ResMed, Inc. F2Q08 (Qtr. End 12/31/07) Earnings Call Transcript

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 |  About: ResMed Inc. (RMD)
by: SA Transcripts

ResMed Inc. (NYSE:RMD)

Q2 FY08 Earnings Call

February 07, 2008, 4.30 PM ET

Executives

Kieran T. Gallahue - President and CEO

Brett Sandercock - CFO

Keith Serzen - COO, Americas

David Pendarvis - Sr. VP, Organizational Development and General Counsel

Analysts

Joshua Zable - Natixis Bleichroeder

Jason Mills - Canaccord Adams

Michael Matson - Wachovia

Timothy Lee - Caris & Company

Benjamin Andrew - William Blair & Company

Paul Choi - Merrill Lynch

Alex Smith - JPMorgan

Joanne Wuensch - BMO Capital Markets

Andrew Goodsall - UBS

Operator

Good day, ladies and gentlemen, and welcome to the second quarter 2008 ResMed Inc earnings conference call. My name is Akiya and I will be your operator for today. At this time, all participants are in a listen-only mode. We will conduct a question-and-answer session towards the end of the conference. [Operator Instructions]

Before we begin, the company has asked me to address certain matters. First, ResMed does not authorize the recording of any portion of this conference call for any purpose. Second, during the conference call, ResMed may make forward-looking statements, such as projections of future revenue or earnings, new product development or new markets for the company's products. These statements are made under the safe harbor provision of the Private Securities Litigation Reform Act of 1995. Risks and uncertainties exist that could cause actual results to materially differ from the forward-looking statements. These factors are discussed in ResMed's SEC filings, such as the forms 10-Q and 10-K, which you may access through the company's website at www.resmed.com.

With that said, I would like to turn the call over to Kieran T. Gallahue, ResMed's President and CEO. Mr. Gallahue, please go ahead sir.

Kieran T. Gallahue - President and Chief Executive Officer

Thank you, Akiya. As noted, this is Kieran Gallahue, and I will be facilitating these calls on a go-forward basis. Before I begin, I would like to acknowledge our Founder and Executive Chairman, Peter Farrell who has led the organization from its inception and who has presided over these conference calls where he has announced record results for 15 consecutive quarters. That's an amazing result by any measure. And just to put that in perspective, in 1995, we had annual revenues of less than $25 million and today we are reporting revenues in excess of $200 million for a single quarter.

I'd also like to remind our investors that Peter hasn't gone anywhere, he remains a very critical part of our strategy development process and of course he is a well-known luminary in the industry. I personally feel very fortunate to have worked with him in these past five years and I very much look forward to working side-by-side with him as we move forward. All right, let's get on to the call.

So we are going to structure these calls a bit differently as we move forward. After this initial introduction, I am going to hand the ball off to Brett Sandercock, our Chief Financial Officer and he is going to review results. At that point, I'll take the ball back and make a few comments putting the quarter into perspective and updating you on key developments and then I will open up the call for your questions.

So with that, let me hand it off to Brett. Brett?

Brett Sandercock - Chief Financial Officer

Great, thanks Kieran. So, I'll just run through the December quarter results briefly and start from the top. So, revenue for the December quarter was $202.7 million, an increase of 14% over the prior year quarter. Favorable currency movements added approximately $10 million to our Q2 revenues. Our income from operations was $36.8 million for the quarter and net income for the quarter was $26.9 million. Our pro forma rate is $0.41 for the quarter. Now this measure excludes restructuring cost, stock-based comp expense and amortization of acquired intangibles. On a GAAP basis, our EPS is $0.34.

In terms of overall currency impacts on our results this quarter, the weakening U.S. dollar had a negative impact on our EPS of approximately $0.01. Gross margin for the quarter was 60%; this is broadly consistent with the September quarter. SG&A for the quarter came in at $67.6 million, an increase of 18% over the prior year quarter. If you look at that in constant currency terms, SG&A increased by 10% over the prior year quarter. And SG&A as a percentage of revenue was 33% this quarter compared to the year ago figure of 32%.

R&D expense for the quarter was $14.9 million, an increase of 24% over the prior year quarter. Again in constant currency terms, R&D expense was a more modest increase of 9% over the prior year quarter. R&D as a percentage of revenue was 7%, which is consistent with the year-ago figure. And looking a little forward with ongoing commitment to innovation, total product pipeline and clinical trial commitments, we expect R&D expense as a percentage of revenue to continue in the 7% to 8% range through the balance of FY '08.

Now amortization of acquired intangibles for the quarter was $1.9 million and stock-based compensation expense for the quarter was $5.3 million. For the balance of FY '08, we expect that quarterly stock-based comp expense to pick up to around $5.7 million in the third quarter. Now that reflects an up tick, as a result of annual stock option grant in November last year.

Turning to revenues in more detail. Overall, the Americas sales were $100.2 million, an increase of 7% over the prior year quarter. While sales outside of the Americas totaled $102.5 million, an increase of 21% over the prior year quarter.

Now our traditional break out of the revenues by product segments. In the Americas, flow generators were 2% lower than the prior year quarter, while masks and other increased by 12%, reflecting strong sales in our new product introduction. For revenues outside the Americas, flow generators increased by 16% over the prior year quarter reflecting momentum in our S8 II sales, while masks and other increased by 31%, again driven by strong new product sales. On a group basis, flow generator sales increased by 9%, while masks and other increased by 19%.

Turning now to cash flow. Our cash flow from operations was $18.9 million for the quarter. However, excluding the impact of recall costs, cash flow for the quarter would have been $31.2 million. Capital expenditure for the quarter was $21.9 million. This includes $14.2 million in building construction costs, predominantly associated with our San Diego headquarters. Depreciation and amortization for the quarter totaled $13.8 million.

