Somanetics Corp. F1Q08 (Qtr End 02/29/08) Earnings Call Transcript

Mar.18.08 | About: Somanetics Corp. (SMTS)

Somanetics Corp. (SMTS) F1Q08 (Qtr End 02/29/08) Earnings Call March 18, 2008 10:00 AM ET

Executives

Mary Ann Victor - VP, CAO and Secretary

Bruce Barrett - President and CEO

Bill Iacona - VP, CFO, Treasurer and Controller

Analysts

Matthew Dodds - Citigroup

Greg Brash - Sidoti & Company

Anthony Petrone - Maxim Group

Jonathan Block - SunTrust Robinson Humphrey

Martin Yokosawa - Oberweis Asset Management

Stan Manny - Manny Family & Investments

John Suhan - Morgan Stanley

Operator

Good day, everyone, and welcome to the Somanetics Corporation first quarter 2008 financial results conference call. Today's call is being recorded and webcast. With us today from the company are Bruce Barrett, the company's President and Chief Executive Officer; and Bill Iacona, Chief Financial Officer; and Mary Ann Victor, Chief Administrative Officer.

At this time for opening remarks, I'd like to turn the conference over to Mary Ann Victor. Please go ahead.

Mary Ann Victor

Good morning, everyone. Thank you for attending our first quarter 208 investor conference call and webcast.

Statements in this call concerning our future business, operating results, expected net revenues, anticipated investments and other guidance are forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. Such statements are based upon management's expectations as of today, March 18, 2008. You are cautioned not to place undue reliance on these statements. Information contained in these statements is inherently uncertain and actual performance and results may differ materially.

Factors that could cause actual results to differ materially from any forward-looking statements include economic conditions in general and in the healthcare market; the demand for and market acceptance of our products; our current dependence on the Cerebral Oximeter and SomaSensor; our dependence on distributors and independent sales representative firms for a substantial portion of our sales; our dependence on single-source suppliers; potential competition; the effective management of our growth; our ability to attract and retain key personnel; the potential for product liability claims; government regulation; changes in our deferred tax assets; future equity compensation expenses; the challenges associated with developing new products and obtaining and maintaining regulatory approvals; research and development activities; the lengthy sales cycle for our products; sales employee turnover; changes in our actual or estimated future taxable income; changes in accounting rules; enforceability and the cost of enforcement of our patents; potential infringements of others patents; and the other factors set forth from time to time in our Securities and Exchange Commission filings, including the 2007 annual report on Form 10-K filed on February 6. The company undertakes no obligation to revise or publicly release the results of any revision to the forward-looking statements that may be made during today's call.

I'll now turn the call over to our President and CEO, Bruce Barrett.

Bruce Barrett

Thank you, Mary Ann. Good morning and welcome to our first quarter call.

To give you some perspective on our first quarter financial results, our internal plan was to achieve just under $10 million in net revenue, and diluted earnings per share of $0.12. US sensor dollar growth was strong in the quarter, up 28% from the prior year period and in line with our expectations, and purchases from our international distribution partners were also in line with our expectations.

However, US INVOS hardware net revenue was well below our expectations and accounted for almost the entire $1.3 million shortfall to our internal plan for the quarter. And when you have 88% gross margins, a topline miss in any area of the business plays havoc with the entire P&L.

In the US market, the majority of our sold INVOS hardware is in the pediatric market segment. Pediatrics is a rapidly growing market segment for us as evidenced by a 63% first quarter increase in pediatric sensor dollar volume over the prior year quarter. New business activity in pediatrics is strong, and we expect we'll grow stronger as we progress with the launch of our new cerebral and somatic infant sensors as they will support increased activity in the pediatric and neonatal ICUs.

For these reasons, we believe the first quarter US INVOS hardware results do not represent a new trend. However, we are adding a fairly broad range to our fiscal 2008 guidance that reflects the Q1 US INVOS hardware results and the inherent uncertainty associated with forecasting these revenues.

Our new guidance is for net revenues to grow between 20% and 30% to between $46.2 million and $50 million. This broad range is intended to count for the uncertainty associated with US INVOS hardware revenue, but it also recognizes the potential upside to our original modest plans for the new cerebral and somatic infant sensors for the pediatric and neonatal ICUs, now that we've had a positive initial experience in the first quarter with these new sensors.

Our guidance for gross margin remains unchanged in the 87% to 88% range, and our guidance for operating margin remains unchanged at between 25% and 27%.

Income before income taxes is now forecast in the range of $15.3 million to $17.5 million as compared to our previous guidance of $17 million to $18 million. The upper end of the range is reduced to reflect the lower than planned interest income, due to continuing interest rate cuts and its impact on interest income associated with what is currently a $90 million cash, marketable securities and long term investments balance.

And now Bill will walk through our first quarter financial results in more detail. Bill?

Bill Iacona

Thanks, Bruce.

As we reported in our earnings release, our net revenues were $8.7 million for our first quarter of fiscal 2008, an 8% increase over the same period of 2007. US net revenues increased 12% in Q1 to $7.4 million and represented 86% of our total net revenues for the quarter.

For the three months ended February 29, US disposable sensor revenues increased 28% to $6.6 million, while our INVOS hardware revenues decreased 44% to $815,000. Our international net revenues for the quarter were $1.3 million, consistent with our expectations for Q1.

In Q1, we placed 80 INVOS monitors in 48 hospital accounts in the United States. Of these INVOS monitors, 30 were placed in 13 new customer accounts and 50 were placed in 35 existing customer accounts that requested the use of additional equipment. Internationally we sold 69 INVOS monitors. As of February, our installed base of INVOS monitors in the US was approximately 2100 monitors in 677 hospital accounts.

In the first quarter, our US sensor unit sales increased 22% to 64,490. Pediatric sensor sales accounted for approximately 30% of total US sensor revenues for the first quarter, and approximately 25% of total US sensor units for the quarter. Total company sensor unit sales increased to 87,630 in Q1, compared to 81,950 a year ago.

