Sonic Innovations Inc. F4Q07 (Qtr End 12/31/2007) Earnings Call Transcript

Sonic Innovations, Inc. (SNCI)

F4Q07 Earnings Call

February 5, 2008 5:00 pm ET

Executives

Michael M. Halloran - Chief Financial Officer & Vice President

Samuel L. Westover - President, Chief Executive Officer & Director

Analysts

Joshua Zable - Natixis Bleichroeder

Mark Mullikin - Piper Jaffray

Shawn Fitz – Stephens, Inc.

Sam Bergman – Bayberry Capital Management

Al Kildani – SF Capital

Mark Matheson - Raymond James

Presentation

Operator

Good day ladies and gentlemen and welcome to the fourth quarter 2007 Sonic International’s earnings conference call. (Operator Instructions) Hosting today’s conference is Mike Halloran, Vice President and Chief Financial Officer and Sam Westover, Chief Executive Officer. I’ll turn the call over to the host, Mike Halloran. Please proceed, sir.

Michael M. Halloran

Just to let everybody know this is Sonic Innovations, not Sonic International. We haven’t changed our name at all. Before moving into review of the fourth quarter and our thoughts on the future I’d like to remind everyone that during the course of this conference call we will offer projections and other forward-looking statements regarding future events and the future financial performance of Sonic Innovations. I wish to caution you that these statements are just predictions and that actual events or results may differ materially and adversely. I refer you to the documents we file from time to time with the Securities and Exchange Commission and specifically the section entitled Factors That May Affect Future Performance included in Part 1, Item 1(a) of our annual report on Form 10-K for the year ended December 31, 2006 and in Part 2, Item 1(a) of our 2007 quarterly reports on Form 10-Q which identify important factors that could our actual results to differ materially and adversely from those contained in our projections and forward-looking statements.

With that Safe Harbor Statement let me turn the call over to our President and CEO, Sam Westover.

Samuel L. Westover

Good afternoon and welcome to our earnings call. Today I have three topics that I’d like to discuss. First our results for the year 2007, second our results for the fourth quarter and third guidance for 2008. We’re very pleased to report that 2007 was our best year in terms of revenue, gross margin, gross profit, operating income, net income and earnings per share. Revenue increased 16%, our gross margin improved from 57.7% to 63.1% and gross profit increased 27%. Our income from continuing operations doubled. 2007 was also our best year in net income which was 74% higher than our previous best and it was much better than last year’s loss of $1.6 million. During 2007 we established a new distribution capability and acquired companies with over $14 million in annual revenue. The annual region improvements were also strong. European revenue increased 21%, North America Revenue increased 12% and rest of world revenue increased 15%.

We launched three new products in 2007, Velocity, ion 200 and NaturaPRO-open. Velocity is our premium product offering. Velocity combines a sophisticated set of breakthrough algorithms to provide the hearing impaired customer with outstanding hands free operation in a variety of listening environments. Using environmental sound cues Velocity is able to automatically adjust the hearing aid settings to best meet the challenges of a particular listening situation without requiring the wearer to press a button. Ion 200 extends the popular ion family to include patent pending adaptive directional technology, adaptive feedback cancellation, advanced digital noise reduction and an updated moisture resistant form factor. NaturaPRO-open extends our popular natural line to include an affordable open ear product which is practically invisible and comfortable.

2007 was a year of significant improvements. I’m proud of our team for the progress that we’re making but at the same time I was expecting better. So let’s talk about the fourth quarter. With one important exception we had a good quarter. Revenues were up 12.4%, gross profit was up 20% over the fourth quarter of 2006, gross margin improved from 60.3% to a remarkable 64.5% which is the highest gross margin in the company’s history. As part of our global distribution expansion we acquired total annualized revenue of over $1.6 million since our last call and $14 million during 2007. We acquired 21 retail locations during the year. We will continue to expand our global distribution capabilities and we will continue to keep you up to date on our progress.

We showed continued strong growth in the fourth quarter in Europe with an increase in revenue of 12% and a rest of world increase of 26%. We were disappointed however with North America improvement of only 6%. In North America we had strong results in October and November as we were expecting. In December however we saw a sharp decline in the wholesale business. It was the lowest revenue that we’ve seen in this market in a number of years. We attribute this to the constant media discussion of the possible downturn in the US economy and the instability of the stock market. The users of our products tend to be senior citizens who watch the news and some have their own stock portfolio. We’re not convinced that our fixed income customers are significantly impacted by a slowing GDP. We do think however that they can be convinced to delay their hearing aid purchases by a never ending news story of impending financial decline.

December also experienced a two week long ice storm and severe winter conditions that did not help. We only saw these influences in North America. The rest of our operations, and remember that more than half our revenue comes from outside North America, continued to show strong growth. The reduced performance in North America wholesale in December kept us from achieving the earnings that we were expecting and we think that it is appropriate to consider the current economic climate in the US in our forecast for 2008. We continue to be optimistic about our global growth prospects and expect that consumer confidence in the US will recover.

So now let’s talk about 2008. January in North America wholesale was much better than December but a still a little softer than we would have liked to have seen. Consumer confidence generated by the perception of the performance of the US economy is a variable that produces a range of possible outcomes. Should confidence return quickly we would expect to see a return of our North American historical growth rate. If not we should be prepared for a different growth rate. So we’re going to give you a fairly wide range for 2008 expectations. As the year progresses we’ll have better visibility and we’ll narrow the range. We want to share with you how it looks to us right now.

