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The Cooper Companies, Inc. (NYSE:COO)

Q2 2008 Earnings Call

June 5, 2008 5:00 pm ET

Executives

Albert White – VP of IR

Robert Weiss – President & CEO

Eugene Midlock – Sr. VP & CFO

Analysts

Michael Weinstein - JP Morgan

Larry Biegelsen - Wachovia Capital Markets

Unidentified Analyst - Citigroup

Joanne Wuensch - BMO Capital Markets

Lawrence Keush - Goldman Sachs

Peter Bye - Jefferies & Company

Jeff Johnson - Robert W. Baird

Operator

Good day ladies and gentlemen and welcome to The Cooper Companies second quarter 2008 conference call. (Operator Instructions) I would now like to turn the presentation over to your host for today’s call, Mr. Albert White, Vice President of Investor Relations and Treasurer; please proceed.

Albert White

Thank you. Good afternoon everyone and welcome to the Cooper Companies second quarter 2008 conference call. I’m Albert White, Vice President of Investor Relations and Treasurer and joining me on today’s call are Robert Weiss, President and Chief Executive Officer and Eugene Midlock, Chief Financial Officer.

Before we get started I’d like to remind you that this conference call will contain forward-looking statements as defined by the Private Securities Litigation Reform Act of 1995, including all revenue and earnings per share guidance and other statements regarding anticipated results of operations, market conditions and planned product launches.

Forward-looking statements necessarily depend on assumptions, data or methods that may be incorrect or imprecise and are subject to risks and uncertainties. Events that could cause our actual results and future actions of the company to differ materially from those described in forward-looking statements are set forth under the caption ‘forward looking statements’ in today’s earnings release and are described in our SEC filings, including the business and risk factors section of Cooper’s annual report on form 10-K. These are available publicly and on request from the companies Investor Relations department.

Now before I turn the call over the Robert, let me comment on the agenda for the call. Robert will begin by providing highlights of the quarter followed by details on several key topics. Following Robert’s remarks Eugene will comment on the second quarter financial results. We will then open up the call for questions.

With that, let me turn the call over to Robert for his opening remarks.

Robert Weiss

Thank you Albert and good afternoon everyone. I hope everyone was as excited about our results as we were as we issued our press release moments ago on our second quarter results. Before I get too much into the details I’d like to make sure that everyone understands that if you hear nothing else, I’d like you to walk away with certain key highlights and key messages from today’s call.

First of all, the global contact lens market remains very strong. We don’t say its recession proof we do its recession resistant. So we have a great market that we’re participating in. Secondly our products are doing fantastic. We view we have the best-in-class products in each of the three modalities of contact lenses; the single-use lenses which is our Proclear one-day entrée and the two-week space which is dominant in the United States where two-thirds of the market is one-week and two-week, we now have launched Avaira. And in the monthly space we have Biofinity best-in-class in the silicone hydrogel monthly market.

Financially we’re performing very solidly. Our restructuring charges are almost behind us. We continue to see manufacturing improvements across all product lines and we should start seeing free cash flow in the third quarter, if not a net positive very close to a positive. CooperSurgical continues to perform well and really supports the overall business with its free cash flow.

As far as second quarter results, I view them as very impressive and hope you share that. We had $263 million in revenue, up 17% and 10% in constant currency. CooperVision had revenue of $222 million, up 18% and 10% in constant currency. CooperSurgical contributed $41.5 million plus 11% and 9% of that was organic growth. Our earnings per share in accordance with GAAP was $0.25 for the quarter and our earnings per share excluding call-outs was $0.49. I’ll let Eugene elaborate on the details of a lot of the numbers.

As far as new products driving the top line, Biofinity for the quarter had revenue of $12.4 million which is now at a $50 million annualized run rate and that’s in line with our $50 million to $70 million of expectation for the fiscal year. Biofinity sequential growth was 37% above the first quarter which was $9 million in revenue. Biofinity effective in March of this year, no longer had any rationalization going on worldwide, in fact we now have adequate capacity of [sphere] to roll it out country by country anywhere it is approved to be sold. Biofinity will now be rolling out expanded powers into higher minuses and pluses so it will be filling out the range.