In the US our average selling price for sensors increased 5% in Q1. The increase in average selling prices in the United States was primarily attributable to increased sales of our pediatric sensors, which sells for a higher price than the adult sensor. Gross margin was 88% for the first quarter ended February 29, consistent with what we had expected for 2008.

For the three months ended February 29, our operating expenses increased 26%. The increase is primarily attributable to our addition of sales and marketing and R&D personnel, as well as increased professional fees associated with auditing, tax and legal.

First quarter income before income taxes was $1.8 million, compared to $2.6 million a year ago Net income for Q1 was approximately a $1 million or $0.07 per diluted share. While we do not expect our reported income tax expense to reflect material cash tax payments for the foreseeable future given our previous NOLs, we have begun making state income payments.

Our recognized income tax rate in Q1 was 42% due to additional state tax expenses in the quarter. We expect our effective tax rate for fiscal 2008 to approximate 36%. As of February 29 our cash, marketable securities and long-term investments balance was $89 million, and we had no borrowings. For the first quarter, our cash provided by operations was $3 million.

I will now turn the call back over to Bruce, who'll talk about our business for the remainder of 2008.

Bruce Barrett

Thank you, Bill. We are focused on a number of initiatives in 2008 to pursue growth as well as build upon our significant competitive advantage in the market place. One initiative is the launch of our new smaller, cerebral and somatic infant sensors. With these sensors we plan to increase our investment and activity in the pediatric and neonatal ICU market segments.

We have eight years of experience with our current pediatric sensors in these settings. There have been many pre-reviewed publications describing the use of these sensors, primarily with neonates undergoing congenital defect repair. However the current sensors design limits their use to more motivated early adopters which we have predominantly found in the congenital heart repair market place.

Our new sensors are better designed for the smaller patients in these environments and set the stage for us to pursue a broader opportunity within the pediatric and neonatal ICUs. These sensors incorporate a milder adhesive with a smaller more flexible pad. They have also been designed specifically to eliminate pressure points beneath the optical assemblies.

In the first quarter, we had a very positive initial experience with these new sensors. We expanded our activity to eight US centers and realized our first commercial sales selling 220 sensors to two accounts that are $195 per sensor in the final days of the quarter.

In the second quarter, we plan to expand our activity with these new sensors to between 15 and 20 new customer accounts in the US. In addition, we anticipate many of our current pediatric sensor customers who'll want to convert to the new sensors which we will accommodate as our supply allows at a premium to current prices. The gating factor for the number of new accounts we pursue is the amount of customer education required to properly establish a new account. In recent months, we hired six clinical managers to support the initial increase in educational activity, and we anticipate the need for additional educational resources as the year progresses.

In mid-April, Covidien, our distribution partner in Europe, is sponsoring a two day symposium for approximately 200 pediatric and neonatal ICU clinicians as part of their launch of these new sensors. Experienced INVOS customers and researchers from the US and Europe will share their data and experiences at this program.

We have also organized a pediatric and neonatal ICU Clinical Advisory Board and we conducted our first meeting in February. This Advisory Board is comprised of thought leading clinicians from pediatric and neonatal ICUs across the US. We have organized this group to guide our thinking with regards to clinical research, technological advances, and market development.

During our initial meeting, the Advisory Board had the opportunity to observe a neonatal piglet experiment with the INVOS System. In this experiment, they were able to witness the responsiveness of the technology, the episodes of hypoxia, as well as organ-specific ischemia in the brain, kidney and bowel caused by reducing blood flow to these organs. The piglet model provides a compelling demonstration of the performance in potential clinical utility of the INVOS technology in smaller patients.

Based in part on this neonatal piglet research, we have filed a new 510(k) with the FDA, to among other things further expand our labeling to include tissues in addition to cerebral and skeletal muscle tissues. This submission is one in a series of planned new FDA submissions.

Another growth initiative for the Company is to continue our work to establish the INVOS technology as standard of care in adult cardiovascular surgeries. In this regard, we are working to capitalize on The Society of Thoracic Surgeons evidenced based decision to incorporate cerebral oximetry into their adult cardiac surgery database.

On January 1, 2008, the STS added cerebral oximetry to their adult cardiac surgery database. The STS believes its database is the largest quality improvement program in the world for adult cardiac surgery and information from the database is used to establish practice guidelines for their specialty. Our goal is to support their efforts and hopes that the results will support the establishment of practice guidelines that include the use of cerebral oximetry in the future.

In the first quarter, we launched new INVOS system software that automates the data collection process for including cerebral oximetry data in the database and we've begun discussions with thought leading clinicians regarding future analysis and publications of cerebral oximetry data from the database.

Also in the quarter, Covidien conducted another two day symposium in Paris in February for more than 200 participants focusing on the use of the INVOS technology in adult cardiac surgery. We believe this symposium will also help support continued adoption in Europe in this market segment.

With regards to new markets, we've both R&D and clinical research initiatives. In R&D, we are focusing our attention on advancing the INVOS technology to expand its applicability. For example, we are beginning the development of a non-adhesive, or minimally adhesive sensor for use on neonatal patients with undeveloped skin. We believe such sensors will unlock significant additional market potential within the pediatric marketplace in the neonatal ICU.

Also with regards to developing new market opportunities, we've now completed enrollment in a pilot prospective and randomized multicenter intervention outcome study in diabetic patients over the age of 50 undergoing major general surgeries.

This 50-patient pilot study was conducted at Duke University and the VA Medical Center in Durham. The data from this pilot will be analyzed in the coming months and used to evaluate the patient enrollment and investment requirements to conduct the complete prospective, randomized trial. The intention would be to demonstrate that use of the INVOS technology can reduce severe adverse clinical outcomes in this patient population. If we move forward with the larger study, these initial 50 patients will be included in the final results and we will include additional centers to speed enrollment.