We’re launching two new products in the first quarter. The first I can announce now and the second will be announced just before our AAA convention. Ion 400 is our newest high end open fit product which brings the hands free features and advanced technology of velocity to an open fit which is the most popular form factor. Our patients now will have all the power of velocity in the small and comfortable form of the popular ion. Ion 400 will be available to order in the next few weeks. We also have a number of products that we’ll be releasing throughout 2008 and we have more products in development that we’ll be releasing in early 2009.

In terms of guidance for 2008 we expect revenue to be between $145 million and $151 million. We expect earnings per share in 2008 to be between $0.10 a share and $0.21 a share. We expect acquisitions to be between $15 million and $25 million. We also plan on opening 10 Denovo stores in our global distribution expansion which will cost us $0.04 a share which is included in the $0.10 to $0.20. Without the Denovo stores we would have been expecting $0.14 to $0.25 a share. Current analyst ranges are between $0.15 and $0.21 so our expectations are in the range of analyst expectations.

So in summary 2007 was a significant improvement in the company’s performance by every measure. Revenues are up in North America, Europe and rest of world and up 16% overall. Gross margin improved to 63%, net income improved from the $1.6 million loss to a $717,000 gain. We showed strong growth in the fourth quarter in Europe and rest of world and slower growth in North America as a result of reduced consumer confidence in December. January has already demonstrated improvement in North America over December. We’re giving guidance of revenue growth in 2008 between 18% and 23% and EPS growth an astounding between 233% and 567%. So the bottom line is we had a bad December in one market but 2007 was by far Sonic’s best year ad 2008 will eclipse that performance.

After Mike goes through the details of the financials we’ll open the call up for questions.

Michael M. Halloran

Before I get into the numbers for the fourth quarter I would like to remind everyone that we sold Tympany our auditory testing equipment division on February 20^th, 2007 to a group of independent investors. Accordingly we have reflected this division as a discontinued operation in our financial reporting at year end 2006 and in quarterly 2007 filings and will continue to do so. From here forward my commentary refers to the hearing aid business or in other words our continuing operations.

I would like to discuss guidance for 2008. Our covering analysts have an EPS range of $0.15 to $0.21. Our guidance is for $0.10 to $0.21 per share. The difference between the company’s guidance and the analysts is we plan to open 10 stores in 2008 which impact the company as Sam indicated earlier approximately $1 million or $0.04 per share. We opened new stores in 2006 in our Australian operation and the results in 2007 have been quite positive. Adding in the $0.04 gets the analysts in a range of $0.11 to $0.17. We are comfortable with our guidance of $0.10 to $0.21. The range is caused by the uncertainties Sam mentioned in the North American market.

I will now go through the fourth quarter in more detail. Net sales in the fourth quarter of 2007 were $32.3 million up 12.4% from the fourth quarter of 2006 net sales of $28.7 million. We are very pleased with the growth in Australia which is a return to our past sales growth. The new stores we developed in late 2006 and opened in 2007 contributed to this growth. As a result of this success as stated earlier we’ll do the same in 2008 for the North American market. By segment North American fourth quarter sales of $11.4 million increased $0.6 million or 5.8%. The growth in retail sales more than offset the reduction in North American wholesale sales. We have specific strategies to improve North American sales in 2008 and have begun to execute on them in January of 2008.

European sales of $13.6 million increased 11.6% over 2006 fourth quarter sales of $12.1 million. Sales continue to grow fueled by sales and marketing programs and additional sales personnel in certain European geographies. We believe 2008 will improve over 2007 because we have a number of commitments from large retailers as well as we expect improvement in our own retail operations. Rest of world sales of $7.3 million in the fourth quarter 2007 were up $1.5 million or 26.4% from 2006 sales of $5.8 million. This was a record sales quarter and we are pleased especially considering this included the Christmas holiday shutdown.

In 2008 we expect to see record sales and to achieve in excess of $145 million. We have previously said to expect approximately 6% to 8% growth in our base business and we still believe we can get there. Our expectations in the North American market are not what they were but the strength of the rest of the business has accelerated and thus we still feel comfortable with the 6%. I am very pleased with our fourth quarter margin. The improvement over third quarter margin of 62.7% was quite remarkable. A number of things caused the record margin including the effect of the weakening US dollar, cost savings for moving production offshore, the change in distribution to more retail and our focus on improving our product quality which lowers both our return rates and our warranty costs. I expect the first quarter of 2008 to be in the 64% range. However this depends on the mix of sales by geography, the retail wholesale mix, the penetration into large customers in Europe and foreign currency movements.

SG&A expense in the fourth quarter of 2007 of $18.5 million was up $3.6 million from last year’s fourth quarter level. Selling, general and administrative expenses increased in the fourth quarter because of an additional $2.4 million associated with our retail initiative including acquisitions and integration costs, $1 million from foreign currency and an increase in marketing costs in Europe partially offset by a reduction of those costs in North America. In 2008 we expect overall leverage on our operational expenses of slightly less than 1% on our business that we had prior to our retail acquisition strategy. Adding back the acquisitions brings it essentially flat. However I expect to see a slight up tick in SG&A percent to sales when we include the Denovo stores. As we grow larger the leverage on our existing business as well as on acquisitions will improve. The Denovo stores are a drag on leverage in the near term but clearly will add shareholder value in the long term. R&D expense in the fourth quarter 2007 was $2 million up a fraction over 2006. We expect research and development to increase to approximately $2.3 million or $2.4 million per quarter in 2008. The increase is to fill out product gaps we currently have in our product offering.