In terms of balance sheet, our balance sheet remained strong. Total assets at December 31, were $1.3 billion, net equity was $1 billion. Cash and cash equivalents net of our external debt were $156 million at the end of December. I'd now like to hand the call back to Kieran for comments.

Kieran T. Gallahue - President and Chief Executive Officer

All right. Thanks Brett. All right. I'll make a few comments and what [inaudible] questions that are frequently asked and try to answer those in advance. And then I'll open the call up to more general Q&A.

First you can see; we now had our 51st quarter of record results. And those results are in spite of the fact that we had anticipated both Q1 and Q2 of this year to be challenging due to difficult base year comps, GAAP period in our product introductions cycle and the response to earlier price challenges. I should also note that Q2 should be the last quarter where we expect our motor business to negatively impact our Americas growth rate. Q2 represented a few milestones and I'll be remissive if we pass by this call and I didn't note them. This was the first quarter in the company's history that we surpassed $200 million in revenue for a single quarter. And I am very pleased to report that both the Americas and ex-Americas market both contributed over $100 million each, that’s a very nice balance of geographic revenues.

All right. Let's transition to talk you about the future and let me say this as a header note. I feel extremely optimistic about this industry as we look forward and I feel just as optimistic about the role that ResMed can play within this industry. And let me tell you why I feel that way. I'm going to cover three basic topics although there're certainly many more that we can go through. I'll talk about our planned, product introductions schedule, a heart failure clinical study that we're initiating and finally the preliminary decision by CMS to allow home sleep testing.

First our planned new product introduction schedule. In this quarter, we are launching and in fact in the past few days we've launched two important new products in the Americas. First, the VPAP Auto, which is a bilevel device. The second is the Mirage Micro nasal mask. All right, first on to the VPAP Auto, so what's different about it? First it's our first bilevel product we introduced into the more compact S8 body. It is far smaller than our previous generations bilevel. Second, it will use the same accessory sets such as our S8 humidifier as we use with the more general S8 product line. This helps to provide scale economies for ResMed, while eliminating non-value added changes for our customers reducing their inventory challenges. Third, it's powered by a unique patented double-ended motor, it's the same motor that powers our S8 II CPAPs that we are currently selling outside the Americas.

This motor is a core component in our next round of product introduction, because it vastly increases the efficiency of the motor, allowing us to increase performance, while simultaneously reducing noise generated by the device. Because noise is an important factor in user comfort and compliance, we feel this is going to be a very highly valued future of our customers and in fact since it's in the S8 II device that's been launched ex-U.S. we've already being receiving very positive feedback about that.

The fourth value proposition for the VPAP Auto is the integration of our unique Easy-Breathe waveform and you will be hearing a lot more about the Easy-Breathe waveform in the coming months. The Easy-Breathe waveform is an extremely comfortable flow pattern that once again improves user comfort and as we know that's a major factor in driving compliance. So, we are very optimistic about the launch of the VPAP Auto, given the timing of the release we should see some of the impact in Q3 although it's going to be a partial impact in this quarter and more full impact in Q4.

Second product we’ve introduced within the past few days is the Mirage Micro Mask, and this is our first product introduction into the standard nasal mask category in four years. Just as the quadro set of new standard for a full-face mask performance, we believe the Mirage Micro will set a new standard for comfort, ease of fitting and performance within the standard nasal mask category.

As we look to Q4, we should have a full quarter of impact both from the Mirage Micro and the VPAP Auto and then we are going to introduce another series of products during the fourth quarter. Let me go through those for just a minute. On the CPAP side, we will be introducing several of the S8 II product series in to market, in the Americas that we've already launched during Q2 in Europe or outside the Americas. Once again, the products will be powered by our unique double-ended motor technology that has allowed us to improve performance and at the same time lowering noise levels. Just like the VPAP Auto, we will retain the current S8 design and accessories in order to minimize transition challenges for our customers while maintaining our on supply chain scale efficiencies.

Finally, we expect to be introducing of new mask product into the nasal pillows category also during Q4 and we will provide more detail on that product as the product launches. So as you can see, we've got a fantastic new product flow over next five months or so and it is a... it is a product line that is built up with innovative technologies, but is also consistent with our strategy of maintaining efficiencies with the customer in our own supply chain.

All right, next I would like to address the industry drivers and first, let's talk about congestive heart failure. In January this year, we have begun the recruitment of our first patients into the predominantly European-based clinical study in heart failure. We've long noted the critical role of the treatment of SDB can have on very serious and very costly co-morbidities such as congestive heart failure, such as diabetes, hypertension and others. This study represents a very tangible stake in the ground of our commitment to both providing and generating value from the these co-morbidities. This study, which is intended to be conducted over a five or so year time frame is targeted to the use of adaptive servo-ventilation and very specifically to the use of the ResMed ACS2 product in severe heart failure patients.

The primary end points measured by the end points, which are meaningful to the heart failure and to the payer communities, mortality and hospitalizations. The study will engage two primary critical medical specialties, cardiologists and respirologists or pulmonologists. Heart failure costs government billions of dollars per annum to treat and we're optimistic that the use of ResMed's adaptive servo-ventilation, very specifically the ACS2 products will provide clinical benefits but positive economic benefits. While we don't intend to report specifically on the study as it progresses, we'll provide updates as material information or results become available.

Finally, let me briefly comment on the preliminary national coverage decision that CMS in December. First of all let me highlight that this decision is preliminary and a final decision is due out in mid March of this year. Now, our reading in the preliminary decision is that CMS has recognized that SVD is an enormous public health issue and they're seeking to increase the access to diagnose this in treatment of the 90% of the patients who have not yet been diagnosed or treated.

We also see the decision as an indication that home testing will be complimentary to the current diagnostic pathway and we're hopeful and confident that our valued partners in the sleep community will continue to play a pivotal role in treating patients and we plan to support our partners as they evolve and thrive in this new environment. From the perspective of impact on the SVD device community, this represents an additional driver for growth over the long haul, and one more reason for us to believe that the industry continues to have bright prospects.