And finally, in the area of intellectual property, we applied for one new patent during the quarter after having made disclosures for certain design elements of our new infant sensors in the previous quarter.

In summary, we believe the Company is well positioned for growth. Our launch of the new cerebral and somatic infant sensors for the pediatric and neonatal ICUs is one growth initiative. Our pursuit of practice guidelines in adult cardiac surgery by supporting inclusion of cerebral oximetry data in the STS Adult Cardiac Surgery Database is another.

We have a new 510 (k) pending to continue the expansion of our labeling to new applications with others to follow, and we are working on the development of new products that will expand the applicability of the INVOS technology, like non-adhesive sensors for the neonatal ICU.

We are also pursuing clinical research, such as the prospective, randomized, multicenter trial in diabetics, undergoing major general surgery to lay the groundwork to enter new market segments with the INVOS technology in the future.

And in combination with these and other growth initiatives, we have pending patterns that provide us opportunities to enhance our intellectual property portfolio and extend our leader position in this evolving technological field.

And now, I'd be glad to take any of your questions.

Question-and-Answer Session

Operator

(Operator Instructions). We will take our first question from Matthew Dodds with Citigroup.

Matthew Dodds - Citigroup

Hi. Good morning, Bruce.

Bruce Barrett

Good morning.

Matthew Dodds - Citigroup

A couple of questions on the hardware sales, given the Q1 results, I know it's really into Q2, but is it possible there may have been some slippage from Q1 into Q2, that's one question. And the second question is internationally, I know year-over-year the number from, Covidien was roughly flattish, but it had been trending higher.

So I'm just kind of wondering, if you can comment maybe on inventory levels with them because sometime that fluctuates and at some peers it's pretty low, other peers it's higher. I am just wondering you didn't comment specifically on where you think their inventory is?

Bruce Barrett

Okay. Yeah, on the first question, you said from first quarter to second quarter, did you mean fourth to first?

Matthew Dodds - Citigroup

Well, I mean in the current, so in the current quarter will there be some orders that maybe slipped into the Q4.

Bruce Barrett

Okay. I understand your question. Yeah, the potential is certainly there. I think there is a couple of things to consider, first of all, if you look at last year in the first quarter we did okay in those hardware, but like a lot of our quarters it happens towards the very end of the quarter. I think a lot of our customers recognize that we're a public company. And they're hopeful that they can get a deal done toward the end of the quarter. And we're obviously pushing very hard to get the hardware deals done at the end of a quarter.

So if you look at any quarter that we have, a very significant part of our hardware revenues occur on the last days of a quarter. So we never know on hardware how the quarter is going to turnout until it's over. I think that's one factor.

The other factor that we have is that we did do $2.7 million in hardware in our fourth quarter, which, obviously, we knew when we put our guidance out for the first quarter. But despite that large amount of hardware sales in the fourth quarter, which was almost three times what we had in the third quarter, we felt like we had the projects to still deliver another reasonable quarter in the first quarter. So, the potential is that actually the fourth quarter we closed some of the lower hanging fruit that would have typically bled over into the next quarter.

As we look at the second quarter, my expectation is that we're going to have to wait until we get toward the end of the quarter to know where the hardware is, because that's where it tends to come in, in terms of timing. But if you look at our project volume, we clearly have the project volume for the quarter and the year for us to do pretty well this year as it relates to the INVOS hardware. We also expect that as we launch the infant sensors that we're going to find that there's additional opportunities out there that we don't yet have on our project list for hardware.

So, at least at the moment, we feel like we dug ourselves a little bit of a hole in the first quarter, but it could probably be just about any quarter for us. We just don't expect it to be quarters that repeat, because usually if we have a good solid quarter like we did in the fourth quarter, I guess it's possible we have a weaker one the next quarter, and then things sort of balance out as we go overtime.

I think the point I was trying to make though on my presentation is, that most of our revenue is for hardware and pediatrics in the US, that's a rapidly growing segment of our business. The project activity is growing in that area and the infant sensor should help that. So, we, at least, don't have any indication at the moment that hardware revenues won't improve as we move forward.

As far as with Covidien, yes, we didn't have a lot in our plans for Covidien for the first quarter. We knew coming into the first quarter that they are actually undergoing a process of reducing the number of weeks of inventories that they carry across their product offering in Europe. My understanding is that it's related to the fact that they've implemented some new systems, which they feel allow them to maintain a lower level of inventory. So, we anticipated that coming into the quarter.

But like our US INVOS hardware, you are right. We've had some volatility in purchases overtime from Covidien, and that will probably continue to some extent just because they also have some parts of the territory that they cover that are distributed markets like the Middle East. And what you'll see from a place like the Middle East is they tend to have large tenders that come through. So, a hospital may buy 25 monitors and 10,000 sensors all at one time, and then you don't see another order for a long period of time, and that tends to affect the volatility of their purchases from us as well.

Matthew Dodds - Citigroup

But it sounds like for Covidien, the inventory level, if anything, get from quarter-to-quarter?

Bruce Barrett

That's our understanding, yes.

Matthew Dodds - Citigroup

All right. Thank you, Bruce.

Operator

Thank you. We'll take our next question from Greg Brash with Sidoti & Company.

Greg Brash - Sidoti & Company

Hi, Bruce. Hi, Bill. Thanks for taking my call.

Bruce Barrett

Good morning, Greg.

Greg Brash - Sidoti & Company

Just wanted to get a sense on your confidence level going forward with these hardware sales, I know they tend to be a little lumpy from quarter-to-quarter. But I mean are you still very confident we're going to see an uptick in Q2 and this was more of a one-off?

Bruce Barrett

Well, I have confidence you're going to see an uptick in Q2. I have more confidence anytime we look over a little longer period of time with hardware, just because what's going on in the marketplace and the fact that we're growing so strongly in this area where we tend to sell the hardware. It's very difficult to pick any particular quarter, but I would expect that we will see some bounce back in the second quarter having had such a light first quarter.