Operating income was $0.3 million for the fourth quarter 2007 compared with $0.5 million in the comparable quarter in 2006. Year to date operating income improved $1 million from a break even in 2006 to a $1 million gain in 2007. A deeper look at the numbers reflects a nice opportunity for the company in its retail business. We had our best sales month and acquired retail revenue in January of 2006. The revenue recognition of losing one month on all acquisitions will become less of an impact as we grow. What I mean is for the first 30 to 45 days we have little or no revenue from our acquisitions because we do not recognize revenue in them until generally the second or third patient visit. Also to improve the operating results in our retail locations we have reduced headcount at the retail locations and absorbed the functions at the corporate office.

Other income was approximately $1 million in the fourth quarter 2007 compared to $0.3 million in the fourth quarter 2006. Q4 2006 was impacted by foreign currency translation gains on our inter-company balances. I would expect a slight loss each quarter going forward operationally. The improvement in income before income taxes on a year to date basis is significant. We went from a gain before taxes of $1 million to a gain of $1.8 million. This demonstrates that when being near break even a small improvement in operations can have a big impact on earnings. We had tax expense of $0.3 million in the fourth quarter of 2007 and $0.1 million in the fourth quarter of 2006. The large tax provision in Q4 2007 is because of the full utilization of a net operating loss in one foreign location causing us to record taxes on temporary differences. On a year to date basis our effective rate is 54% which should improve dramatically in 2008. The future effective rate is difficult to gauge because it is highly dependent upon profitability by geography and the near break even results for income before income taxes. However we have budgeted approximately 25% in 2008. Our net operating loss carry forwards are approximately $21.3 million in the US and $12.9 in the balance of the world.

On a year to date income from continuing operations we doubled over 2006. I’m very proud and we need to continue to improve and gain leverage from our existing business as we grow from Denovo and our acquisition strategy. Basic weighted average shares outstanding were 27.6 million in 2007 versus 23.9 million in 2006. This increase was primarily due to 3.2 million shares issued in a private sale completed in the third quarter of 2006.

Briefly turning to the balance sheet as of December 31^st, 2007 cash and marketable securities totaled $20.7 million. Cash flow from operations was approximately $0.5 million in the fourth quarter of 2007. We noticed a slow down in payments by some major customers who have subsequently paid in January. We have a number of inventory and accounts receivable reduction initiatives and I am confident we will see significant cash generation in 2008. I would anticipate over $8 million in cash flow from operations in 2008.

At this time I’d like to turn it over for questions.

Question-And-Answer Session

Operator

Your first question comes from the line of Joshua Zable of Natixis Bleichroeder. Please proceed.

Joshua Zable - Natixis Bleichroeder

Thanks very much for the color; it’s really helpful giving that big range there. I know there’s obviously some uncertainty here but maybe you can just help us understand, obviously it seemed like you guys had a strong couple of months then December things just kind of fell off and then it seems that you’re indicating that January is going better. Obviously you have some new products launched or launching which is obviously a good thing, but can you just kind of talk about maybe some of the feedback, the dynamics of sort of the marketplace, what you saw and gain I know you’re giving a wide range but just sort of what you’re seeing in January, maybe what changed if anything? And again obviously you saw a delay in payments, that’s coming now so just any more color would be real helpful.

Samuel L. Westover

First of all, Tim, important to remember that a majority of our revenue comes from outside the US and the US is the only developed country in the world that doesn’t offer its citizen a hearing aid benefit. In Europe and Australia the government will pay for a hearing aid and even if the economy does have a downturn there, the government still gives you a free hearing aid so it tends not to have as much of an impact. The US on the other hand is a little more subject to those sorts of issues and although we haven’t seen much of it, in December it was just a dramatic change and in talking to our customers who purchase products from us and then sell to the ultimate consumer, the patient, they just didn’t have as many patients as they’re used to. And it was a significant drop. Sure the weather was bad but weather is bad other times as well. But I think if you watched the news it was just a constant drumbeat of impending financial disaster in the United States and most of our customers are senior citizens and I think they listen to that. But one good thing about health care is that when you delay health care for financial reasons it doesn’t mean you don’t buy it later, you just don’t buy it now. So I think December was the first big push on that. Like I say January is better, still not as good though as we would have expected. It’s much better than December, we’ll see how February shakes out and I know there have been some significant efforts to change the public relations aspect of this perceived potential downturn which isn’t necessarily showing up in the numbers yet and with Congress passing stimulus programs and the Fed lowering the discount rate, all of those things sound like good news to the people watching the news and as there continues to be more good news like that I think people will feel more comfortable about making large discretionary health care purchases such as hearing aids.

Now on the cash flow issues it’s not uncommon for December to have customers that want to hold over until the next year. Maybe it was a little bit more than usual in December, but that’s not uncommon. People like to close their year with cash balances. So I’m not really concerned about the financial stability of our customers, they were just a little slower in December paying. Mike, I don’t know if you wanted to say anything else.

