about a therapy here that truly does change the quality of life for people. If we keep it in perspective like that, there are people who if we can help change the quality of their life with a device like this, it is an extremely valuable device to people and physicians who treat patients.

I think with that we are at about an hour. We can take one more question if you have it. It sounded like you had a follow up.

Anthony Petrone - Maxim Group

Are you seeing any delays in purchasing due to the pending release?

Daniel J. Moore

No, we haven’t seen any delays in purchasing.

Just to wrap up, if we come back to the quarter. I mentioned at the beginning of the call that this was a plan that was laid out. At least the strategic direction was laid out a year ago. Some of us came to work on it 9 months ago others joined 6 or 7 months ago. It has really been a team effort uniting around the plan, refining that plan. Whether the first objective of profitability or growing epilepsy or figuring out the best strategic direction to get to depression patients and maximize the value of that asset for our share holders, looking at the other intellectual property and partnerships, we believe we are making good progress in all areas. Don’t take any of it for granted. It has been 3 quarters, we have a lot of quarters ahead of us and we expect that we will continue to have to work hard day to day and execute to bring this neuro-modular technology of vagus nerve stimulation to more patients. We are optimistic about the future of epilepsy. We are optimistic about the future of depression and believe that we have something special here that will continue to work on behalf of our shareholders to maximize the value of this company. With that I will close the call and again thanks for taking the time to listen in to our results. Thanks to the whole team for making it happen.

Operator

This concludes today’s conference call. You may now disconnect.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!