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ZOLL Medical Corp. (NASDAQ:ZOLL)

F2Q08 (Qtr End 03/30/08) Earnings Call

April 23, 2008 10:30 am ET

Executives

Richard Packer - President and CEO

Ernie Whiton - CFO

Analysts

Phil Nalbone - RBC Capital Markets

Joshua Zable - Natixis Bleichroeder

Jonathan Block - SunTrust Robinson Humphrey

Gregory Macosko - Lord Abbett

Operator

Thank you for holding for the ZOLL Medical Corporation 2008 Second Quarter Results. Today's call is being recorded at the request of ZOLL Medical Corporation. If anyone has any objections you may disconnect now. At this time, all participants will be in a listen-only mode, and a question-and-answer period will follow today's speaker. At this time I would like to introduce your host, Mr. Richard Packer, President and Chief Executive Officer. Sir, you may begin.

Richard Packer

Good morning. Welcome to our fiscal 2008 Q2 conference call. I have with me Ernie Whiton, ZOLL's CFO. We will both make a few brief comments and turn to your questions. Ernie, if you will cover the Safe Harbor please.

Ernie Whiton

Thanks, Rick. The matters we will be discussing today which are not historical information consist of forward-looking statements. Reliance should not be placed on forward-looking statements because they involve risks and uncertainties, which may cause actual results, performance and achievements of the company to differ materially from the anticipated future results, performance and achievements expressed or implied in such forward-looking statements.

Forward-looking statements may contain estimates and actual results may differ materially from estimates. Factors such as overall economic conditions, the demands to the company's products and services, availability of raw materials and manufacturing capacity, risk of nonpayment of accounts receivable, risks associated with foreign operations, risks involved in litigation and other risks and uncertainties described from time-to-time in the company's filings with the Securities and Exchange Commission may cause the actual results to differ materially from Management's current estimates and expectations. The company disclaims any current intention to update forward-looking statements in the event of any changes in the facts, circumstances or expectations that underly those statements. Rick?

Richard Packer

Thank you, Ernie. I intend to be brief as I believe the results speak for themselves. This quarter continues to show the strength of our business across all of its pieces driven by new products and our largely unique focus on total resuscitation rather than just defibrillation.

Results in the North American hospital market continued to be quite strong. Our new R Series product with its differentiated features combined with our old standby product, the M Series, is giving us a very strong combination of products to attack the market. Add in the innovation of the AutoPulse and the Real CPR Help feature on our defibs and it appears we are setting ourselves apart in this marketplace.

Two accounts highlight our success this quarter. First the Mayo clinic in Rochester, Minnesota again chose ZOLL as their resuscitation partner and replaced their older M Series and ADs with the R Series and the AD Pro. Real CPR help was a key to retaining this prestigious account. We're glad to continue our partnership with the Mayo clinic.

Looking at a new defib account, we have standardized the Medical College of Virginia, which is part of Virginia Commonwealth University in Richmond, Virginia. They purchased 200 R Series, standardizing their whole facility on ZOLL. This is the first time this account has ever used ZOLL defibs.

The entree into this account was the AutoPulse. MCV deployed dozens of AutoPulses across their facility last year. Success with the AutoPulse allowed ZOLL to establish a relationship with MCV, which then allowed us to sell them on our vision of resuscitation in ZOLL's unique approach to defibrillators. MCV is a great example of how selling our broader resuscitation vision helps us expand our core defib business.

Turning to our North American pre-hospital business, our strong trends continue here as well. In EMS equipment and data, our business continues to expand. The combination is best highlighted by our announcement this morning of a standardization agreement with Rural Metro, one of the two national ambulance companies.

In this agreement Rural Metro has decided to standardize their whole fleet on ZOLL's electronic field data collections software. Along with this, as Rural Metro replaces their fleet of aging defibs, they are standardizing on the ZOLL product line, primarily RE Series.

Traditionally, we have done little defib business with Rural Metro as they have been standardized on Physio control products. So this is a major breakthrough for ZOLL and gives us not only nice incremental business over the next few years as the standardization rolls out, but also a partnership at a national level in EMS that can be used for model for other similar arrangements.