Michael M. Halloran

Josh, let me add a little color on our inventory as well. A couple of things happened in inventory and one of them is we have new products as Sam indicated that’s coming out in the first quarter and I think as those new products get out and they’re behind the year products so therefore you have to stock. The second thing that’s kind of a key initiative we have in the 2008 year, the way we build inventory today is we build inventory and we have a number of private label customers and when we build product for these private label customers what we’re doing is we have to put it on the shelf in the configuration or with the private labeling. In 2008 what we’re going to do is have what I’ll define a generic behind the ear and then just as it’s ready to go out when the customer orders it we’ll switch it over to the private label and I think that will improve our inventory pretty dramatically. So I’m confident 2008 will be much better than 2007 from a cash flow perspective and then accounts receivable same thing. We’ve made some progress. It’s interesting, when you look at Q3 to Q4 on the accounts receivable side we’re essentially flat and that includes an improvement over the foreign currency because foreign currency and particularly in Europe where most of our receivable are at least from a foreign currency perspective the dollar weakens a bit so you would expect it to go up and it did not. So I’m pretty confident we’ll have –

Joshua Zable - Natixis Bleichroeder

I just have a follow-up here and then I’ll get back in queue, obviously again the range you gave given like what you saw in December is still pretty impressive especially the high end there, obviously the other sort of areas or geographies are doing pretty well and from an acquisition I guess integration perspective things are going well. Can you just give us a little bit of color of sort of any specific trends? Obviously like you said outside this country reimbursement obviously allows us to avoid sort of any ties to the economy so to speak, but is there anything in particular that you’re seeing why you guys are so strong or is it just simply really good execution out there?

Samuel L. Westover

I think the division managers we have in Europe and also in Australia are doing a terrific job and the programs that we’ve put in place a year or even two years ago are now maturing and our core processes are functioning very well. We started out by having to improve and develop processes and experiment with different types of models that would be successful in the various marketplaces. Now we’re comfortable with the models that we have and it really is just execution. So now instead of inventing new processes and procedures we track our metrics in the processes that are in place. So we’re very confident that those will continue to perform well. So we’re very pleased with the results we’ve had.

Operator

Your next question comes from the line of Mark Mullikin of Piper Jaffray. Please proceed.

Mark Mullikin - Piper Jaffray

First I just have a couple of financial questions for Mike and then a broader question for Sam. How much did foreign currency contribute in the fourth quarter to the revenue line?

Michael M. Halloran

Compared to the fourth quarter of last year on the sales line 7.7%.

Mark Mullikin - Piper Jaffray

7.7%

Michael M. Halloran

Correct.

Mark Mullikin - Piper Jaffray

And what does the ‘08 guidance factor in for foreign currency?

Michael M. Halloran

For ‘08 we have about 1%. We’re anticipating the dollar to weaken a bit. Or excuse me to strengthen a little bit.

Mark Mullikin - Piper Jaffray

What’s the point of contribution from currency factored into the top line?

Michael M. Halloran

What’s that Mark? I’m sorry.

Mark Mullikin - Piper Jaffray

Is 1.1% of FX contribution to the top line?

Michael M. Halloran

That’s correct because we expect the dollar to strengthen.

Mark Mullikin - Piper Jaffray

And what’s the CapEx expectation for 2008?

Michael M. Halloran

$2.5 million.

Mark Mullikin - Piper Jaffray

And that includes the $1 million for the Denovo stores?

Michael M. Halloran

It does not. That’s just our base business.

Samuel L. Westover

And that excludes acquisitions as well.

Michael M. Halloran

That’s correct. And Denovo will be about I’d say about $1 million, Mark. Typically it’s about $100,000 per store. So you got 3.5 total.

Mark Mullikin - Piper Jaffray

3.5 total in the CapEx on the cash flow statement?

Michael M. Halloran

Correct.

Mark Mullikin - Piper Jaffray

And are all those Denovo stores in Australia then?

Michael M. Halloran

They were in 2006.

Samuel L. Westover

That’s part of our global distribution expansion. So we’re not nailing ourselves down as to where they will be. Somewhere in the world we’ll be opening up 10 new stores.

Mark Mullikin - Piper Jaffray

So it could be Europe, the US, Australia?

Samuel L. Westover

That’s right but it will be in geographies where we have existing competent management than can handle retail stores.

Mark Mullikin - Piper Jaffray

I guess it raises an interesting question, and this is my broader question for you, Sam, around M&A and the Denovo stores. I guess with the economy being pretty skittish here what’s the M&A environment like in terms of the willingness of these audiology practices to sell? I mean is it opening up more because they’re worried about the economy?

Samuel L. Westover

You and I are thinking the same way. It’s a little bit too early to answer the question because this has all come about very quickly and when people decide to sell their practice it takes them a while to work that through so during the month of December people tend not to think about big life changes such as this. So we’re through January now but I haven’t seen it yet but I’m expecting to see exactly what you’re describing where people will be a little nervous and think maybe now is a good time.

Mark Mullikin - Piper Jaffray

And then I guess just one more question then on the Denovo stores, is that something that could change through the course of the year depending on the M&A environment? Might you do more M&A and less Denovo activity if the valuations on the M&A side become much more attractive?

Samuel L. Westover

Frankly if we weren’t a public company we would have more focus on the Denovo than on the acquisitions because the return on investment from a Denovo is very, very high and we’ve already developed the capability of bringing those to break even within a six to nine month period and we’ve already done that. The problem though with Denovos is as we’re describing it hasn’t an adverse impact on your bottom line and as a public company there’s only so much tolerance for that. So as a result we end up doing acquisitions which are immediately accretive and that’s easier to do as a public company and we do Denovos up to the point where we think we and our investors can tolerate it.