Proclear or one-day single-use product, had revenue of $7 million, up 1200% above the prior year but importantly sequentially 47% above the first quarter. Proclear one-day also effective March of this year no longer had capacity constraints. Overall our single-use sphere market was up 62% above the prior year, 44% in constant currency. Avaira was launched in April of this year. It had insignificant sales for the second quarter of only $114,000. Avaira is capacity constrained today but we are ramping up nicely. Avaira we expect to meet or exceed the $8 million to $10 million of targeted revenue we had in our fiscal 2008 guidance. Part of our bullishness on that is the fact is that in May of this year, we sold $2.6 million of Avaira. Some of that included certain chains.

So that leaves us feeling very comfortable as far as our expectation there and quite frankly we’re probably more in the $10 million to $12 million of comfort level then the $8 million to $10 million that’s in our guidance. As far as Proclear one-day, when I say its best-in-class that’s our entrée into the single-use market which comprises 34% of the world or $1.8 billion. Avaira participates in the two-week space which is 39% of the world market or $2 billion market and Biofinity participates in the monthly space which all monthly and beyond is 27% of the world market or $1.4 billion.

So having a play in each and every one of the modalities we view is very crucial to our success going forward. As far as future products are concerned our outlook is bright. With Biofinity we now have a manufacturing platform that will allow for $200 million in revenue which equates to about $70 million of lenses of through-put. With that expanded capacity we are now on track to launch a silicone hydrogel toric that we’re now forecasting for the first quarter of calendar year 2009.

In fact we expect to start production this quarter. We will launch with 1200 SKUs, not 864 like a competitor recently did. We will launch an expanded range of 3800 SKUs that we will expand out within 12 months. We will also launch a two-week silicone hydrogel toric by the end of calendar year 2009. We remain on track to launch Proclear one-day in Japan in the first half of fiscal year 2009 and keep in mind Japan is a $1.1 billion market; 57% of that is single-use lenses. So Proclear one-day which is a very nice entrée will--we expect a lot of good things out of it in Japan.

We expect new products to exceed 70% of our revenue in 2012 and today our new products that we’ve launched since 2005 exceed 26% of our revenue. As far as the market is concerned we’re cutting back on a lot of the data that we’ve done, slicing and dicing it so many different ways that people start losing focus on which numbers we’re talking about. So hopefully you find the press release a little streamlined and it was very intentional that we cut back on some of the volumes of data we’ve thrown out there at everyone.

What you or we need to know about the market is that in calendar year 2007 it was a $5.2 billion market and it grew in constant currency 7%. In the first quarter of this calendar year it grew 6% so we have a solid market and it continues solid in spite of the recession that may be plaguing the United States and others. The drivers in Q1 2008, single-use was up 11% in constant currency and now accounts for 34% of the market. Silicone hydrogel was up 31% in constant currency and now accounts for 30% of the global soft contact lens market or over $1.4 billion.

In the United States new fits were 51% of the total fits in the silicone hydrogel modality and in torics 45% were silicone hydrogel fits. Looking at our products in the second quarter ended April 30th, our single-use was up 44% in constant currency. Our Proclear family of products was up 25% and our geographic expansion in Asia Pacific saw a growth there of 22% also in constant currency. Silicone hydrogel really Biofinity is now at a $50 million run rate and as I indicated it’s within our range of $50 million to $70 million estimate for this fiscal year for Biofinity.

We’re obviously excited about this momentum and we’ve only just begun to rollout Avaira, our two-week space. Regarding Avaira yes it’s true that we’ve distributed the product to Wal-Mart. I can confirm that. Regarding Avaira yes it’s true it’s available for private labels, if it’s a win-win for us and the large chain. And yes it’s true we are on track to beat or exceed the $8 million to $10 million of revenue for this fiscal year.