We remain in an industry that is 90% unpenetrated and achieving sustainable industry growth in the 15% to 20% range is supported by these types of drivers. Now, importantly, there's some water to flow under the bridge before this decision is finalized, and before we feel its full impact in the industry. In general, medical community takes a bit of time to absorb change and it wouldn't be surprising to us if it is 18 months to 24 months to pass before this thing sorts itself out. Nonetheless, it remains a very positive change for the industry and one that we look forward to supporting.

So in summary, we're very optimistic about the future of the industry and the role that ResMed can play in our industry's growth and we're looking forward to the positive forward momentum that we'll see not only from our new product introductions that we'll be seeing over the next five months, but also these positive developments in the industry as a whole. All right, with that why don't I take a break and turn it over to Q&A. Akiya?

Question and Answer

Operator

Thank you. [Operator Instructions]. Your first question comes from the line of Joshua Zable of Natixis. Please proceed.

Joshua Zable - Natixis Bleichroeder

Hi, guys. Thanks for taking my call here. Peter, I take this opportunity to thank you for all your help over the years and Kieran I guess you obviously been around for a while, but a formal welcome to the party here. Just obviously kind of the main... probably the big question that sticks out is the flow generators in the Americas. Can you just comment, I mean everything else looks great. Maybe that's a function in the motor business. Just if you can give us a little commentary on that.

Kieran T. Gallahue - President and Chief Executive Officer

I mean, I'll let Keith to handle part of it, let me just open it up. We're basically a gap period here. We've had some very difficult base year comparables that we are dealing with and it sort of peaks out in Q2, we have got the new product introductions that will be in the flow generator side, that will be coming forth, not only the VPAP Auto here in Q3, but also we are going to see in Q4 and quite frankly there is also a bit of pricing impact that was in those numbers as well. So little bit lower than we are used to, that's for sure. But again, we've got confidence as we move forward that will be flowing out of that. Keith, you got anything to add to that?

Keith Serzen - Chief Operating Officer, Americas

Kieran I think that that is a pretty adequate job of going through the explanation, the only... but the only thing that I would add is that we’ve also had some growth in our sales force over the course of the last year or so and as a result of that growth, we've had some promotions within the sales force, we've expanded some territories and added some new territories. Well, one of the things that we found is that it takes our reps about six months to really begin to ramp up to a level of productivity once they come on board, and fortunately we are at the point where those reps, those new reps that we've added are now clearing that six month productivity and moving towards nine months.

So with the refreshing of the product line which gives us an opportunity to really get the sales force excited about what they are selling and the combination of the reps becoming more mature in what they are doing, I think that that's something we look forward to.

Joshua Zable - Natixis Bleichroeder

Great. And then just a follow-up, can you guys just talk about the sort of overall health of the market here. I know you sort of alluded to it but obviously just obviously with you and Respironics out there and I guess as it relates to may be home diagnostics, are we expecting sort of some change here with people kind of ready, maybe holding back as things get, and then obviously expect a pick up when it sort of goes full swing?

Kieran T. Gallahue - President and Chief Executive Officer

Yes. So... I think periods of changes there is always short-term opportunity for people to sort of look and question what their role is, but the general signals in the market is positive one at this point. I think that the home… the preliminary decision on home testing certainly is one that bodes extremely well for the long-term access of the patients for the diagnostics process and removes some of the bricks and mortars limitations that may have been governor on growth as we've seen in the past. So near term, there is certainly going to be some jockeying for position out there, as various members of the medical community determine what the role is that they are going to play in this new world going forward. But I suspect that we'll yield some more positive contribution versus negative side. I think the changes are good.

Joshua Zable - Natixis Bleichroeder

Great. Well thanks a lot. Great job guys.

Operator

Your next question comes from the line of Jason Mills of Canaccord Adams. Please proceed.

Jason Mills - Canaccord Adams

Thank you and how are you. Wanted to follow-up Kieran if I can on the last question or the last answer about some of the constituents within the supply chain here are jockeying for positions, I'm trying to figure out how they could fit in. Could you elaborate on that a bit further, specifically it seems that we are seeing growth in the number of beds which is an underlying variable that is important for growth in the underlying market. However may be not as robust as you've seen in years past and perhaps that is because folks in the supply chain are trying to figure out what is going... what the markets or what the environment is going to look like after the final decision. Could you help us understand what you see in terms of growth in the number of sleep labs currently and how you think that will change as folks sort of figure out how... where they fit in?

Kieran T. Gallahue - President and Chief Executive Officer

So part of this is... information we have directed sort of detail or data, and part of it's going to be more just looking at the market and we are providing--.

Jason Mills - Canaccord Adams

Sure.

Kieran T. Gallahue - President and Chief Executive Officer

But, we're seeing continued growth on the sleep lab PSG, capacity side but let's face it, if we are looking for the real growth in the capacity that's going to be this home testing as it comes through, because then it moves well beyond the bricks and mortars and we're all going to have a look at a different indicators of growth as we move forward. And as far as I'm concerned that’s a very positive thing, right because it demonstrates that there is going to be more ways of growing capacity. It's good to see that sleep labs continue to expand some of their capacity because we feel [inaudible] important role within… in this… in the diagnostic process. There were to be a certain amount of the patients that will be able to be fully tested and diagnosed with home testing and there will be a certain amount of those patients which are going to need more comprehensive care, such as those, let's say in complex sleep apnea that are going to need the help and support of that in the lab diagnostic process. So we are pleased to see that they'll continue to do that. So in general... again I guess I can only say that there are various players who have spoke up that are waiting for the final decision, but are looking to get in the gap to actively engage.