Mark Mullikin - Piper Jaffray

And on the new product front is there anything, I mean ion was a huge hit obviously in the open hearing aid. Is there anything of that order of magnitude in terms of new product introductions or are we looking at more line extensions?

Samuel L. Westover

Well we’re doing both. So we will be launching products in categories that we don’t currently serve so that could generate significant revenue for us. We’re not ready to announce those yet but throughout the year we’ve got a number of those that we have planned. The one we’re launching right now is the Velocity that everybody wants. So we launched Velocity last year around July and that’s been very well received, excellent product, we’re getting great reviews on it but what they really want is the comfortable open ear form factor that will now be available and we think that we’ll be able to expand the enthusiasm around Velocity and carry that out to a marketplace that’s larger and get a significant improvement there. So it’s a line extension but it’s a very important one.

Operator

Your next question comes from the line of Shawn Fitz of Stephens, Inc. Please proceed.

Shawn Fitz – Stephens, Inc.

Just a quick question, Sam, you talked earlier in the conference call about the three new products you launched this year. Have we seen really a full contribution from those full products? I mean are they kind of at full stride as we exit 2007 and enter 2008 or is that still yet to come?

Samuel L. Westover

No, I think we’ve gotten the word out on them in the US market. We have not launched them in all of our European markets though. For example Velocity is not launched all of our European markets at this point. So there’s still a future opportunity for that.

Shawn Fitz – Stephens, Inc.

But in the US you feel like you’re kind of hitting full stride with those products?

Samuel L. Westover

That’s right.

Shawn Fitz – Stephens, Inc.

And then, Sam, you alluded to during your discussion of operating expenses that SG&A was up due to a $2.4 million I guess spend on retail initiatives. Could you maybe flush that out a bit for us in terms of what exactly that involves and where that incremental spending is going?

Samuel L. Westover

Sure. We made a number of acquisitions over the last year and the mix in the retail business is different than the expense distribution in the wholesale business. So in retail you should expect to see 53% to 55% percent of your revenue being spent in administrative costs. So as we acquire these practices of course there is revenue that comes with them and there’s also expenses that come with them as well. It’s really a direct result of acquisitions that those particular expenses have gone up.

Shawn Fitz – Stephens, Inc.

I guess the important thing there then based on your description of the selling expense involved in the SG&A side of the acquired retail unit, that hasn’t changed markably from what you all were experiencing earlier? So am I right in thinking that the economics of these retail acquisitions haven’t changed?

Samuel L. Westover

Yeah, that’s exactly right. When you make an acquisition you get more revenue and you get more expense and that’s all it is.

Shawn Fitz – Stephens, Inc.

But you’re not finding out that you’re having to spend significantly more on the SG&A side of the acquired clinic than maybe you all had thought mid-06 when you first started initiating the strategy? Is that an accurate statement?

Samuel L. Westover

That is an accurate statement. There is an overhead component to this and that’s in place already so that was one of the accomplishments of 2007 to build the management team for this retail expansion and that’s in place. There are certain costs to go along with that but those are behind us and they’ll continue at that same level. So now every acquisition that we make it’s all positive going forward.

Shawn Fitz – Stephens, Inc.

Last question on the acquired unit side, my recollection is that previously you all talked about a goal of maybe $15 million to $20 million in 2007, it sounds like you guys were able to complete about $14 million worth of deals. Was there anything in particular that impacted that or any explanation to kind of talk about where you came out relative to some of your objectives?

Samuel L. Westover

No. I know in the past I’ve described acquisition hunting like fishing and we’ve got our line in the water and we’re looking for the right fish. We throw a lot of them back because they’re just not what we’re looking for and we have a very disciplined approach where we will not overpay and we will not buy a practice that’s too small and we won’t buy a practice that doesn’t fit the criteria that we’re looking for. So we’re selective and we feel good about the acquisitions that we made during the year. The acquisition team knows that it was very important for them to get to $15 million but they didn’t get there, they got to $14 million. So they’ll do better this year.

Shawn Fitz – Stephens, Inc.

I guess the key take away there is that there’s an issue of timing, the pipeline in terms of activity and the opportunities for you guys to fish hasn’t changed necessarily. Is that the right way to interpret this?

Samuel L. Westover

That’s definitely the case. There’s no change in pricing. We’re not paying more for acquisitions now than we were a year ago and we’ve also expanded our acquisition team so that we have more people that are working on it and we think that will also be helpful in getting more deals done during 2008.

Shawn Fitz – Stephens, Inc.

Last question, Sam and Mike, it sounds like you guys are maybe being a little intentionally cagey as it relates to your Denovo strategy but can you maybe just walk us through how you’re approaching this strategically and tactically as it relates to where you go with these units?

Samuel L. Westover

Where we’re going to put the Denovos you mean?

Shawn Fitz – Stephens, Inc.

Yeah, I’m just trying to kind of understand what’s kind of the key decision making aspects to where you guys go with your Denovo strategy as it relates to geography?