We are also on track to rollout 10,000 fitting kits by the end of this fiscal year and expect to rollout a total of 17,000 in rolling out the product over the next 12 months. We sold $2.6 million in May as I indicated. This is why we remain and are very confident of beating the $8 million to $10 million in our guidance. As far as guidance, cash flow and CapEx and margin, just to pull that all together, I’ll let Eugene get into the Q2 numbers in a lot more depth but importantly we have not changed our guidance. We expect to improve our GAAP gross margins and operating margins going forward. We have great visibility on start-up costs for three key areas. We can see what is going to hit the P&L seven months in advance.

The three key products being, high volume conversion that we did late last year onto Gen II, the Proclear one-day as well as Biofinity. Two months after our year-end shutdown in December which we do as a matter of historical cycle we shut the plant down during a slow period, we did a conversion over of certain things we learned in our [line five] of Biofinity which was given to R&D and as a result of that we saw our yields double compared to between November of 2007 and March of 2008, we doubled. That equated to going from two million lenses a month to four million lenses a month at the same cost.

What does that mean? If I were to translate having two million more of lenses available to sell and assume you sell about 70% of them at a price of around $4 or more, that would be $5.6 million monthly or $67 million annually of theoretical revenue and gross margin. There is zero incremental cost on that. So one of the drivers going from GAAP where we were to where we’re headed and why we’re confident on the visibility is the fact that that’s in the bag. We’ve already done that conversion. And we already know that we have the yields above our targeted 50% yield for Biofinity.

Today Biofinity is hitting the P&L at a run rate of $50 million and with the capacity we already have in place that we sunk in the CapEx for, we can exceed $200 million in revenue. Among other things, we’re expanding the power range. We’re accelerating the silicone hydrogel toric launch into the calendar year of first quarter next year. As I indicated we’re going to be in production on that this quarter. We expect to expand Biofinity beyond torics into multifocals sometime later in 2009 or when capacity allows.

Important message here is with Biofinity we’ve already sunk in the CapEx. We have the capacity to generate four times as much revenue of it. We’re beating our targeted yields in manufacturing cost. March’s manufacturing cost was less then one-half of November and December. And Biofinity is the majority of the call-outs that you see in our P&L that you see in the second quarter. As we leverage CapEx and capacity or our GAAP gross margin will go up, our operating margin will improve and also will our free cash flow.

On CapEx in 2006 we started six major projects that required in excess of $400 million. Three are completed costing over $150 million; Biofinity, distribution centers and the high volume conversion onto Gen II. Our building expansions in the UK and Puerto Rico are essentially complete. Our one-day capacity expansion which is over $150 million represented 13 Gen II lines allowed us to support the best case demand scenario and quite frankly given the large lead time we’ve ended up with more capital then we currently need today; there’s a good news and bad news scenario about that. The good news is that in the future we will not need to supplement those cash requirements and its also true that we’ve been running capacity constraint forever and for the first time like many good corporations that run in the neighborhood of 75% to 80% capacity, we’ll have the latitude to back up a line that may go down and do certain other things that we’re interested in doing.

So as much as anything while we got ahead of ourselves and therefore you saw capital be quite high and some of those capital requisitions are still in the pipeline so through the end of the first quarter of 2009 some of what we ordered last year will still be rippling through the system. After the first quarter of next year, CapEx will drop off very noticeably. In addition to CapEx to be spent in 2008 and 2009 we still need to sink in money into the Avaira production area and as a result of that our CapEx requirements going forward are going to be predominantly in that arena together with maintenance CapEx.

Key messages, most of our six high ticket capital projects are complete. Capital will drop off from the $160 million to $170 million in 2008 to $125 million to $140 million in 2009. And even further post 2009 we would expect below the bottom end of that $125 million low end of the range we’re giving you for 2009. Unlike the past three years, we won’t have to shift where we make most of our products. We won’t have to shift where we distribute essentially all of our products and we won’t have to introduce all new products in every modality such as the two-week, the one-day, etc.