Greg Brash - Sidoti & Company

And just looking through my numbers here, it looks like the number of sensors per monitor declined from where we were through most of '07, any reason for that?

Bruce Barrett

None in particular. I mean I know that's a great metric to use, the forecast of what's going on, so it's a helpful metric to have. As far as our business low is concerned in terms of how we manage it, it is not a metric that we manage to. And the reason is we tend to loan a significant part of the hardware that we provide to a hospital.

And if you do the math on the depreciation of the instrument and our margins, we're really not financially motivated to limit putting out monitors unless the number of sensors is going to get down around two sensors per monitor per month. So when we're up around the 10-12 range, we're still well above any threshold of a financial motivation to limit the productivity.

As we move into the ICU, also, the productivity is going to be different per monitor, because you get into monitoring patients for a much longer period of time than you do in the operating room environment for adults where you may bring one or two patients through the operating room in a day. You are hooking these patients up at the ICU and you may monitor the patients even with the same sensors that they can keep them on for many days, even though we label them for 24-hour use. So you may not get the same productivity.

And people want to buy more beds just in case they have a patient that they want to monitor. So they'll put more monitors out. So, our motivation is actually to place more hardware even if the productivity on the sensors per monitor per month goes down because financially there is no motivation not to do that. At the same time, we don't do as many companies in our space we historically have done.

We don't just go place monitors and hope they get used. This is truly a concept sale. The customer has to understand what they are doing with the technology to employ it properly and for the monitors to be productive. So we don't try to spruce up our quarterly placements by just putting out hardware, which should be very easy to do.

There are plenty of customers who'd expect more hardware; if we just wanted to put them out there. But we are very careful with our investments to make sure that we're putting monitors out there, they have been properly trained, the customers are being trained and they are going to use them appropriately.

Greg Brash - Sidoti & Company

Just going back on the sensors for monitors, so you are not too shocked, I guess, that it has been declining and that's largely a function of launching into say a pediatric or the infant sensors where the docs would use the sensor for longer period of time.

Bill Iacona

Yeah. And there are other things that are built into that number that since it's not a number in the forefront of our thinking as to how we are managing our business, we report to you every quarter the incremental monitors that have been placed and we just keep adding that on to a perpetual base. The reality is that some of those monitors that may have been out there for eight or 10 years may not be in use anymore, they may have been upgraded to new technology, or maybe it's a small hospital that the physicians left and no one there uses it anymore. So there are examples of those that would also push things down.

The other thing that would be an example is, some of our larger especially adult cardiac surgery customers, who have used it in the operating room, want to monitors patients post-operatively in the ICU and in fact, you may recall couple years ago, the Delaware Valley Society of Thoracic Surgeons had done a quality initiative on stroke and one the recommended guidelines was to use cerebral oximetry in the OR routinely but use it post-operatively in the ICU on high risk patients.

So, when we accommodate these customers and provide more hardware in the ICU, whether we provide it or they buy it, the reality is those adult cardiac surgery patients come to the ICU with the same two sensors on. So it just immediately reduces the productivity per monitor per month. So financially it's not a great metric forecasting-wise, it's an interesting metric to use but there is a lot of different pressures that would cause you to believe that that number is going to go down rather than up, although we can't predict exactly what the number is going to be as we move in the new market.

Greg Brash - Sidoti & Company

Okay. And then just one more question on the hardware sales, I know at the end of your last conference call you're looking for 5% to 10% lower than Q4 which puts you at sort of $10 million to $10.5 million range. And you came in line, I guess just because most of the sales tend to happen at the end of the quarter. But is there anything else going on here, say a longer sale cycle, anything from the competition, smaller hospitals having issues obtaining credit to buy monitor. Are you seeing any of that?

Bill Iacona

Well, if you look at most of our hardware revenue, it's in pediatrics and we don't have competition in the pediatric marketplace today. So, I can't assess competition as a part of -- there is no question that, we're a part of the problem in that given the financial situation in terms of loaning hardware, while we want to create and sustain a hardware sales model in the pediatric and neonatal ICUs, we do tend to loan the hardware to these accounts while they peruse their capital budgets.

So it's not as motivating for them, I guess to acquire the technology when they've already got it setting there for free, so that's makes the process a little more unpredictable for us. But most of our hardware coming from the pediatric area is not a competitive issue. There have been examples and if you look at just the sales cycle in general, to the extent we do sell some hardware into the adult cardiac market.

There have been examples where our recent competitor, where we were in a sales process, has come in as a mean to trying to attract some interest, and just said we will provide it for free, which is, we've got maybe two examples of that where it disrupted the sales.

So it's not a major impact, but if you just look at competitive activity in general in the length of sale cycle, we do have new evaluations in certain accounts where people are going to consider the competitive alternative and that extends the length of the sales cycle.

We are not losing share, because generally we fare very well in those evaluation. And we do have loss of sales productivity at times whenever we have to protect our current business against the evaluations. Because again, customers will try anything that’s new though, they will buy a box of sensors or get a box of sensors and give it a shot and see how it works.

So we'll spend time in those sorts of situations as well. But again, we are faring very well in almost every single one of them.

Greg Brash - Sidoti & Company

Okay. Bruce just one more final quick question. Do you guys have a share buyback plan in place and is that something you or the Board would consider at this point, with your stock trading at around $12 right now?

Bruce Barrett

We do not have one in place. It is something that we discuss on an occasional basis, and it's something that we actually talked about last night as a Board and we plan to investigate a little bit more aggressively as we push forward towards our annual sales meeting in April.

But we've come to know conclusions on that. I think the things we have to consider or will consider as we look at that are, why did we decide we wanted to have a really strong cash balance in the first place, and have any of those reasons really changed, and do we really think that the best use of the cash while we think the potential answer is that that is a good use of cash potentially, especially in this interest rate environment.

But why is the best use of the cash to buy back shares, that's something that we'll be investigating as we move through the coming weeks.