Samuel L. Westover

Management is key. We wouldn’t go to a market where we don’t have operations or management and open some stores. We will only open stores in markets in which we already operate and markets where we already have retail activity and we have retail management in Australia, in Europe and in the United States. So you can conclude from that that’s where those Denovos will be. We experimented with this in ‘06 where we opened eight new stores in Australia. They broke even very quickly and did well and you noticed in the fourth quarter there was 26% revenue growth in Australia. Well those Denovo stores were very helpful in that even through we had to pay for that in ‘06. In ‘07 we’re getting a good bump from that. And that’s what we’re going to do with these 10 new stores. We’ll pay for it in ‘08 and in ‘08 you’ll get a nice revenue pick up in earnings from that. We go through what you’d expect. We do market research, we look at areas where we think there’s an opportunity, we look at the competition in the marketplace, we look at the advertising environment, we look at the medical referral environment and it’s fairly scientific. We have large databases that we call through looking for the right markets and when the numbers all line up, then we open some stores. One other thing, we won’t likely open just one store in one market. We’ll probably open up three stores in a market because you get better leverage from your advertising dollar that way.

Shawn Fitz – Stephens, Inc.

Is there anything unique in the Australia market that we should understand as we think about how transferable that experience is there to the United States?

Samuel L. Westover

I think we had some advantages in Australia by having a longstanding retail organization that’s very skilled and so we were able to add on to their existing structure. That was helpful and from that we learned that that’s the right way to do it and that’s the way we’re going to do it here as well. Australia has a government reimbursement scheme, they call it, that allows you to put your location on a list and from that list you’re able to attract new customers. The United States doesn’t have such a list. Here the way your consumers find out about you is through advertising, direct mail, physician referrals, those types of things. But we do all those same things in Australia. So it’s not exactly the same, but I think the experience is very transferable and now that we have our management team and infrastructure and systems in place we’re ready to start doing those in other markets.

Operator

Your next question comes from the line of Sam Bergman of Bayberry Capital Management. Please proceed.

Sam Bergman – Bayberry Capital Management

Couple questions, one in regard to the average line for a retail store, on the acquired stores, what’s the average line versus the Denovo stores?

Michael M. Halloran

That’s a good question, Sam, typically what we would see is about $400,000 to $500,000 for an acquired store and I think it’d probably take you two to three years to obtain that in opening up a new store.

Sam Bergman – Bayberry Capital Management

Now that you have most of the infrastructure in place, how much savings should there be on the G&A line in ‘08 when you acquire stores? What would be a percentage of savings?

Michael M. Halloran

We typically for the 2007 acquisitions we have built out what I’ll call our corporate level as Sam indicated earlier. In addition to that we have about $500,000 of acquisition costs and about another $500,000 of integration costs, so let’s call it $1 million. That would be flat going forward. What you will find is the store which is typically about 55% of sales value to 60% depending upon the amortization is what you’d see. So you start to see, if you figure $1 million on $14 million is what we’ve acquired this year. Next year if we acquire $15 million you can get an idea of what kind of leverage you would expect.

Samuel L. Westover

And when we acquire a store or acquire a practice there are certain things that they do like payroll and payables, insurance billing and things like that that can be done centrally and we have the people in place centrally so you can reduce your overhead that way.

Sam Bergman – Bayberry Capital Management

Is that where the overhead has changed a little bit in the acquired stores? It hasn’t happened in sales, it’s happened in payroll and other administrative?

Samuel L. Westover

That’s right. It’s all back office because the revenue generators are the hearing care professionals and we don’t want to change that. We want that to continue and even expand. So we just want to do it more efficiently.

Michael M. Halloran

For us, we put our systems in in Q3 and Q4 for our acquired retail operations and prior to that we would have literally each retail location would have its own set of accounting records, general ledger, payroll. So in Q3 and Q4 we implemented our Australian computer system. As a result of that we were able to reduce our headcount in G&A in the fourth quarter at the location.

Sam Bergman – Bayberry Capital Management

So basically what you’re saying is, this infrastructure will support the new 10 Denovo stores and perhaps $15 million worth of acquisition in ‘08 without adding to the costs?

Samuel L. Westover

Yep, that’s right.

Michael M. Halloran

That’s correct.

Samuel L. Westover

That’s exactly right and we know those numbers are right because in Australia they’re handling a much larger base of retail locations than we have in the US and the overhead structure is not dissimilar.

Sam Bergman – Bayberry Capital Management

Do you have a breakout of the retail sales versus wholesale sales in the quarter?

Michael M. Halloran

We do. The retail sales this quarter were about $2.7 million for acquired retail.

Sam Bergman – Bayberry Capital Management

What about the –

Samuel L. Westover

Retail globally is of course a much larger number.

Michael M. Halloran

Right.

Sam Bergman – Bayberry Capital Management

Do you have a number for the existing retail stores?

Michael M. Halloran

If you’re looking for the acquired retail number it’s $2.7. If you wanted an overview of what our sales are by retail, I don’t have that. I’d have to add up three different geographies.

Samuel L. Westover

But it’s more than half of our revenue.

Michael M. Halloran

But it’s more than half, correct.

Sam Bergman – Bayberry Capital Management

It’s more than 50% of the revenue?

Michael M. Halloran

Yes.

Sam Bergman – Bayberry Capital Management

Last question is how would you compare the quality of the line up of products this first quarter of ‘08 versus last year ‘07?

Samuel L. Westover

No comparison. It’s so much better right now. Our products are very competitive. Last year some of our competitors had some features that we really couldn’t match that we think add benefit to the patient and we were working very hard to close that gap and that gap is absolutely closed. So we feel very good about our product line right now.