There is some members in the sleep community, they feel they can play a very important role as part of the hub-and-spoke model of engaging other specialists and primary care physicians. You’ve heard public statements from home medical equipment providers, who feel that they can provide a role in helping to accelerate the diagnostics rate by getting engaged in home testing. I suspect that there will be other players that will get involved in that as well. So from our view is we try to borrow [ph] that down and say what does that mean from an industry perspective, and I got it clear everything that we are seeing in that is extremely positive, it means that there is going to be more awareness building that there will be more interested parties in various stages of the market that will be looking to try to take those 90% of the patients who remain undiagnosed, and try to find a complimentary path way to help them reach therapy.

Jason Mills - Canaccord Adams

Great, that's very helpful, just two quick follow-ups here, I don’t if they are quick, but I'll try to make them quick. So I understand how that would impact positively perhaps longer term, near term… perhaps some of an impact that we won't see the final decision until March. So from what you've laid out we have this environment for you, we have new products and easier year-over-year comparisons and perhaps still some jockeying for physician as a modest option. So, with that said as we look into the near term to the second half of your fiscal year, could you helps a little bit with respect to your expectations for the growth, especially in our U.S. business but also the ability to maintain the growth you put up this quarter in the international business given what's lying in front of you for the next couple of quarters?

Kieran T. Gallahue - President and Chief Executive Officer

Sure. So obviously the… anything to do with the home testing, actually one point of clarification before I start, when I say the jockeying for position I mean that's our positive side, I don't know that's an offset at this point so.

Jason Mills - Canaccord Adams

Okay.

Kieran T. Gallahue - President and Chief Executive Officer

But if we go to the next stage, obviously in the international side they are not going to be influence or impacted by the home testing, really what’s driving that is positive introduction of the SA-2 it's been a very well received product into that market, as well as some of the new mass products, as well as quite frankly execution. We have been improving in many areas of the world, we’ve been improving our execution, so I feel very good about that piece, obviously the piece that’s influence by currency is lot [ph]. But, as far as the execution the basic fundamentals of the business I feel very good about the way that the team is performing and the basic stable of products that we have. On the America side as we move forward we've been stating here for quite a number of quarters is that, we felt that Q1 and Q2 were going to be difficult because of the product gaps and some of the base year comps and sort of absorbing some of the pricing channels. And then as we move through Q3 and Q4, we are beginning to get into that product flow in Q3 and a bit more product flow in Q4, and we have proved... we expect that we will begin climbing back during that period back to market rates of growth. So, we continue to feel comfortable with that assessment.

Jason Mills - Canaccord Adams

Great. And then last question, I will get back in queue, regarding gross margins. I mean, just sort of in plain speak here, have we seen the trough in gross margins? I think 60% was kind of a line that most of us wanted to see sort of stabilize that and can we see expansion from here giving clearly a lot of what you have talked about with respect to the new product suggest efficiencies are being worked into the manufacturing facilities, and I guess it speaks to how can that sort of be a greater influence to your gross margins relative to the price pressure you have seen in with respective ladder. Do we expect to see that abate a bit as Respironics becomes part of a larger organization that probably is more interested in sales… interested in running a profitable business.

Kieran T. Gallahue - President and Chief Executive Officer

Yes, I think you have got a short-term element to that question, you have longer-term element of that question, and would I be looking for margin expansion in the next few quarters? No, I think that will be difficult to look for. One of the very comforting things of this market is that many of the pricing pressures that we talked about six months ago, nine months ago, it seems that there has been a floor established in the market. We are not seeing price levels drop below where we had seen some of the deals, six and nine months ago. On the flip side of that, you do have obviously more customers as we have said it is going to happen here, more customers who are getting this price level. So what you are going to see externally during that time period is a bit continued pressure on ASPs here over the next few quarters, but again the good news is we are not seeing... it is simply an expansion to more customers. That's a very classic way of what happens in price in this market.

So, a lot of the gross margin improvements that... and some of the fundamental drivers that we would see really come with significant changes in the product evolution, and that we would see in sort of next generations of product and some of the changes that we are working on behind the seasons in the supply chain. So near-term, would I be looking for expansion? No. Are we fundamentally doing the right things to continue to reduce our cost of goods over the longer haul, absolutely.

Operator

Your next question comes from the line of Michael Matson of Wachovia. Please proceed.

Michael Matson - Wachovia

Sure. I guess, just wanted to ask you again a little bit about your confidence level in a rebound, I mean the comps obviously do get easier, but the growth in the US does seem to have slowed pretty substantially and the numbers that are out there show, I mean the consensus estimate shows a fair bit of acceleration in the next couple of quarters. Are you comfortable with those?

Brett Sandercock - Chief Financial Officer

Well, I don't comment on any specific sort of numbers that are out there, but let me talk a little bit more in general, Michael. So, again these first couple of quarters, we did have very difficult base year comps, and we in a gap in the product flow etc. As we move into the Q3 and Q4, again we are climbing back towards market levels of growth. So, do I feel comfortable with that? Yes, I do feel comfortable that we can climb back towards those levels. I am not here saying that we are going to get back to where we were a year and half ago at 45% and 50% growth levels. I don't think that would be reasonable to assume, but I do think that we have some very good positive momentum to get back to market levels to grow.

Michael Matson - Wachovia

Okay and then, I was wondering if your growth... are you going to do anything to try to rein in the SG&A and R&D levels, given further growth in those expenditures, given the slowing revenue growth that we are seeing, because they... they were growing a little faster, I think in your overall revenue growth in the quarter, I realized some of that might have due to currency?