Internationally, it was another very good quarter. AD's were particularly strong, more than doubling over last year's results, as our CPR health feature leads buyers to prefer ZOLL. Professional defibs were also strong, particularly in our direct operations this quarter.

But lest anyone think we are hitting on all cylinders, the one significant downer for the quarter was international AutoPulse sales, which were significantly below last year's levels. After a series of quarters with increasing numbers of AutoPulse sales, it appears that the sales force took a bit of a breather this quarter. We look for much stronger performance in the next two quarters to get us back on track with AutoPulse internationally.

Turning to some other brief updates, on the CIRC trial which is our major AutoPulse trial we made significant progress. Vienna, Austria, our second largest site, has begun enrollment in the trial. Houston, Texas, our largest site, finally achieved IRB approval and is in the last phase of community notification and should be enrolling next month.

I was able to visit the Houston site last month to assess our progress with the staff and I can tell you that from the fire chief to the crews on the street level, everyone is excited about the AutoPulse and anxious to get going on this trial. So once Houston is up and running, it should be a top notch site for us. We still have the potential for 1,500 patients or thereabouts by the end of the year, and depending on the strength of the results, the potential for some data in 2009.

One other exciting development during the quarter, was the recent announcement by the American Heart Association changing their recommendation for CPR. For those that missed it, the American Heart Association or AHA for the first time endorsed the concept of eliminating the need to do rescue breaths in favor of continuous chest compressions. This means you should compress the chest at 100 beats per minute without any pause.

This is very exciting news for ZOLL, because it further validates the primacy of chest compressions over other interventions and will help drive demand for unique ZOLL products, such as the AutoPulse and Real CPR Help, as the task of performing chest compressions just got a whole lot harder. Now, this recommendation only applies to lay rescuers at this point and has not yet been adopted by the Europeans. But its impact will be felt throughout our markets.

So all up, a very strong quarter for ZOLL. In a moment, Ernie will take you through the details of our outlook. But let me just say that we have a lot of momentum in ZOLL and we're generally executing the plan. But there's obvious uncertainties surrounding all business today as we all try to figure out where the economy is headed, and for ZOLL particularly, what this year's elections will mean to healthcare spending. So we need to continue to grind each day, week and month to reach our goals.

However, we believe that you can see the direct connection between the investments we made a few years back and the results we are achieving today. And as we make investments today in the LifeVest and hypothermia, for example, we believe you will see similar positive results in the future. Ernie, I'll now turn the call over to you.

Ernie Whiton

Thanks, Rick. Let me start with our balance sheet. Balance sheet remains in excellent shape. We finished Q2 with total cash and related short-term and long-term investments of approximately $47 million dollars. This reflected a decrease of approximately $4 million versus Q1. We spent approximately $5 million on fixed asset and related additions, including AutoPulses for the CIRC trial, LifeVests and demo units.

Cash from operations was approximately breakeven. Our DSO's and accounts receivable improved from 76 days to 74 days versus Q1. Our inventory turns decreased from 3.3 to just under 3 times reflecting an increase in finished goods. Inventory, the extra inventory will support our second half fiscal '08 shipments.

Accounts payable and accrued expense levels decreased reflecting the timing of payments. Year-to-date, we've generated approximately $6 million in positive cash from operations and we expect to be significantly positive for the rest of the year.

Now, let me turn to the P&L. As we indicated in our press release this morning, our revenue growth was outstanding. As Rick mentioned, our performance was broad based across all markets. As we indicated in our press release, our gross margins returned to historic levels as anticipated. Gross margin for Q2 was 54.1% versus 53.7% in Q2 of last year.

Our Q2 operating expenses decreased as a percentage of sales from 48% to 45% as compared to Q2 of last year, reflecting leverage on our growth. Sequentially, operating expenses increased $4.5 million dollars reflecting higher sales compensation and related expenses associated with the sequential increase in revenues.