Greg Brash - Sidoti & Company

Thanks. What would be your other planned uses of cash?

Bruce Barrett

Well, the obvious ones are to continue to pursue our growth to defend our intellectual property position. Should we feel the motivation that we need to do so in the event that we identify other opportunities to license or build upon our product portfolio through the acquisition over licensing and technologies that complement what we do and allow us to accelerate our growth, we would be interested.

Other things would be like clinical research sorts of studies. But at the moment, we believe we're able to do what we want to do without tapping in to those cash reserves, but it's certainly not a bad thing to have a strong balance sheet as me move forward as a growing company.

Greg Brash - Sidoti & Company

Okay. Thanks. I will hop back in queue.

Operator

We will take our next question from Anthony Petrone with Maxim Group.

Anthony Petrone - Maxim Group

Thank you, guys. Just a quick question, you mentioned in the press release about the cerebral and somatic monitoring sensor and that you began commercial shipments of that. Exactly when in the quarter did the shipments begin?

Bruce Barrett

Well, we were sort of referring to the commercial shipments since the first sensors that were shipped for money. And we didn't ship them for money until the last two days of the quarter. We shipped a couple of orders from two different customers as I mentioned. I think the takeaway there is, that was two customers for 220 sensors, but that the ASP was a 195, which is our list price.

So the information I was trying to translate there is that our ASP may in the early days, be quite a bit higher than maybe we were projecting. But we've always thought we would probably settle in something more than mid $100 range, $150 or so. So for a while, at least while we were, we've got more interest in the product, the ASP will probably stay up a little bit higher.

Anthony Petrone - Maxim Group

And as it is released to the 15 to 20 hospitals, perhaps was there any delay in monitoring purchases related to, I guess, the official commercial launch of these sensors?

Bruce Barrett

There have been customers who have been saying when they can get the sensors then they will acquire the hardware. So we have some of that. We also have customers who just finally decide that they would go ahead and buy the hardware in the fourth quarter, knowing the sensors were coming, and in the meantime, they had been using the current pediatric sensor. But, yeah, we do expect that there will be an increase in hardware activity in the US.

But you also got to expect, that while people might be able to come up with the moneys to buy couple of monitors. For the most part people will have to go through a budget process of some sort or at least a fund raising process through some sort of a charitable organization or endowment to come up with the cash to buy hardware.

Anthony Petrone - Maxim Group

Sure. I think that leads into my question here, and again, I had brought some last quarter. So in terms of kind of budgeting for the new fiscal year for hospitals, and I know this is hard to kind of get a look into, but, how many of your, I guess, customers are in that process right now? And when do you expect that process to be finalized?

Bruce Barrett

Well, if you look at our plan for the year for hardware and we don't give it out in that much detail, we have enough identified projects for hardware that we believe are going to be sold hardware and closed this year to achieve our original plan. If we closed everything we've got on our list, and nothing fell off, then nothing came on.

So, we also know that some of those won't close, or they'll close, but they'll be smaller than what they were originally budgeted for, because the account will say you can buy two of them, not four of them. So we know there are all different sorts of scenarios that transpire, we also know that we tend to sell.

We're thinking in the neighborhood of about 20% of our hardware that we sell, even within a quarter is projects that we didn't really know existed because there will just be an account who has come up with money and decided they want more unites, we weren't involved really with the process and they're just placing orders, so, is that.

And then the question is just how much early activity will they be associated with our increased activity with these new sensors and that's something that's unknown, but we're encouraged by our early feedback in the marketplace.

Anthony Petrone - Maxim Group

So it sounds like there is margin for error based on the business model. As you said 20% is coming from deals, from unexpected deals, would you kind of consider margin for error, as you move forward?

Bruce Barrett

Yeah, there is a margin for error and we've got a couple of areas, besides three big areas there is margin for error in our forecasting. One is in hardware. It could be better worse than we think, but we think we put a pretty broad range on it at this time in our guidance. Hopefully, we've accommodated it, so we don't have to come back later and change it again.

Second, this is early in our launch of the new sensor, so both the number of sensors as well as any early hardware purchases associated with those sensors, both in the US and our distributors in international markets is somewhat uncertain. And then, we are entering the final couple of years of our relationship with Covidien. I think they're less anxious to carry significant inventories of our product.

Yes, they're investing heavily to launch these new sensors. So that will be something that could create some uncertainty as we move closer, perhaps not this year, but certainly as we move closer to the exploration of our agreement in February 2010, that could be something that create some uncertainty.

Anthony Petrone - Maxim Group

Sure. And then final question I guess just on purchasing strategies at the hospitals accounts. How do they go about, I mean what process, how levered are they I guess to the credit market? Are they purchasing these mostly through leasing terms and third-party leasing companies? Do you find that to be a trend that has been in the marketplace for sometime, and if so, has that changed at all?

Bruce Barrett

Well, from what we see, no. Most of them are just buying it out right from us. Now, after hospitals buy products from various companies, my understanding is there is a lot of them will then go bundle their capital and do something separate with a leasing company. But as far as how they work directly with us, they just purchase directly from us.

But certainly, anytime you are going after a capital cycle, you are creating an uncertainty with your purchase if it's got a disposable associated with it. And the timing of these closing of any of these deals is quite uncertain, which is why we have a tough time predicting it. Eventually, you hope to have enough volume of deals that you don't have to be as good at predicting, because a certain percent of them just close every quarter and you can, at least, some predictability that way.

But right now, a few deals can make a big difference in the quarterly number when our amount of revenue we're expecting from hardware is relatively modest. So we have a lot of 1 and 2 monitor deals, and then we have a handful of 10 and 15 monitor deals. So if you can close a few of the 10 and 15 monitor deals in one quarter, you have a blowout quarter like we felt we did in the fourth quarter. If you don't get any of those big ones and you are reliant on just the 1s and the 2s, like we saw on the first quarter, then you don't have a good quarter.