Kieran T. Gallahue - President and Chief Executive Officer

Yes, big part of it was due to currency, I think Brett had given the breakout on… for instance on R&D and the growth in constant currency and we're substantially lower. At this point, feel very comfortable particularly in R&D line with the amount of investment that we are providing into the business and, when you are in a market that’s 90% untapped, our view is this is not the time to take your foot of the accelerator. So we are doing the smart things I think in the sense that as the currency is going a bit against us, we have slowed constant currency growth of those, but we are going to starve the business. We simply… this is simply the wrong phase of this industry's growth. And particularly, when you look at all the good things that are happening whether it is the… the home testing decision that we are looking forward to in March, already we talk about some of the data that's coming out in the co-morbidity, be it congestive heart failure, the study I think is going to be very important over the long haul both the payers as well as to the clinical community, and in areas such as diabetes and occupational health there are so many aspects in this market that are untapped, that our job is to keep this market growing and to participate more than our fair share in that growth and so, I think now is the wrong time for us to look at any substantial leverage of that.

Michael Matson - Wachovia

All right, and then I guess just two product related questions on some of your recently introduced products, I guess not that recent, but the Adapt SV and then the Tango kind of at the low and high end of the markets, just any updates you can gives us there on the progress with those products?

Kieran T. Gallahue - President and Chief Executive Officer

Yes both are playing their role, the Adapt SV remains, and remember the Adapt SV is also known as the ACS 2 in Europe, so it remains a core element of our strategic growth as we move forward and it is the basis of this congestive heart failure study. So we continue to gain traction in the understanding awareness of complex sleep apnea and we continue to focus on the significant role that a complaint [ph] congestive heart failure outside the U.S. As far as the Tango, I remember is really two different parts to the strategy behind Tango, on one side it was basically to pick up some great, it was… we haven't traditionally participated in that very low-end part of the market. And the idea was when you are on a sales call and they are buying those low end, let's participate, we are doing okay in that area, that is not really our core skill set, we tend to sell higher technology, we tend to sell algorithms that make a difference and focus on other aspects of the sales process.

So I'll say that we are doing all right, we are certainly not hitting out of the park with the part of it. The other part of the Tango of course was more of a, sort of strategic blocking strategy overtime. And not for any particular competitor or any particular risk on the horizon, but we got a nice market here and one other things that we look to do is to create barriers to entry over time, and if you look at the most rational place that a competitor might try to enter the market it would be where the intellectual property barriers and the technology barriers low switches, the low end CPAP and it has done an effective job I think in that side of the market, which is to create a bit of block.

Michael Matson - Wachovia

All rights that's all I've got thanks.

Kieran T. Gallahue - President and Chief Executive Officer

Great for asking the questions.

Operator

Your next question comes from the line of Tim Lee of Caris & Company. Please proceed.

Timothy Lee - Caris & Company

Hi. Good afternoon. Kieran, can you just give us your thoughts on how do you think the market dynamics may change here with Respironics in the hands of the Philips, I mean do you think we are ahead into a era of greater pricing stability and… Keith it will get as well I guess given his experience with Philips as a part of heart chain [ph]?

Kieran T. Gallahue - President and Chief Executive Officer

Yes. That will be great. So in... obviously the waters got to flow under the bridge here. So, we're sitting here trying to predict the future. But, I can tell you that my view on the acquisitions is I'm very positive on it, I think it's great. And I think in a lot of ways it's great validation of the growth prospects in this industry, I think it's recognition of this industry being highly under penetrated and I think, having a large well known brand entering the marketplace should help us in creating awareness within the industry and creating awareness within the various medical cilo [ph]. So, I'm very positive and very optimistic about the future and Philips’ entry into the marketplace.

As far as pricing, we will have to see how that flows. I encouraged to note the reputation of their company is usually to sell on value on a market expansion and value being bringing new and innovative ideas to the marketplace. That's the kind of market that we think is appropriate, again for such an under penetrated market. So my view is that it's a positive development and I am looking forward to working with them in market expansion and obviously competing with them in the appropriate manner. Keith, you have anything to add to that?

Keith Serzen - Chief Operating Officer, Americas

Kieran, I would just say that I agree with you 100% on the perspective that Philips sells on the basis of value, they also have a history of growing markets, which is one of the things that lot of us are very excited about. We... ResMed has spent a lot of time growing individual market segments. Respironics has spent a lot time as a close follower. We view Philips as a company that will invest in the market growth and put as much time into the development driving, more people into the diagnostic channel and the therapeutic channel as we are. So, we are very excited about this.

Timothy Lee - Caris & Company

One last if I may just, can you give us your current thoughts on how you think competitive bidding is going to play out in the marketplace?

Kieran T. Gallahue - President and Chief Executive Officer

Again, water is got to flow under the bridge there. We will wait to see what the... how the results pan out there and you know what bids are accepted and what not. We hear mixed things from the marketplace. As with anything before the final pronouncements, you get plenty of rumors running around. And the good thing here is that, you know, CMS was running a bit higher on the pricing than you'll see at most managed care and other payers, so there's room to move on that to start with. And from our perspective, it's 10% of our global sales 20% of our U.S. sales and so we think we are still well positioned to compete there. But, it's not a direct impact on us, it's an indirect impact.

Timothy Lee - Caris & Company

Thank you.

Operator

Your next question comes from the line of Ben Andrew of William Blair please proceed.

Benjamin Andrew - William Blair & Company

Good afternoon Kieran.

Kieran T. Gallahue - President and Chief Executive Officer

Good afternoon.

Benjamin Andrew - William Blair & Company

Just few things I wanted to follow-up on. First, if you look at the U.S. generator growth versus the international and you normalize for currency, what's your sense about how important the driver the new generators have been on the constant currency generator growth overseas and should we see that really kicking in quickly here in the third fiscal quarter with the new product?

Kieran T. Gallahue - President and Chief Executive Officer

Yes great question. So you know the... a large part of the S8 II impact has not even really been felt in the ex-U.S. market. It was launched during the quarter and so you have the product introduction time and depending on what market you are in, you either see a delayed impact or you see it more similar to what you see in the Americas. France would be an example of where you see it more quickly. Germany would be an example of where there's a multi-month delayed impact on that. So, what I can speak to is all leading indicators and the signals and the feedback we've had from market and I got to tell that people are responding very well.