You will recall that Q1 included approximately $8 million in revenue, related to California that carried virtually no selling expenses. In addition as planned, our LifeVest selling and marketing increased approximately $1 million dollars. Other increases reflected typical growth in the business.

Selling and marketing decreased just under a point as a percentage of sales from Q2 of last year to Q2 of '08. Sequentially, selling and marketing increased approximately $3 million reflecting the higher sales compensation and related expenses, and the planned increase from the LifeVest sales force expansion.

R&D also decreased just under a point as a percentage of sales from Q2 of last year to Q2 of '08. The sequential increase of approximately $700,000 from Q1 to Q2 reflected CIRC trial and other clinical expenses in general spending on R&D.

G&A decreased from 9% to 8% on sales in Q2 versus Q2 of last year. Overall, return on sales, that is operating income as a percentage of sales improved three percentage points from 6% to 9% on sales reflecting leverage on our growth.

Other income decreased $600,000 versus Q2 of last year, reflecting lower average cash and investment balances, lower interest rates and foreign exchange fluctuations. In addition, in Q2 we recorded a modest reserve for investments of $200,000. We currently have approximately $2 million of auction rate securities backed by student loans and $300,000 of mortgage backed securities on our balance sheet.

Although these investments remain very highly rated, given the current liquidity environment, we received advice from our investment advisors that a modest reserve was appropriate. We believe this is conservative, as we have the ability to hold these investments as liquidity in the market stabilizes. Accordingly, we have reclassified these amounts to other assets on our balance sheet.

Our tax rate remained flat at 36% versus Q2 of last year. We anticipate a 36% rate for 2008 as the R&D tax credit has so far not been renewed by Congress. For the first half of fiscal '08, our tax rate of 36% compares to 33% in the prior year six month period, as the R&D credit was renewed last year and triggered a retroactive benefit that drove the lower than typical first half of '07 tax rate.

Our Q2 EPS of $0.27 cents was higher than expected, reflecting our stronger than anticipated sales performance. EPS grew 80% as compared to Q2 of '07 EPS of $0.15 cents.

Now I'd like to make some observations looking forward about 2008. Obviously, we are now running ahead of our plan for 2008. In our original annual guidance, we indicated we thought we would see an annual revenue growth over 2007 of 20% and a $1 a share in EPS.

We now believe we will see fiscal 2008 revenue about $20 million or so higher than our original annual guidance. Now, please keep in mind that approximately $9 million of full year revenue relates to California, which carries very little profitability.

We expect other income to run a million or so lower than we originally anticipated for the year, reflecting the current interest rate and liquidity environment. Additionally, based upon the strength of our business, we might spend another million or so on investments in our business.

Finally, we expect our tax rate to run about 36%. Putting all this together equates to operating income as a percentage of sales of approximately 9% for the year, and EPS for the year of approximately $1.10.

Let me add some flavor on annual revenue growth by major area of business. One growth scenario might look as follows: North American hospital revenue grows in the high 20% range, including US military and big government revenue of something in the $17 million to $20 million range. Excluding military and big government, North American hospital resuscitation revenue might grow in the low to mid 20s range.

North American pre-hospital might grow in the mid 20s, including data growth of 30% and public access defibrillation growth of 20%. Note that these numbers would include LifeVest revenues where our outlook remains positive and unchanged. International revenues might grow in the mid 20s instead of the mid teens. Again, this might all equate to revenue of something in the range of $390 million or so and $1.10 of EPS.

So in summary, our outlook for fiscal '08 is bullish based upon our first half, but as Rick pointed out, there is some big macroeconomic uncertainties out there, so we believe this is good balanced guidance. Now, let me turn the call back to Rick.

Richard Packer

Great. Jonathan, if you would conduct the question-and-answer period, please.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Phil Nalbone from RBC Capital Markets.