Anthony Petrone - Maxim Group

Sure. And I guess the final question is for Bill. When looking at the cash balances, any of that invested in auction-rate securities, and if so, has the liquidity in that market improved over the past 28 days?

Bill Iacona

Nothing is invested in auction-rate securities. So for the cash balance that you see at $89 million at this point about we've had maturities coming due on marketable securities. So about 60% of that cash is actually in cash and bank accounts, and the other 30% is invested in AAA-rated government agency bonds.

Anthony Petrone - Maxim Group

Okay. Great. Guys, thank you.

Bill Iacona

Yes.

Operator

We'll take our next question from Jonathan Block with SunTrust Robinson Humphrey.

Jonathan Block - SunTrust Robinson Humphrey

Hi, guys. Good morning. Thanks for taking my questions.

Bruce Barrett

Good morning, Jon.

Jonathan Block - SunTrust Robinson Humphrey

Just sort of a handful if I can roll through. First, just in terms of revenue guidance, Bruce, I think last quarter you said maybe $1 million of neonatal was embedded in the $50 million number. Has that changed with the revised guidance?

Bruce Barrett

Well, we haven't really changed the forecast for it because we don't have other than experience that says the sensors are functioning very well, which gives us more confidence. We don't really have any new information in terms of a lot of purchases from a lot of accounts to change the number. But since that I was trying to give within my commentary for the guidance is that we think there is certainly upside to that number as long as things proceed the way they look like they might, but we don't know exactly what that number might be.

So, if we do have a problem with US INVOS hardware as the year goes, due to the uncertainty associated with predicting that, we do think there is the potential that our activities with these new sensors offset that, either by creating more sensors or creating more hardware revenue. So, that's something that we just won't have good visibility for until we get at least another quarter or so under our belt with these new sensors.

Jonathan Block - SunTrust Robinson Humphrey

Okay. And then, just in terms of the guidance and maybe trying to parse some of the noise on the capital equipment side, the US sensor number did seem pretty solid at 28%. So, I'm just wondering in terms of forecasting specific to US sensors is, let's call it a mid 20% number, a good number to use here in '08 in the US?

Bruce Barrett

That's the number that we used.

Jonathan Block - SunTrust Robinson Humphrey

Okay.

Bruce Barrett

For the year, and that's the number that we used. Between the new sensors adding to that and then hardware growing at a faster pace of sensors, which obviously didn't happen in the first quarter, that's how we were getting to modeling our 30% sort of growth.

Jonathan Block - SunTrust Robinson Humphrey

Okay, great. And then, I think you expressed that there isn't too much noise on maybe the leasing programs, but with the majority of the capital equipment coming from the pediatric, I don't think I've ever gotten this number. My apologies if you put it out there. But just the penetration in pediatric, not in the sensor side, I know you said 30% of your revs, but specific on the hardware side, what percent of the pediatric technology already in the ICU?

Bruce Barrett

Other than to tell you, it's a small percentage. We are trying to get a grip on exactly where our hardware is. Our challenge is as we put out the same monitor regardless of what people use it for. So we're entirely reliant upon the sales force to tell us what our penetration rates are, which is a tough spot to be reliant on for getting that kind of information. But we are trying to grab that. But there are over 4,000 pediatric intensive care unit beds in the US, and so we're relatively lowly penetrated, less than 10% certainly and maybe less than 5%.

Jonathan Block - SunTrust Robinson Humphrey

Okay, great. And then, Bill, I always bother you for a couple of these small items. Out of the 80 US monitors in the quarter, how many were sold versus placed?

Bill Iacona

Right at about 40%.

Jonathan Block - SunTrust Robinson Humphrey

40% sold?

Bill Iacona

Yes, 40% sold. So right at that 40-60 mix.

Jonathan Block - SunTrust Robinson Humphrey

Okay. Got you. And then on the international side, if you can just break out the $1.3 million in the equipment versus the sensors?

Bill Iacona

International?

Jonathan Block - SunTrust Robinson Humphrey

Yes, I'm talking international.

Bill Iacona

That was about just north of $600,000 in hardware internationally.

Jonathan Block - SunTrust Robinson Humphrey

Okay. And last question for you guys. Just shifting gears, on diabetic, would we get the data from the 50-patient pilot this quarter, and then, how many patients do you think will be needed for the follow-up trial?

Bruce Barrett

Part of the purpose of the pilot was to determine what the power of the study needs to be. So the only information that we would have to help give early insight to that is that we actually saw statistically significant outcome changes in the Murkin trial in diabetics and his cardiac surgery trial with 57 patients. So we have reason to believe that it could be a relatively small trial that will be required such as 150 to 300 patients.

However, that's the purpose of doing the pilot is there is really no data that we could get a hold of in the literature, nor could our investigators who are doing the study that would power for us of study of diabetics over the age of 50 undergoing major general surgeries for the types of endpoints we're looking at. So we had to do the pilot.

As far as the analysis, we currently have the data on what our performance was of the INVOS. So one thing we know about the analysis is that they did a very good job of collecting the INVOS information. Duke University actually has all the data related to outcomes and we are going to be somewhat dependent on them. So, our expectation would certainly be that we can get that analysis done this quarter and make a decision moving forward as to whether or not we know exactly what we need to do for the rest of the study, and if it makes sense to pursue. But we are a little bit dependent upon the folks at Duke to get the analysis done.

Jonathan Block - SunTrust Robinson Humphrey

Okay, great. Thanks guys.

Bruce Barrett

Thanks, John.

Operator

We'll take our next question from Martin Yokosawa with Oberweis Asset Management.

Martin Yokosawa - Oberweis Asset Management

Hi. Someone mentioned last week; that coincided with the stock drop of Terumo Medical. Can you tell me how you compete against them if they entered the market?

Bruce Barrett

Are you speaking of Terumo Medical?

Martin Yokosawa - Oberweis Asset Management

Yes.