And the thing that they seem to be keen on is the difference in this motor technology. I... they are getting the concept, that is like changing the engine in your car and it is very different, I mean it is much more efficient the... motor spins at a slower rate and yet it gives higher performance and that all leads to a major issue in this market place which is how do you reduce noise, and so it provides wins in each of those segments. So, all the indicators that we had out of the ex-US market place today have been extremely positive. And I think it will have a very positive impact on our ability to sell in the Americans, to be able to not inconvenience our customers by making them change their accessories and what not, and yet giving them a whole new engine to the car. So, its ... I think the signals [ph] are good.

Benjamin Andrew - William Blair & Company

So, if you look at the US generator growth and what is really going on here, you were down 7%, what's mix? I mean, what is price and then what's units? Are units down, you know, units flat and prices down $10.15 [ph], what's going on?

Kieran T. Gallahue - President and Chief Executive Officer

Well I think when we are down, we are down about 2% in the flow generator right?

Benjamin Andrew - William Blair & Company

Excuse me, I am sorry, I was thinking on the plus 7 on the total, so minus two, but what is going on there?

Kieran T. Gallahue - President and Chief Executive Officer

Right, so it is a little bit of both. Clearly you had some, some price in that, but for the most part I still have to say that flow generator on a volume basis is flat, so it may not have gone backwards, but it's flat. And part of that is the various elements that I noted earlier, I mean part of that to difficult base... part of that is the product gap. We were sort of in anticipation of these changes to the S8, where we can introduce some new feature sets and introduce some new value props, and some of that is, some of the are points that the Keith has noted, but--.

Benjamin Andrew - William Blair & Company

Okay, okay.

Kieran T. Gallahue - President and Chief Executive Officer

But I don’t know, Keith do you have anything to add to that?

Keith Serzen - Chief Operating Officer, Americas

I would just say that, when you look at the S81, it is a product platform that is 10 or 11 quarters old and our competitor has had a ref... a new product introduction during that period of time, the momentum swung in their direction, the S82 with the new motor and the, and the noise factor and the easy breath capability is something around our organization is looking for very strongly to bring significant life into what we were doing. It is… for intends and purposes we will view it as a new product introduction and we are very exited about it, it depend and will swing back.

Benjamin Andrew - William Blair & Company

Okay, and so then just kind of finishing up on the generator side..

Keith Serzen - Chief Operating Officer, Americas

But then, let me interrupt you for a second, because I don’t think Kieran caught this in his response back to you, you asked specifically about Q3, that product will be introduced into the US at the beginning of Q4.

Benjamin Andrew - William Blair & Company

All right, yes you got that… but you got the S8 platforms for the VPAP and there is… it may help a little bit I guess.

Kieran T. Gallahue - President and Chief Executive Officer

Yes. Exactly.

Benjamin Andrew - William Blair & Company

Okay, so if you think...

Keith Serzen - Chief Operating Officer, Americas

Partial quarter impact.

Benjamin Andrew - William Blair & Company

Sure. So if you think about though the impact of the Adapt SV, I mean this a very high dollar price system. What sort of impact is that having? Is that $5 million product a quarter at this point and is that keeping the core generator business from being down 5 or 10 on a unit basis, or is this all generally flattish?

Kieran T. Gallahue - President and Chief Executive Officer

W haven't broken out that, that piece in the past and so I… I don’t feel comfortable at this point going below that on sort of the mix analysis, but in general I think it's fair to say that, that when you look at the materiality of the impact, the flow generators is flat to down a little bit, and I think that’s… it is a fair assessment and a conclusion to walk away with them.

Benjamin Andrew - William Blair & Company

Okay, and just one quick question for Brett if you are still around. The tax rate in the quarter, can you kind of walk me through what's going on there and what we should expect for the balance of the year please?

Brett Sandercock - Chief Financial Officer

Yes, hi Ben. So, the tax rate for this quarter was 30.9% the effective tax rate, which is pretty similar to Q1. I expect the balance of FY '08, it will be around that level as well.

Benjamin Andrew - William Blair & Company

Okay. So no changes there and then finally on CapEx, you obviously see the impacts of the facility build out in San Diego. What's your thought on that and how long that's going to run at kind of a higher level, and is there any additional CapEx for facilities expected beyond that new facility?

Brett Sandercock - Chief Financial Officer

No, so we're pretty much through, we had some extension for the manufacturing facility down here in Sydney, which was completed in December, so that's pretty much through there. So, now we've got the county Mysore [ph] facility that’s been constructed, it is due to finish around March 2009, and roughly [inaudible] a quarter on CapEx for that facility.

Operator

Your next question comes from the line of Paul Choi of Merrill Lynch. Please proceed.

Paul Choi - Merrill Lynch

Thank you, Brett may be some housekeeping questions with respect to currency, can you, first give us what your FX assumptions are for the, in terms of the total impact for the rest of this year?

Brett Sandercock - Chief Financial Officer

If I could tell you what the currency is going to do, I could probably do that but I think, I mean you just don't know where we're going to go with currency particularly at the moment where it's pretty volatile. But clearly we have some hedging in place, which mitigates to some extent. I think, and I am looking at... I don't think we're going to get a perishable movements out of next year for a while in the Euro or the all the end.

When you look at how various analyst predictions, some are up and some are down. So I think we just continue to manage as we've done and in terms of the impact though if you're looking at, there was one thing this quarter what might be in the next few quarters. Suppose if the currencies wash through you probably looking at the sort of impact over the next few quarters, barring any major movements in the currency.

Paul Choi - Merrill Lynch

Great very good. So then in terms of, as we think of margins impact over the quarter here, we should think of the gross margin perhaps being relatively flat with the room for potential little bit of improvement [inaudible] is that the correct way of thinking about it?