Phil Nalbone - RBC Capital Markets

Hello, and congratulations on another pretty remarkable quarter. I wanted to address the shareholder rights plan, Rick. I think a lot of people will have questions about this. Is this renewal of the plan in response to anything specific or any perceived threats or is this just a routine exercise in corporate governance given that the existing plan was about 10 years old

Richard Packer

Yeah, the existing plan ends in June, so we weren't going to have another board meeting before it ended, so this was just a routine renewal of what we think is just a good corporate governance item for a company like ZOLL.

Phil Nalbone - RBC Capital Markets

Okay. But just to clear the decks here on I think a pretty salient issue. Do you perceive ZOLL to be in play, have there been overtures? Do you think the stock has been so egregiously undervalued that you would be likely to get a hostile bid?

Richard Packer

There's a whole bunch of questions tied into that question, Phil. Again, this is just the timing thing, this thing was going to expire. We needed to renew it because we think that's the good general thing. It is not in response to any outside events, it is what it is. As to the value of the company, we're almost getting back to where we were before our largest competitor was shutdown, so I think we made a lot of progress here. But don't tie anything together other than this thing was going to expire in June, and we feel that it's a good thing for ZOLL to have generally.

Phil Nalbone - RBC Capital Markets

Okay, great. Thanks for indulging me on those questions. I wanted to look again at the overseas performance, by our numbers ZOLL has averaged 33% revenue growth over the past eight quarters in the overseas markets and that's despite competing head-to-head with Physio in those markets for the entire duration. What do you think that tells us about ZOLL's ability to compete in a fair fight with Physio and to take market share and exactly why are you taking market share?

Richard Packer

I think it's pretty telling as to what's going on, and the international market doesn't even have some of the advantages that the domestic market has, for example, data. We're not as strong with our ZOLL data brand in international as we are domestically, so we can't even get the kind of leverage that I highlighted with Rural Metro internationally. And in spite of that, just head on head with defib on defib, we've had very, very strong growth. I think that is driven primarily by the strength of the product line and the unique aspects that our product line has, not just in its individual defib features but also this whole concept of there's more to resuscitation than just the shock, the AutoPulse, Real CPR Help are very, very important elements of driving the whole product line forward.

So that's I think the prime reason.

The second reason is that we have good management in international. As you know, we changed that management a couple years ago, or actually three years ago, now brought in a fresh set of eyes, we've redeployed some assets, got some good things going in the Far East. While not at all slowing down what we were doing in our direct operations in Europe, so I think that is as simple an equation as we can get. We have sales people that are very passionate about this, we give them things that are unique and different and matter to a clinician and they're able to drive that through the market.

Coming back to the United States, I think that's one of the reasons you're seeing such strong performance in the hospital market. The right product portfolio, but I'll remind you that a year ago at this time we changed our leadership of the hospital market to put a more passionate player in place there that believed more fully in what we're attempting to do across the whole product line not just defibrillators, but selling data, selling the AutoPulse, selling Real CPR Help as a feature on the defibs, and I think we're seeing the fruit of those changes.

Phil Nalbone - RBC Capital Markets

Great, one last thing. It would appear that you racked up some pretty big wins in the quarter against Physio. So I have to ask the obvious question again, Rick. To what extent is ZOLL's current success in the US market a fallout from Physio's troubles, and are you worried about their full fledged return to the market some day?

Richard Packer

I worry about Physio all the time, because they are major credible player in this market as I do Phillips. So nothing I say should be interpreted as these big guys that we compete with don't worry me. Of course they do. We spend a lot of our time thinking about how we're going to beat them in the marketplace.

Having said that if you look at a couple of these things that I highlighted, Rural Metro, we've been working on Rural Metro more than two years. I was there a year before Physio was shutdown for what I think was a pivotal meeting to break the ice and break through with that organization getting them to see the vision of data and defibs and how it could work for them. So it started long, long before they had any acute problems with Physio control.

Medical College of Virginia, same kind of thing. They are very AutoPulse centric, because as you know, Richmond Ambulance has had terrific results with the AutoPulse. They see the AutoPulse coming in, they believe in the AutoPulse, that's moved to the hospital. A long time ago we started planning AutoPulse for that facility, long before any acute problems with Physio control. So those two in particular, I think I'm very comfortable saying with or without Physio control being shutdown, I think we would have wins in the ZOLL columns in those accounts.