Bruce Barrett

Okay. Terumo Medical essentially in the division that would be interested in cerebral oximetry is in the perfusion market, predominantly selling perfusion pumps on bypass cardiac surgery. So their position in the cardiac surgery market place, they happen to have their headquarters for this division here locally in Ann Arbor, and they've been interested in cerebral oximetry for many years. And in fact they've been in the process of attempting to develop a Cerebral Oximeter either by themselves or with a partner that's been a little unclear, which technology they are using. But they've been working on the development of a system many years as well.

For at least the last three or four years, we've heard off and on that they are six to 12 months away from entering the market. I don't know what happens, what causes it to get delayed, rather than I know that you've got a couple of issues. One is as there is IP in the areas some of which we hold, and second it’s a very difficult technological challenge that you just don't know if you got a product that works until you get it in the market place and gain some experience above and beyond even getting a study done that just provides the FDA enough data to give you a clearness.

So, our intelligence is that they are not six to 12 months away, that they're struggling and still having some issues, but I can't say that our intelligence is perfect. So perhaps, Jonathan will be able to get some intelligence that we don't yet have. But where they do would compete initially would be in the adult cardiac surgery area, because that's where we understand they're trying to develop a product for in cerebral oximetry only, and the question would be whether or not they can come to market with a device that’s competitive. But then above and beyond that, there has to be a real compelling or reason for a customer to move away or select a product when you've got an alternative that has what we have, which is more than 10 years of positive data, prospective randomized trials that show it makes a different in outcome, and we've had 10 years to advance our technology and make it work very reliably in the setting.

So customers who are taking care of patients are not really excited to jump to a new technology, but they will try them. I mean they want to see what's out there. So, we would expect to Terumo enter, that they would have a level of success extending sales cycles and getting the evaluations and causing us to protect our business. But as long as we do that and we work with our customers, typically the history would say is that the leaders in these sorts of specialty technology fields don’t lose their position, and there's lots of examples of that.

Martin Yokosawa - Oberweis Asset Management

That was helpful. Thank you.

Operator

We will take our next question from Stan Manny with Manny Family & Investments.

Stan Manny - Manny Family & Investments

Good morning. Europe, with Covidien contract to come in a while, have you any plans of going direct in Europe, or are you considering it?

Bruce Barrett

We are considering all our options in Europe; obviously Covidien has been a very good partner for us, they've done a very nice job building the business in the recent past, and they are, we believe pretty well positioned to have some real success growing the neonatal and pediatric ICU markets with the new sensors that we are launching. And they have the infrastructure to pursue the market aggressively, such as the wherewithal including facilities and financial resources to conduct things such as these master classes like they did in the first quarter for adult cardiac surgery with 200 clinicians and as they plan to do in the second quarter for the neonatal and pediatric ICUs.

Those programs, I am sure cost them at least $0.25 million a piece to implement. So there are a lot of very positive things about moving forward with Covidien as a partner even beyond the original expiration date of the agreement. At the same time, distribution is a make versus buy decision.

Strategically there may be reasons why we would prefer to be direct and have complete control over our destiny and reduce some of perhaps the quarter-to-quarter volatility that we have with a partner, and the other option is obviously to consider other partners. And the reason other partners might be of interest is because, we can't move forward past February 2010 with our current low transfer prices that we have for our adult and pediatric sensors, which were negotiated at a time when we expected the market price for sensors to be less than half of what it turned out to be.

So, over the last eight years as the market price has moved from $50 to more like $125, if you look at the strength of the Euro, all that margin has been for the benefit of our distribution partner and not ourselves. So, the question would be, whether or not we'll be able to negotiate what we consider to be a more reasonable distribution margin at least for existing business, as we move in to 2010 with Covidien or if that's an easier negotiation to have with another partner who doesn’t view that they have any sweat equity in that original margin.

So there's three options; that's either stick with Covidien, which I think is a very viable and real option because they are a good partner for us, it's to go direct which has a certain amount of investment that would be required, but may strategically be a good alternative for us or it's to go with a third party.

Stan Manny - Manny Family & Investments

In this contract currently with Covidien you have no price increase or cost change options obviously?

Bruce Barrett

Right.

Stan Manny - Manny Family & Investments

But do you have a cancellation clause or is there a time that you would be able to define this much prior to 2010?

Bruce Barrett

Well certainly it will be defined as we move through 2008 and certainly no later than early 2009, because if the answer ends up being that we are not going to move with Covidien forward past February 2010, we need know at least a year to 18 months in advance.

Stan Manny - Manny Family & Investments

Have you approached them on a price increase outside the contract recently, or?

Bruce Barrett

Well, we have the right to price new products at any price we choose. So if you look at our transfer price for the new sensors, which they are calling neonatal sensors in Europe, we are calling infant sensors in the US, we are transferring those at $75 a piece instead of $20, $25 a piece. So that's our opportunity in the short-term to work with our transfer pricing. But we have to be also cognizant of the fact that, when you are looking at a new concept like this, it takes a lot to develop a concept.

There is a lot of investment required. So the lower transfer pricing motivates them to be willing to make investments that generally the manufacturer might be responsible for making like these $0.5 million worth of master classes that they are running in the first half of this year.

So there is good and bad about having a low transfer price. If you have a transfer prices too high, then a distributor has, especially when their choice is to sell your product at a low margin or their own self-manufactured products at a high margin, you are not going to get their attention.

So we have to be thoughtful about what we do, but that's basically the landscape that we are looking at as we enter a period of time, when we are going to be need negotiating what's going to happen after a February 2010.

Stan Manny - Manny Family & Investments

Okay. I have a question on developments. Our troops run into these brain problems because of the suicide bombers. Your unit seems to be adaptable to a measuring if there is any problem in the brain. Have you investigated use in the trauma area for brain bleeding?

Bruce Barrett

There has been some work with our device in the area of traumatic brain injury and some of that work has actually been done at Walter Reed Army Medical Center. And we actually had some purchases from Walter Reed Army Medical Center for technology in our fourth quarter. Some of which was sent to Afghanistan, some of which was sent to Iraq.