Brett Sandercock - Chief Financial Officer

Yes, I mean, not too much more add that Kieran said at the moment it is around 60% in the short term we likely get any expansion on that, probably not. But if you look at September to December that margin was around the sort of 60% mark with the whole various factors, obviously some mix in our performance in March generally speaking would mean that you'd get some benefit on the margin.

Paul Choi - Merrill Lynch

Okay. Pretty good and then one question, I'll put it either Kieran or Keith, in terms of the S8 recall, can give us some update please on what you stand on that in terms of completion and remediating it and how long do you expect will take complete please.

Kieran T. Gallahue - President and Chief Executive Officer

I'll throw that to Keith.

Keith Serzen - Chief Operating Officer, Americas

So we believe that… well first of all there is two different ways to break that down one is the world… the ROW recall which I think that this point is pretty well on it, pretty much on suite to total completion. In the U.S. we believe that we are about 70% completed with this, we believe that we are at the point where there is no further distraction to the sales force or very minimal going forward. But we also believe that they will be in this for another probably one to two quarters, which is what we had anticipated when the first announced the recall.

Operator

Your next question comes from the line of Alex Smith of JPMorgan, please proceed.

Alex Smith - JPMorgan

Hi, guys. Just a question on the heart failure trails. How much is that going to cost in terms of financing and can you give us some... are going to be trying for that or someone else.

Kieran T. Gallahue - President and Chief Executive Officer

So, we will be funding it, and Brett you want to go through the estimates?

Brett Sandercock - Chief Financial Officer

Yes. So it will be... looking at the study it will be ... it's around 4 years to 5 years 4.5 years with the total cost of between $10 million and $12 million over that period of time. Spread reasonably evenly, but you might get little bit of a kick up in FY ‘09 on that study. But in terms of the total funding it's around that $10 million to $12 million over that period. To the extent, we will have quickly that... we go through that spending depends on how quickly you recruit through the clinical trial and so on. But in terms of overall ballpark figures that's what we're talking about.

Kieran T. Gallahue - President and Chief Executive Officer

So, let me just...

Alex Smith – JPMorgan

In fact in addition to the 7% or so as you spend on R&D or part of that on going commitment?

Brett Sandercock - Chief Financial Officer

That will be part of the on going commitment we think we'll run around the 7% to 8% including funding that trial.

Alex Smith – JPMorgan

Okay. And I guess another question is obviously with that home testing the roll of auto setting devices becomes a bit more important in terms of setting the pressures in the home. Kieran, do you think that we could see a mix shift towards IPAPs as the CMS ruling does come through pretty much as the proposal?

Kieran T. Gallahue - President and Chief Executive Officer

Yes. I think, again I think we have to wait for… see how the proposals pull through the finish line here. But certainly you would think it would open the opportunity for the additional use of auto setting technologies. There is the whole question of how the titration event occurs at home if the diagnostic process happens at home. One of the great benefits of auto setting technology is that it adjusts night-by-night, day-by-day over the entire time period of the individual user. So, it is absolutely perfectly tailored to those types of opportunities and I should note that, we did not waste any time... as soon as preliminary decision came out within a couples of weeks we were back as we have before. We're trying to take advantage to see if we can get increased compensation, and increased reimbursement for our customer to be able to supply those auto-setting devices.

So it is long shot, I wouldn’t necessary model in success at this point, but I think it that… there was a very good economic rationale for the increased use of auto setting, it's going to simplify the process, it's going to improve patient care, it's going to reduce the expense of the HMEs in handling these patients. But I think they need be to appropriate compensated. So we're going to drive on that. Just one more on, by the way on the congestive heart side, I don't pass by that question without noting. This is a very significant event for us, I think in putting a stake in the ground of congestive heart failure. We've talked quite a bit about the co-morbidities and we've taken some significant actions over time. But, this is a very interesting pivotal study that should help demonstrate benefits in both mortality and hospitalization and that's an important aspect in the health economics and the continued reimbursement in this area. So, it's a very important role and leadership role that we're taking in this market.

And in addition, there is a side benefit, what you're doing there, is you're the increasing the awareness and the understanding of the role that adaptive servo-ventilation plays within the heart failure community and we look forward to generating benefit during the life of that study. So, it's a very important study from multiple aspects.

Alex Smith – JPMorgan

Kieran you mentioned that you've basically applying to get a new for an IPAP, how long do you think that process might take?

Kieran T. Gallahue - President and Chief Executive Officer

Why don’t I throw that over to David Pendarvis who leads many of our efforts in that area.

David Pendarvis - Sr. Vice President, Organizational Development and General Counsel

As you know, we’ve gone through this code this the past and haven't received it. So as Kieran said, we don't want everybody immediately model in, increase reimbursement for our automatic device, but that would come up during the first half of calendar '08 and again that's at the CMS level. So, as with all of these things both home testing and any increased reimbursement, that impacts the U.S. Medicare reimbursement first and anything that would happen positively would take a while to roll through the commercial payers throughout the rest of the US. So, we look forward if we got something positive, we would hope to see it answer in the first half of the year.

Alex Smith – JPMorgan

Thanks very much guys.

Kieran T. Gallahue - President and Chief Executive Officer

You bet.

Operator

Your next question comes from the line of Joanne Wuensch of BMO Capital Markets. Please proceed.

Joanne Wuensch – BMO Capital Markets

Hi, thank you for taking the question. You told us that FX was a negative penny contributor to EPS. What was the impact of the top line?

Brett Sandercock - Chief Financial Officer

Hi Joanne it is Brett. Yes, on the top line, we had favorable currency movements at around $10 million to the revenue number.

Joanne Wuensch – BMO Capital Markets

Okay. How many patients are you going to be having in your congestive heart failure trial?

Kieran T. Gallahue - President and Chief Executive Officer

The objective is 1200 patients. So, it's quite a sizable study, particularly for this industry it's certainly the largest study of its nature.