From a commercial standpoint, I need to emphasize that Physio shipped more than 40% of their pre-shutdown capital equipment in their last reported quarter. Now we know that they're not shipping as many AED's and more of that is going to hospital and to EMS. This all affects just North America, of course. So rough calculation says they're shipping 50%, 60% of their pre-shipment levels to the ambulance market and to the hospital market. So if you are a sales person, trying to convince a customer that you can meet their needs, there are lots of shipments that you're able to point to and tell that customer, I can meet your needs.

So from a commercial perspective, from a sales people, our ZOLL sales people out there engaging with Physio in day-to-day combat, they've been fully back in this market since late last summer when they first began to ship. So that's where, if we've seen an effect, we've already started to see that effect. And as of yet, I think our strengths are overpowering their strengths and we're doing quite well. So I don't think that there's going to be any major change when they finally relieve that whole backlog of orders that they've accumulated over this period of time.

Phil Nalbone - RBC Capital Markets

Great, thank you very much.

Operator

Thank you. Our next question comes from Joshua Zable from Natixis.

Joshua Zable - Natixis Bleichroeder

Thanks for taking my question and congrats on a terrific quarter here. I apologize, I had some technical difficulties, so I was a little late. So, if I ask you to repeat things I apologize to everyone on the call here. Just in general, obviously a monster quarter here, you're getting into, starting to sort of lap your comparables on your hospital product. Maybe you can kind of talk about what you're seeing going out there going forward. And then sort of historically what the lifecycle on a product would be sort of, or the ramp if you can give us a little color on that?

Richard Packer

As you point out, Josh, the R Series, this is the first quarter that we had shipped a little bit, just a little bit last March a year ago, so we're beginning to come up on to quarters where we had the benefit of the R Series. As you know, it takes about nine months for capital equipment to really get into the swing of things, and so we're just still seeing the R Series begin to ramp up. But if I were to look forward, I'm not and Ernie points out, we're not pegging the hospital market to be 40% grower or anywhere close to the 60% that we did quarter-over-quarter in this past quarter, simply because the comps will be higher. But that marketplace grows in the low single digits anything that's in the teens and above, obviously is very strong performance on ZOLL's perspective.

We think that we're still just getting started with the R Series. There is a one-two punch going on with the M Series and the R Series. Both are doing quite well. And as we look forward, we think that the pipelines notwithstanding any major disruption of the hospital business due to the elections or Clinton effect or anything like that, but on a steady state, I think we have a good pipeline of business going forward.

Joshua Zable - Natixis Bleichroeder

Great. And then just, I guess again on a macro, and I guess you sort of answered it, but just again strong across all business units here, nothing out there says that hospitals or even EMS should have a reason to buy more defibs today than they were, specifically. So it seems to be obviously share gains. I mean, is there any trend specifically you're seeing going on, obviously AED's with obviously your technology, your CPR technology is going to help, but any macro trends maybe going on to explain such robust growth?

Richard Packer

Yes, I think the macro trend is that the world of resuscitation is really looking very closely at circulation as a prime driver of saving more lives. That people are looking at a defib more beyond the shock. It's no longer an argument over joules and biphasic wave forms and things like that, so much as it is, do you have the CPR feature, and does your defib have a vision of where resuscitation needs to go in the future? And are you coming at resuscitation with just a shock box or are you coming at this problem of resuscitation with other technologies.

I think that's the macro trend. And in ZOLL's case, for example, with hypothermia, which is not in the market won't be in the market for a bit of time yet. Our sales people, when they sit in front of code committees and talk about ZOLL, they talk about hypothermia, and they talk about us being the only defib company that's involved in this marketplace, that's investing in that technology. This is technology they care about, and I think it matters when they then look to the defibrillator that they're going to buy, and they say maybe we should favor the company that seems to be on the leading edge of the total picture, not just the best box that's sitting in front of us.