So all that translates to while we’ve had negative cash flow in the first six months of this year, about $64 million, we should be closer to a breakeven over the next two quarters and quite frankly expecting to be positive and going forward with much less capital requirements in 2009, we will be cash positive. We would expect north of the $50 million range and thereafter in 2009 we would expect to be north of $100 million as among other things CapEx drops, revenue leverages our plant capacity, operating margins and gross margins improve and then one other thing, we’ve sunk a lot of money into inventory build for all these new products and we will start getting some cash out of the inventory build and leverage that more efficiently in our distribution centers.

CooperSurgical our women’s healthcare franchise is running very smoothly. In spite of a fair amount of non-US sourcing, its gross margin remains around 60%. CooperSurgical’s GAAP operating income was 19%. Our partnering with the OBGYN beyond the office setting, that is the hospital, has been a stellar success contributing to our organic growth of 9%. Products targeted in hospitals grew 17% in the second quarter or $12 million and now represents 29% of Surgical’s revenues worldwide. With minimal capital requirements, with a solid balance sheet ratio in both inventory and receivables, CooperSurgical generates a lot of free cash flow.

The effective tax rate, I’d like to make one brief comment on, I’ll let Eugene say whatever else he’d like to about it, but I won’t try to steal his thunder there, our effective tax rate today is in the upper 20s. It reflects the fact that essentially all of our $35 million of call-outs anticipated this year, have no tax benefit and as a result if you were to exclude those or as they go away, our effective tax rate from a GAAP perspective should drop right back down to the 15% to 17% range.

In summary before I turn it over Eugene, remember the key messages; the soft contact lens market is doing great. It’s recession resistant. CooperVision now has three new products in each of the major modalities; the one-day, the two-week and the monthly. We now have for the first time adequate capacity in the one-day and the monthly modality. We have visibility on our improving margin trends factoring in inventory turns. Our CapEx will be declining post 2008 and noticeably post 2009, second half. And with higher revenue, improving operating margins and declining CapEx we expect to generate substantial cash flow in the future. And lastly CooperSurgical continues to contribute a solid performance.

With that I’ll turn it over to Eugene.

Eugene Midlock

Thanks Robert, good afternoon everyone and thank you for joining us today. I’d like to spend a few minutes briefly, and I stress briefly, reviewing some of our key financial results for the quarter. I’ll try not to provide too many statistics and numbers so as to kill everyone. You can refer to our news release as well as the 10-Q which will be filed tomorrow morning at about 11:00 Pacific Time for more details.

So let me begin by commenting on revenue and product sales, we had a very strong quarter with revenue of $263.5 million which is up 17% over the prior year and 10% constant currency as Robert indicated. CooperVision grew 18%, CooperSurgical grew 11%; so both of our operating divisions had very strong double-digit growth.

Product sales, Robert summarized fairly well, but as you’ll note in the news release, our specialty lens group grew 11% over 2007. Proclear products grew 33% and the real gainer was our single-use spheres which were up 62% and that was recognized in all of our geographies. Asia Pac and EMA were up around 60% and the Americas were up approximately 95%. So we’re really pleased with our growth in our daily lens business.

Geography-wise, overall basis, the Americas grew by 10%, Europe 20% and Asia Pac 38%; so solid growth again throughout the world for all of our products. CooperSurgical’s product line also grew very well as Robert indicated. The products that we sell to hospitals were up 17%. Our IVF unit sales were up 18% and the international business unit sales were up 25%. So really strong 11% growth overall.

Turning to gross margin our consolidated gross margin was 57% compared to 55% in the second quarter of 2007 and if we exclude our non-GAAP expenses, gross margin was 61% compared with 63% in last year’s second quarter. This breaks out with CooperVision had a gross margin of 57% compared to 55% last year. If we exclude the call-outs the gross margin was 61% compared with 63% in 2007. This was largely attributable to product mix due to the large growth in our lower margin single-use lenses as I mentioned earlier. But as we go through the fiscal year our cost per lens for Proclear and silicone hydrogel will decrease and will favorably impact our gross margins when those products flow through inventory and the cost of sales which should be in Q4. Hence we expect gross margins in the low 60% by year-end. CooperSurgical has a gross margin of 595 which was largely unchanged from 2007.