Joanne Wuensch – BMO Capital Markets

And on previous conference you have talked about the OSI market growing 15% to 20% and your goal or wasn't a goal because I know guys don’t give guidance. But would be around getting to sort of within that range for '08. What are you currently thinking?

Kieran T. Gallahue - President and Chief Executive Officer

So, we historically said that we believe the ex-US market growth is about 10% to 15% per annum and that the Americas market, where we expect to grow at 15% to 20% per annum as an average basis. And so, when you blend those things together, you're somewhere around that 15% plus range. So, we continue to feel comfortable that in the long range that that's the growth prospects of the industry, certainly there will be sometimes when it is a little bit above and little bit below that and we've seen that over the past x number of years. And I'll just say again, I'm just extremely comfortable and pleased with some of the signals for the long-term health and growth in this marketplace, particularly with the home testing.

Joanne Wuensch – BMO Capital Markets

Okay. But am trying to get the arms around... a couple of other people are trying to do... It sounds like if...are we at a trough, do you move out of it and what is your pace of moving out of it? I know comps getting easier, I know you've got new products, I know you don't like to give guidance. Can you just start to put some gate on some numbers though?

Kieran T. Gallahue - President and Chief Executive Officer

Yes. Well, Again I think we'll continue to try to give you the directional piece of it we been giving. Do we think we've troughed [ph] in the America side of this, yes I think we have, and we expect to be pulling out of that. As we go through Q3 and Q4, we've got a partial impact to some new products in Q3, we've got some partial impact of other new products in Q4 and some of that get the full balance. So, our objective is to start to get back towards market rates of growth as we get towards the end of this fiscal year and then take it for there into the next year. So, to answer you directly do we feel like we've troughed in the Americas, yes that's certainly our expectation.

Operator

And your final question comes from the line of Andrew Goodsall of UBS. Please proceed.

Andrew Goodsall – UBS

Thanks very much Kieran. And congratulations in taking out the roll there. Just, I guess just thinking, I guess did node the head with home diagnosis, obviously a potential power driver for the industry. We are sort of hearing, I guess some mechanizing of home healthcare dealers and so on putting plants in place. Could you give us some indication of sort of what steps you might be taking over the sort of next 6 to 12 months and whether there is any cost involved. Just to I guess align yourself to sort of take advantage?

Kieran T. Gallahue - President and Chief Executive Officer

Yes, so I think that will become more and more clear as we get to a final decision and we understand what's in and what's out, right in there is...

Andrew Goodsall – UBS

Yes.

Kieran T. Gallahue - President and Chief Executive Officer

Slight variables in this decision. Type 3, Type 4 devices who are... is going to be able to be involved in the process with the titration penetration process that is going to be acceptable how that going to be reimbursed. So there is some pieces in here that can influence the role that we can play and who will be addressing that. So at this point, I don't anticipate that we have certainly any increased expenditures to support that, and if an opportunity arises and we think that we can see a way of stimulating growth extremely quickly, would we jump on it, you bet. Is that immediately obvious at this point? No its not, I think at this point we and others have... already have technologies, so we've got the ApneaLink which is a very unique device and very powerful device that will certainly satisfy the requirements for the Type 4. There are others that have that and there is a number of suppliers in Type 3, which is good, because that indicates that there is number of players that from an industry perspective can supply devices that can get these devices in the hands to those who need to use them and our intention is to work with our partners that we work with through for quite sometimes support sweet communities as they evolve through this process and most importantly to support the patient outcomes, how can we help them drive to access for more patients. So at this point, again the short answer to your question, we are looking for some significant expenditures in support of this, I don't see that at this point.

Andrew Goodsall – UBS

It sounds like next quarter question bit more details with the decision but, perhaps a quick follow on just actually Germany had been weak in previous quarters obviously could read down rest of all with currency. Could you perhaps just sort of outline were Germany is out at the moment, maybe any [inaudible]?

Kieran T. Gallahue - President and Chief Executive Officer

Sure, yes so Germany as a results perspective continues to be relatively flat, that being said I think we are making very significant progress in a lot of aspects of the German organization in the German market. The new management team has been there for about a year, they took a bit of timing, see underneath them and they have made some very positive changes. The thing to remember is that the German marketplace we're home medical equipment provider and so when we make changes there is this process… for instance with the S8 II, you put the S8 II out there, you need to get out last, then there is a, often a three-month period were you have introduction not only to the physicians but then there is trial periods for the patients. Then there prescription is written and then we have to chase down the payment on that prescription over another 90 days.

So as a result, when you start seeing some positive indicators, you start seeing the flow through a little bit later and then in addition to that course you have deferred revenue etcetera, I mean the service contracts. So Germany, we tend to look for the sort of positive signals of improvement such as in prescription rates or other aspects of the market and we've started to see that. So I'm comfortable that Germany is beginning the slow road back to recovery and it seems in good shape. What that does indicate is that other parts of ex-Americas are doing quite well, we've got A-Pac [ph] that’s doing quite well. We have other countries within Europe, such as France and the UK that are really hitting the ball out of the park and that's both because of the product stream and because of a fundamental execution. So, it's a mix bag and... but the mixed bag is for the most part... Germany still serving that flat range, but signals of improvement, but other than that very, very good progress.

Andrew Goodsall – UBS

Okay. Terrific. Thank you very much.

Operator

And that is all the questions we have for today. I would like to turn the call back over to Mr. Kieran Gallahue. Please proceed.

Kieran T. Gallahue - President and Chief Executive Officer

Great. I appreciate the interest and then the questions. As you can see we did have some challenges in Q2 and particularly some challenges in Americas, but I would like to leave the call with a highlight that I am feeling very optimistic about where this market can head in long term. We have some very good short-term signals, and if you look at our product flow over the coming five to six months we are very encouraged by what it's going to mean to the organization and what it's going to mean to the sleep community [ph]. So I look forward to updating you on future calls and demonstrating our progress. Thank you very much.

Operator

Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect and have a great evening.

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