Joshua Zable - Natixis Bleichroeder

Okay, great. And then early in the year, I know you guys usually are mum on details about LifeVests, but early in the year, you sort of hinted at, historically you guys have been investing and sort of spending as you make money investing in sales force and building that out. And you've hinted at sort of potentially kind of stopping some investing or not stopping the investing, but I guess making more than you need to invest and possibly becoming profitable. Given the strength across all the other business lines and LifeVest, has that changed, in other words, are you going to continue to build out LifeVest or could we see some profitability from LifeVest this year?

Richard Packer

Let me recast what you've said.

Joshua Zable - Natixis Bleichroeder

Okay.

Richard Packer

Josh as both Ernie and I are scratching our heads a little bit here. What we've said about the LifeVest is that we're going to lose $2 million this year on that business. And that is a straight investment in building the sales force faster than bootstrapping would allow it to build if we just stayed breakeven and launching a major clinical trial that has a bunch of startup expense, but once you get through the startup its self-funding because this is a reimbursed product.

What we have said is that by the end of this year, we will be back in a breakeven position. And going into next year, we'll try and make a decision based on the strength of all of ZOLL and what we're trying to accomplish, whether or not we should run that business as a breakeven and let it build its sales force through bootstrapping, whether we should make another investment in that business to get the sales force much bigger than it could by bootstrapping, or if we needed to, slowdown the growth of the sales force, turn the business profitable and have it contribute to the bottom line.

I don't think anything has changed in that scenario. We are not at the point where we need to make those decisions. We are still executing this year's plan, which is make these investments in the beginning of the year and move towards breakeven once again by the fourth quarter in that business. So nothing has changed in our outlook for that business. And there continue to be I think very good, interesting choices that we can make with that business depending on what we are attempting to accomplish.

Joshua Zable - Natixis Bleichroeder

Okay, great. That's a helpful clarification. Thanks.

Operator

Thank you. (Operator Instructions) Our next question comes from Jonathan Block from SunTrust.

Jonathan Block - SunTrust Robinson Humphrey

Sorry about that, hi guys, good morning.

Ernie Whiton

Good morning.

Richard Packer

Good morning, Jonathan.

Jonathan Block - SunTrust Robinson Humphrey

Just some small ones, I think first, just a follow-up on LifeVest. If I missed it, I apologize, but did you break out a revenue number and then what would that growth be year-over-year?

Ernie Whiton

No, we didn't and we haven't.

Jonathan Block - SunTrust Robinson Humphrey

And I take it you're not willing to?

Ernie Whiton

I don't think it's necessary at this point.

Jonathan Block - SunTrust Robinson Humphrey

Okay. Just moving on over to AutoPulse, you mentioned some softness internationally. Maybe just big picture, Rick. Is that anything you have to do with the current environment? In other words, you mentioned some macro issues, is it more difficult to close a sale on an AutoPulse which may be viewed as a bit more discretionary than that of a defib spend and could that be why maybe your sales force has moved away in the current quarter from selling.

Richard Packer

So I would say that generally it's harder to close on an AutoPulse than defibs for the exact reason that you state, Jonathan. An AutoPulse is somewhat more discretionary, it's new technology, you've run your hospital or ambulance service without it up to this point, so you can always get away with not making the investment, you can always use the hands that are attached to your clinicians, of course. I don't think that that has changed and I don't think that that will change for many years to come until the AutoPulse or assisted circulation or automated CPR, whatever you want to call it, becomes a standard of care. When it becomes a standard of care, then you have equity between a shock and circulation, but right now, what you've said is generally true.

If I look at international and the weakness that we had this quarter, I don't think it's macro at all. Where we're selling AutoPulse, they're not the ones that seem to be ringing their hands about the looming depression that's coming like we are here in the United States. The economies that we're selling into seem to be pretty strong, pretty robust. So I don't think that it's any macro related thing, I think it's ZOLL related. We've seen in various parts of our company, some strong AutoPulse quarters and some weak AutoPulse quarters. AutoPulse takes continual attention and continual push because it is harder to sell that product than it is our defibs right now.