Consolidated operating margin was 11% compared to 5% last year. If we exclude the call-outs operating margin was 15% which was pretty much the same as last year. CooperVision had operating margin of 12% compared to 6% last year. If we exclude call-outs the operating margin was 17% compared to 19% last year. This decrease is generally attributable again to additional selling and marketing expenses associated with our new product launches and increase in the revenue mix of less margin products. Surgical’s operating margin was 19% compared to 17% in 2007 and again that reflects a better leveraging of selling and marketing expenses.

SG&A expenses increased by 7% over Q2 of last year but decreased by 4% as a percentage of revenue from 45% to 41%. If you break this apart, selling expenses which includes marketing and distribution and so forth, increased by 11% and are 31% of revenue. This reflects the impact of increased sales in new product introductions. G&A expenses decreased by 6% and are 10% of revenue. This reflects enhanced leveraging of our G&A and some savings attributable to share-based compensation. Both categories of expense decreased equally by 2% as a percentage of sales. On a non-GAAP basis SG&A increased by 13% over Q2 of 2007 but decreased by 1% as a percent of revenue from 41% to 40%. Selling expenses increased by 18% and are 31% of revenue versus 30% in 2007 and G&A decreased by 2% and are 9% of revenue versus 11% last year.

Looking at R&D expenses in Q2 they increased by 15% over last year to $9.1 million and represent 3% of revenue. CVI’s R&D increased 18% to $8 million and 4% of revenue in Q2. CooperSurgical’s R&D were $1.1 million, substantially the same as in the prior year and 3% of revenue. On a run rate in the future we expect R&D to be approximately 3.5% to 4%. Now if you look at the six month numbers it may appear that R&D actually decreased by 10% but last year in Q1 CooperSurgical had $4.2 million of in-process R&D expenses in connection with an acquisition. Adjust for that and the R&D expenses actually were up 16% year-over-year.

Looking at our call-outs or our non-GAAP adjustments, they were $11.4 million in Q2 versus $14.2 million in Q1. Details are contained in an appendix in the news release. We expect again they’ll be around $35 million for 2008 or $0.50 to $0.70 a share. We expect they’ll decrease in Q3 and more significantly drop off in Q4. Note, we will not call out manufacturing inefficiencies associated with Avaira or silicone hydrogel torics. We no longer call-out stock-based compensation, note however, and we’ll talk about this in a moment, we do expect if our convertible bonds are put to us in Q3 there could be a $3 million adjustment for unamortized bond issuance cost.

Effective tax rate for Q2 on a year-to-date basis is 28.76%. For the year we expect it to be on a GAAP basis 18% to 20% and on a non-GAAP basis of 15% to 17%. Again it’s higher in Q2 because of the adoption of FIN 48 which requires that you adjust for more items discretely then you do in the effective rate calculation as well as catch-up adjustments to match our forecast for the rest of the year. This rate will decrease in Q3 again because of more discrete items but note that if we have geographic fluctuations in where we earn our revenue of any significance it will impact the rate.

Lastly I’d like to just address our convertible debentures which we sent out a news release earlier this week, it is possible that holders of the $115 million 2.625% converts which are due in 2023, they have a put option on June 30th and it is possible some or all of these holders may choose to do so if the share price is not equal to $44.40. The put is expected to be funded with our $650 million revolving credit facility which will result in an increase in our interest rate to around 5% from 2.625%. There will be an approximate, as I mentioned, $3 million one-time charge in Q3 for non-amortized capitalized debenture issuance costs which we incurred when we issued the bonds. We expect that the put will be around $0.05 a share dilutive in Q3 and should be $0.02 a share accretive in Q4 and overall for the year, it’ll be dilutive by $0.05. On a non-GAAP basis it looks like it would be slightly accretive in Q3 and thereafter and if you’re running your models, make sure you remember to adjust the shares outstanding when we retire the bonds.

With that I’ll conclude and turn the program back over Albert White.