Sam Bergman – Bayberry Capital Management

Do you expect more products to come out of research in ‘08 versus ‘07 or the same?

Samuel L. Westover

Yeah, I think so. I think we will have more.

Sam Bergman – Bayberry Capital Management

Because you are expanding research and development about $400,000 a quarter.

Samuel L. Westover

That’s right. We’ll have two products that we’ll launch in the first quarter, ion 400 that I just mentioned and we have one more that we’ll be launching just before AAA which will be the end of March and then later on in the year we’ve got another line up of products that we’re pretty excited about. We think that it’ll give our customers exactly what they need.

Sam Bergman – Bayberry Capital Management

Is that expected in the third quarter or later than that?

Samuel L. Westover

That should be around there, end of the third quarter is probably a good time to expect it but there are two big conferences in our business. One of them is AAA in the US and that happens at the end of April this year and then the other one is called EUHA, that’s held in Germany every year and that happens in October. So you like to have your product launches right around those times.

Operator

Your next question comes from the line of Al Kildani of SF Capital. Please proceed.

Al Kildani – SF Capital

With regard to the guidance, the range of guidance, can you give us an idea on the low end and the high end what the underlying assumption is for North America in terms of growth?

Michael M. Halloran

I can give you what we’ve assumed for the low end of the guidance is a reduction in North America of 10% in the wholesale. Then the rest of Europe and Australia would offset that to give us the 6% I talked about.

Al Kildani – SF Capital

And 10% in wholesale and retail would still be up?

Michael M. Halloran

Would still be up, that’s correct. Kind of how we break apart the numbers, if you look at our base business before acquisitions and Denovo you would say North America will be down, Europe and Australia will be up for a net of 6% is what we’ve assumed for our base business and then on top of that you add the retail acquisitions. This year we did say $7.5 million in sales you would double that pretty much for the $14 million for next year, on top of that we would have the $15 million to $25 million Sam mentioned. So assume a little bit less than half of that and then the Denovo stores.

Samuel L. Westover

And that’s for the low end. So if the US recovers faster than [inaudible] start moving up to the high end.

Al Kildani – SF Capital

And on the high end what would that assume about wholesale?

Michael M. Halloran

It would be the reverse and that you would say would probably be a 5% to 10% growth rate.

Al Kildani – SF Capital

And the 10% decline in wholesale assumption that is the low end, is that comparable to what you saw in December?

Michael M. Halloran

Pretty much, yes.

Samuel L. Westover

Well, actually December was worse than that, but we’ve seen January recover better and it’s around there.

Al Kildani – SF Capital

And then lots of color on SG&A and while it’s helpful I’m afraid I’m still not 100% clear, so let me ask this way, going forward when can we expect the growth in SG&A will be closer to or hopefully below the growth in sales?

Michael M. Halloran

That’s interesting. You would expect to see that in 2008.

Al Kildani – SF Capital

For the year or sometime during 2008?

Michael M. Halloran

Yes. It’s interesting, when you look at our business, if you break it apart back to what I’ve said earlier if you take our cost, if you break it apart into the three pieces and that would be the base business, what we had prior to acquisitions, the acquisitions and the Denovo stores. What I said is okay if I break those three apart and I look at from 2007 to 2008 what happens from leverage, right? Because clearly we want to start to get leverage in our business, if I pull out and just go base to base our SG&A goes down by 1%. So we would start to see we’re going to get the leverage that we would look for. If I pull out the Denovo that’s about another 1.5%. So the key for us is as we continue to do Denovo and acquisitions the rate is going up and then you won’t see what I’ll call the ratio of sales improve. So as an example our acquisitions today are about 50% to 55% and on top of that you have to add 5% to 7% for amortization so they’re running at 58% to 62% of sales value. So as you continue to acquire you can say from 58% to 62% you’re never going to improve over your 56% to 58% we’re sitting at today.

Samuel L. Westover

For the acquisitions.

Al Kildani – SF Capital

I’m sorry, did you say that will be a crossover point at some point in 2008 and then it will continue from there or for the year?

Michael M. Halloran

In our base business we have a crossover point where we’re clearly getting leverage but because of the Denovo stores and the acquisitions we will not get leverage in 2008.

Samuel L. Westover

The optics on this are a little confusing because if – let’s put together a hypothetical where you just have a wholesale business and then you’ve got acquisitions that you roll up next to that. What happened in the fourth quarter was the revenue in our wholesale business was lower than we would have hoped for but our expenses were where they were, then you’ve got acquisitions right next to that and the acquisitions show an increase in revenue and expense. When you add them all up it looks like revenue is okay because revenue from the acquisitions masked the inadequacy of the revenue from the wholesale side, but the expenses are both there. So it looks like your revenue is okay, but you guys have an increase in your expenses, when in fact it’s a revenue problem. It just looks like an expense problem. I don’t know if that helps.

Al Kildani – SF Capital

That’s helpful, but I mean so no leverage in 2008. I mean when is it going to begin to show up?

Michael M. Halloran

As we continue to acquire more practices what you’re going to find is the operating expense as a percentage of sales will continue to go up, but offsetting that will be our margin. So as an example in a normal retail practice we’re buying the 100% of sales, 85% is the margin and let’s just call it 605 is the operating expenses. That puts us at a 25% drop through, but I’m sitting today at 57% to 58% as a percentage of sales and you can see as I’m acquiring I’m adding 60%.