When defibs are racing forward and sales people are juggling a ton of business, it's natural that the hard work of getting the AutoPulse going in their country or with their customers might fall to the bottom of the priority list. It's part of the management task to make sure that that is not happening and to make sure that the AutoPulse continues to be at the top of people's priorities list, because it drives our defib business and is clearly one of the big future drivers for growth for our company. And we're so clearly differentiated there, it would be foolish not to use that weapon every single time. But you have got to constantly reinforce that with the sales people. So I'm looking for this to be a blip on the AutoPulse international radar screen, the forecasts look strong and we'll see if we can deliver on that promise.

Jonathan Block - SunTrust Robinson Humphrey

Okay, great, and just moving along to the CIRC trial. I think you mentioned the 1,500 patients. I just want to make sure I understand this correctly. Rick, what drives the results, is it the pace of the enrollment of the 1,500 or is it actually the result and what would trigger, excuse me, statistical significance and, therefore, whether we get it in '09 or 2010 is a little bit up in the air?

Richard Packer

It is statistical significance that drives when the data will be reported. The trial is designed much like the MADIT trial, if you're familiar with that, it's called a sequential design by which some third party is monitoring the results as you go through time so that you can pass levels of significance, not based on I'm going to look at 2,500 patients, but based on how well the product performs against your premise, if you will.

So if the product creates a much bigger difference than what you were anticipating, your body count is going to be somewhat less. And so for us, it's all about get these places well trained, get through all of the IRB and the waiver of informed consent things that need to go on, because this is a little harder to get going than your typical medical device trial. Get those patients enrolling, make sure that the people using the AutoPulse are well trained. Flush out the Hawthorne effects that we saw in the ASPIRE trials, so get the statistical noise out of the system, and then enroll enough patients to see the statistical difference.

So it's very much conjecture as to when we will see results. Even if I knew, every single month we were getting 150 patients in, Jonathan, I'd still be telling you, we might see results here, or we may see results there, depending on the results, the strength of the results.

Jonathan Block - SunTrust Robinson Humphrey

Okay. Great, understood. Just two more, first one real small. Hypothermia, just may be an update, here we are I am guessing roughly six months since the acquisition, what's being done there? I think you mentioned reconfiguring the console and is there maybe a rough point where you might introduce this thing OUS and even here in the US?

Richard Packer

Okay, so when we bought this product there was a finished catheter and a finished console. There were I think a couple hundred consoles that existed and some catheters and these things were out in clinical trials. When we bought that, all of those devices came back before we purchased the assets, the clinical trials were shutdown, because they didn't have the money to complete them. So the problem was that the cost of both the catheter and the console was more than what the market price for these products is. So it was fine for the startup company to go push a bunch of product in the market and lose money, because they were trying to show the viability of their company versus other hypothermia companies. That's not okay for ZOLL.

So what's going on right now is, starting with the catheter, we are value engineering it. So basically, we're taking machine parts of the cassette and we're turning that into molded parts and taking parts that cost $100 to make and taking those parts down to $2. So it's the same basic design, it is the approved design, but it's just being value engineered. At the end of that, system, at the end of that exercise, it will give us a product with a product cost that we could actually go sell and begin to make some money on. We will begin to go sell that cost reduced catheter with the existing consoles that are, when they are originally built we're brutally expensive, but we basically have them for free, if you will.

The second thing is once we get that into the marketplace, we'll go back and value engineer the console, same thing. We have the right design, its proven technology. We just need to take machine parts and turn it into molded parts. Take custom parts and turn them into off the shelf parts and value engineer that. We're hoping that by the end of this fiscal year, we will have frozen the design for the catheter, it will be in its testing if you will, all the biocompatibility kind of work that you need for in dwelling catheters, and that towards the middle of next year, fiscal year, we'll have a commercially viable product to put into the marketplace.