And we are in the process of working with them to understand exactly what their applications of the technology are in that regard because it's not an area that we've focused on traditionally. And whether or not, there will be the need for additional product requirements to support those search of efforts.

Stan Manny - Manny Family & Investments

But it could be a significant market plus patriotic service.

Bruce Barrett

Yes.

Stan Manny - Manny Family & Investments

The time of immediate bleeding. So that is ongoing and it's real.

Bruce Barrett

Yes.

Stan Manny - Manny Family & Investments

Okay. Last question, you have all of nearly $90 million of cash and you say you're evaluating a buyback. My basic question is with all of cash, do you expect to utilize the cash this year in an active acquisition? In other words, are you in an evaluation mode at least on utilizing that cash on acquisition targets?

Bruce Barrett

We couldn't tell you whether or not there is any acquisition target that would happen within a finite period of time. We're always looking at new technologies. They always look great, when you first start looking at them and the more you learn about them, the less interesting they become. So, we're always in that process.

And that's something though that right now, I'd be surprised if we did anything within the fiscal year 2008 with an acquisition because almost anything we would do, I think would likely be a lower opportunity, a higher risk, lower return opportunity from us just focusing on continuing to grow our current business.

Stan Manny - Manny Family & Investments

Okay. Which means that the more likely utilization of your cash, I mean it's growing is a stock buyback as a return on investments for the stockholders, us and you?

Bruce Barrett

From a near-term return standpoint.

Stan Manny - Manny Family & Investments

Near-term, yes.

Bruce Barrett

Absolutely, yeah.

Stan Manny - Manny Family & Investments

That's a realistic. If you come to a conclusion on that media factor, you would announce it of course?

Bruce Barrett

Yes, if we came to a conclusion on a stock buyback, we would absolutely announce it, and may even actually be required that you announce it would be my guess. We haven't looked at that recently, but we would announce it.

I just want to caution you that while we certainly are interested especially as we look at our stock being where it is today versus where it's been, we're certainly interested in near-term shareholder returns. But our preeminent interest in the business is to develop an exciting long-term business, so we have to consider a stock purchase plan in those regards as well.

Stan Manny - Manny Family & Investments

Well, you don't need $90 million certainly to fulfill your dream and money laying on the balance sheet, which is really owned by the stockholders, might be a very, very smart investment. So even if you kept the stock for future acquisition, it's very cheap purchase that you can use as a script.

Bruce Barrett

Yes. We appreciate your view on that.

Stan Manny - Manny Family & Investments

When is your next board meeting is my last question.

Bruce Barrett

We will have a board meeting at the time of our annual meeting with shareholders, which will be April 10th.

Stan Manny - Manny Family & Investments

Okay. Thank you for your commentary.

Bruce Barrett

You're quite welcome.

Operator

We'll take our next question from John Suhan] with Morgan Stanley.

John Suhan - Morgan Stanley

Yeah, Bruce. I was looking on the income statement, and saw the R&D, SG&A $6.4 million versus $5.3. Can you tell us how much was attributable to the ramp-up in the sales force, and are there any metrics for the sales force productivity?

Bruce Barrett

The vast majority of the increase in expense was related to the increase in the sales and educational resources in the field. Bill, I don't know if you've got more detail on at least what, say, R&D was up versus prior year, for example, that you could give. Bill is looking at a couple of numbers here for you.

John Suhan - Morgan Stanley

Thank you.

Bill Iacona

Yes, if you look at the increase in sales and marketing, let's say, year-over-year, you're looking at an increase of about $600,000. You've got increase the other big hitter is the increase in R&D, which is about $0.25 million. And then the other thing that we mentioned in the prepared comments earlier is you've got increase in professional service fees of also about $300,000, which primarily attributable to things related to auditing and tax and legal surrounding our yearend, and things like Sarbanes Oxley and other related items.

So, there are other items within there. But basically, if you're looking at, those are the largest three groups in terms of -- and within sales and marketing, you can assume that and also within R&D that the largest pieces of those are headcounts.

John Suhan - Morgan Stanley

Okay. Thank you. Do you have any metrics that you're using for the increase in the sales force as far as what I'm looking for is future monitor placement? I mean we got a productive sales force and we should see some yield on that in terms of monitor placement?

Bruce Barrett

Yeah. But monitor placement is not the primary thing we look at, the primary thing that we try to track as best as we can as the amount of gross margin generated by headcount and the only thing that makes it little bit difficult is it's not like we just have territories to evaluate. We have some territories where we have a clinical manager also dedicated to it. We have some territory managers who have shared services of a clinical manner from another area. We still have a few territories where we have independent representatives who support our local rep.

So, it's difficult to tie all the results to a particular headcount in our territories, but that's what we use as our metric. As we're really looking at how fast can they generate enough gross margins that they pay for themselves and become productive? And at least on the analysis that we've traditionally done, it takes about six months to seven months for our new headcount to generate enough new margin to cover their expense.

Now, as we move into the neonatal ICU, we actually -- and get more active there then we have been in the past, we expect to add more educational resources rather than territory managers. But we still throw them into the same pot and say, what are we really generating in new gross margin in relation to the investments that we're making.

John Suhan - Morgan Stanley

No. Well, I appreciate the clarification on that metrics for gross margin to headcount. Thank you.

Bruce Barrett

Thanks.

Bill Iacona

Thanks.

Operator

It appears there are no further questions at this time. Mr. Barrett, I would like to turn the conference back over to you for any additional or closing remarks.

Bruce Barrett

Well, thank you all. Thank you for you attention today and we look forward to hopefully presenting you with some better hardware numbers in the second quarter and just a general overall improvement in the financial performance. Because otherwise, we feel like the growth of the business is very well intact and going to become more exciting as we move through the year. So, look forward to talking to you next quarter.

Operator

Thank you ladies and gentlemen. Once again, that does conclude today's conference. We thank you for you participation.

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