Samuel L. Westover

So what the acquisitions end up doing to our financials are revenue goes up, gross margin goes up, the admin ratio goes up and earnings go up.

Operator

Your next question comes from the line of Mark Matheson of Raymond James. Please proceed.

Mark Matheson - Raymond James

One thing I’ve always appreciated about your story is your relative cheapness on price to sales ratio compared to your larger international competitors. Do you find now that you’re looking at about 1X revenue ratio for 2008 revenue price to sales? Have you seen a similar contraction in price to sales from your larger international competitors or are they still at the 3X to 4X sales ratio?

Samuel L. Westover

Well they’re still much higher than we are but I have to say their stock prices have been adversely impacted over the last few weeks for similar reasons. I know that GN ReSound’s fourth quarter their revenue was down 15% over the prior year and ours was up 12% so we’re doing better than they are. Sonova which is the Phonak parent, they also had a downgrade. So we’re not the only company that’s been affected by this, but relatively speaking our stock is an amazing bargain compared to them and I think part of the reason for that, and you can see from what we’re projecting, there is a large fixed investment here, the research and development costs, building the product portfolio, that’s all very expensive and you have to spend a lot of money to get there and we’ve got revenue that’s been covering that but we’re right at the point where small increases in revenue generate huge increases on the bottom line. We’re talking about a 23% revenue growth next year will generate a 570% improvement in EPS so we’ve got a huge upside and I’m sure once we start producing those numbers then you’ll see the percentage of revenue or the value compared to revenue gap close us compared to our competition.

Operator

Our final question comes from the line of Joshua Zable of Natixis. Please proceed.

Joshua Zable - Natixis Bleichroeder

Just a couple of housekeeping things and then more kind of a global question I guess. Just on the quarter, the organic or the manufacturing growth was what? And, what is the retail acquisition contribution? Because, I know you said what you acquired but I know it doesn’t contribute exactly to what you acquired because like you said there’s that sort of time 30, 45 day period where you’re not getting contributions.

Samuel L. Westover

I’m sorry Josh are you saying the revenue increase?

Joshua Zable - Natixis Bleichroeder

Just this quarter in the US can you just break out the sort of manufacturing growth and then what was contributed by the acquisitions?

Michael M. Halloran

So, acquisition revenue in the fourth quarter.

Samuel L. Westover

Acquisition revenue in the fourth quarter was $2.7 million.

Joshua Zable - Natixis Bleichroeder

Okay.

Samuel L. Westover

Which was an increase of $2.2 million from last year’s fourth quarter.

Joshua Zable - Natixis Bleichroeder

And that’s actually revenue contribution that’s not how much you made in acquisitions?

Michael M. Halloran

That’s right.

Samuel L. Westover

That’s correct.

Joshua Zable - Natixis Bleichroeder

Okay. And, how much did you make in the acquisitions? You made about $2 million?

Samuel L. Westover

$1.6 million.

Joshua Zable - Natixis Bleichroeder

Then I guess from the SG&A standpoint I know people are trying to ask a lot about – I’m just trying to see maybe if you can kind of walk us a little bit through the P&L? I know you went through it, I just want to make sure I have my ducks in a row here just in terms of margin assumption and SG&A whether it be a percentage of sale or basically on an absolute basis. Just kind of so when we model out we have an idea if we’re doing the right things.

Samuel L. Westover

I have for 2008 we’ll call it the $0.10 that we quoted. What we’re looking at is a percentage of sales gross profit we ended the year in 2007 at 63.2 and in 2008 we go up about 3% to 66.2. SG&A we’re modeling at about 57.

Joshua Zable - Natixis Bleichroeder

[Inaudible] combined, both SG&A and R&D. Then, I know it’s kind of been a long call so I’ll wrap up. Obviously again, I think we all appreciate the color and the straight forwardness here on the call. It seems like even at the bottom end of your range it looks pretty good. That assumes the sort of weakness in North America but again, ultimately when we look at this market even though the dynamics of the hearing aid market are an attractive one from a long, long kind of long term view because I know we’re all getting a little more deaf as the day goes on and this call probably isn’t helping but, in terms of your ability to sort of execute on the strategy which I think is why most of the investors and most of us are kind of following the story more so than the 5% market growth, is that market growth affect your ability to execute on your strategy in any way?

Michael M. Halloran

I don’t think so. Actually, I think as we alluded to a little earlier and this is just my personal opinion that we have seen yet in the marketplace but, when there’s stress in the marketplace acquisition opportunities are out there and the pricing may be even better. And, I have to tell you our own retail in the US market did very well in December and January. We’re in control of it, we’re in control of the advertising, the referral activities, we can handle it better I think than individual independents that are out there. So, I think our strategy is definitely the right one where we have a strategic advantage because of our manufacturing margin that we can bring to the table and just the fact that we’re bringing large scale corporate capabilities to bare here that are very effective in a retail marketplace. We’re very encouraged and continue to be enthused about our vertical integration strategy and we’re sure it’s the right thing to do.

Operator

This concludes the question and answer session for today’s call. I’ll now turn the call back over to Mr. Sam Westover for closing remarks.

Samuel L. Westover

Thank you. Well, I’d like to thank all of you for your interest in Sonic Innovations. We’ve demonstrated consistent revenue growth and margin expansion. Our strategy is to produce great products, deliver outstanding quality and customer service and expand our distribution and we’re doing all of those things. Thank you again and we wish you all a good day.

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