Jonathan Block - SunTrust Robinson Humphrey

Okay, great, and last one, maybe Rick for you, sort of big picture to end this thing. Your results do speak for themselves, but you mentioned some macro concerns, I think there's been a host of other cap equipment companies that have alluded to, some [actually] look to a slowdown in the back half of March. First question is, did you see anything like that and then the second one would be, just longer term for you guys, where is most of the exposure, is it in the hospital spend or is it on the pre-hospital side maybe from municipality revenue slowing down. Thank you.

Richard Packer

It's a very good question. No, we didn't see anything in any discrete time period here. I'm not sure we're smart enough to sort through what happens in the last two weeks. We have a pretty good hockey stick. We got a lot of orders that felt pretty good to us. In terms of where the exposure is, Jonathan, you've hit both of those things. One is, my biggest concern is the political environment and how hospitals think about what might happen to them in a changed political environment, and whether CFO's get skittish, and therefore, they start holding back on capital equipment purchases just because, right? Their cash flows haven't really changed, but there's a time of uncertainty so they're being conservative. We haven't seen that, we did see that in the '90s when Hillary Clinton went at the healthcare system the first time. That's what I worry about.

The second thing you talk about are the states. The last time states ran unprecedented deficits about a year after that, we started seeing some effect in the EMS market, because there's less money from the states, less revenue sharing to the cities and towns and counties, therefore less capital spending in EMS. Again, we have nothing definitive on that, I think it's yet to be determined exactly where the states are, this would have to be a fairly broad based effect, not just California has a deficit. We don't know whether that will happen again, but if it happens, there may be an effect there.

Jonathan Block - SunTrust Robinson Humphrey

Great, thanks, guys. Great quarter.

Operator

Thank you. Our final question comes from Gregory Macosko from Lord Abbett.

Gregory Macosko - Lord Abbett

Thank you. A brief question. I'm sure I should know it. But the revenue relative to California, would you just go through that relative to the expenses, et cetera, that you've talked about and I don't remember that.

Ernie Whiton

Sure. In the first quarter of 2008 we shipped approximately $8 million worth of product to the State of California. This was a deal that carried about a 30% gross margin because it was a multi-element deal, and we needed to defer the fair market value of the undelivered elements. We ended up recognizing about, I think it was about a 13% gross margin on that revenue, and consequently the margin on the remaining revenue that will be recognized over the course of five years will be much closer to our corporate average gross margins. From a selling expense perspective, there was virtually no incremental expense associated with that deal. So, there was very, very modest profitability on that deal. And essentially what happened in Q2, if you look at our revenues sequentially from Q1 to Q2, the California revenue that was in Q1 with virtually no selling expenses was replaced and then some in Q2 with a much more normalized level of selling expenses.

Gregory Macosko - Lord Abbett

And then, other than the sales force ramp that you talk about. Are there any particular expenses in the G&A line or the R&D line that were more in the quarter than we might normally expect?

Ernie Whiton

Well, there was clearly incremental sales compensation and related expenses associated with the incremental revenues that occurred. And then as you point out, there were expenses associated with expanding the LifeVest sales force, which we had planned.

Gregory Macosko - Lord Abbett

Yes, but the first is basically a positive because…

Ernie Whiton

Yes.

Gregory Macosko - Lord Abbett

On a G&A line or on the R&D line especially, there was nothing there that was particularly different, sort of general ongoing numbers?

Ernie Whiton

No.

Gregory Macosko - Lord Abbett

Okay. Very good, thank you. Nice quarter.

Richard Packer

Thanks Greg.

Ernie Whiton

Thanks Greg.

Richard Packer

Let me wrap up here. I thank all of you for your time this morning. Clearly we're very excited about our results here. We think that we are lined up for a good back half of 2008 and we look forward to speaking with you in approximately three months and reporting on our continued progress. Thank you.

Operator

Thank you, ladies and gentlemen, for your participation in today's conference. This does conclude the program. You may now disconnect.

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Source: ZOLL Medical Corp. F2Q08 (Qtr End 03/30/08) Earnings Call Transcript
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