Albert White

Thank you Eugene, thank you Robert. We’ll take questions now.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Michael Weinstein - JP Morgan

Michael Weinstein - JP Morgan

Basically J&J disclosed today at its Analyst Meeting that one, an astigmatism lens is being launched this month in the US and now its available globally. Two they also are coming out with a silicone hydrogel lens on the daily disposable side utilizing a new silicone hydrogel material there. And they also disclosed that they’re completing the clinicals on their drug delivery lens for ocular allergies and they expect to file that later this year. Just given that you won’t have a silicone hydrogel toric offering until 2009 does this change your view at all on toric share for the balance of the year? And what do you think your prospects are for a daily silicone hydrogel lens and then do you have an internal program and have you made any progress in developing a drug delivery lens of your own to compete with J&J?

Robert Weiss

As far as—we haven’t really quoted our toric market share other then to say that once we come out with our own product line in the silicone hydrogel space that we expect to hold it, but coming off of a 33 worldwide we don’t have our own expectations of holding share. Having said that, dealing with Oasis—Oasis is coming out with another two-week spot where Acuvue Advance for astigmatism is Triple A. Price the same thing. There are two reads on that. Historically J&J has done a trading-up mode from Acuvue Two to Acuvue Advance and then from Acuvue Advance to Oasis. Well they’ve been trying to trade-up 20% or 30% each step-up, interestingly they’re not trying to do it with Oasis, they’re listing the price the same. And $24.00 a six-pack is what it’s being listed at. It seems to me what they’re doing is somewhat defensive. That Acuvue Advance for astigmatism is not the product they want to go with longer term.

The other thing to keep in mind is typically a doctor will not move from a monthly modality to a two week modality so they’re coming into their same sweet spot of the market not finding their way into the monthly modality market; my opinion. Secondly the—as it pertains to the fact that they’re already in the two-week space, the fact that Acuvue Advance for astigmatism has been out there and doing pretty well, those people that wanted to trade to a two week silicone hydrogel lens by and large have traded over a long time ago. So those that are believers in the hydrogel side of the market and its clearly among other things, it’s the argument of if I’m taking them out every day I’m more concerned about the comfort level and there’s just enough of a cult that believes in the softness and the hydrogel attributes, higher water content for example, that I would argue while it isn’t a positive for all competitors by and large its not a big deal. It’s mainly them trying to hold on to what they’ve got.

As far as the one-day daily, that thing really is seems to be geographic-oriented. If I’m J&J and I own the one-day market and I already have a premium product called Moist, that is substantially priced higher then anyone else’s and then I come out with a silicone hydrogel lens that is going to be—to try to price at or above that, its going to be a real difficult chore to take anything other then their own share and it doesn’t sound like a good trade-up strategy because I’m not sure they’re not hitting road blocks on trading people up even higher then what they are. And they’re probably in the neighborhood of 50% premium to the other tier of single-use out there.

So I see it as—and they have a lot to lose not much to gain from two fronts. One is they’re going after themselves without a trade-up strategy. Two is it probably cost them more and actually three is what really baffles me, is there’s ongoing litigation between Seeba and J&J and so far J&J has lost on every front and the last thing I would do is take something that is in a comfort zone called Acuvue Moist and put it in a double jeopardy zone called silicone hydrogel. So maybe they know—I’m sure they’re a smart company, they know what they’re doing, I think, buy I’m not sold on where that’s going and from our perspective globally its not a big deal. It may make some headway in Europe but once again, that’s where they’re the most ripe on the litigation front.

As far as the drug delivery I don’t think contact lenses are going to become a household word for how you deliver drugs to your eyes. We are working on that. I would call it nichey but by and large the drug delivery is going to be more a new niche that people are trying to develop. The average person wearing contact lenses isn’t going to rush out to say I want one that delivers a drug. I think it’s got a long road from a regulatory point of view before the FDA is going to say yes, good idea to deliver drugs to your eye via a contact lens. So we’re working on it but it’s—in terms of number one through number 10 priority, I wouldn’t put it in the top half of that list.

Operator

Your next question comes from the line of Larry Biegelsen - Wachovia Capital Markets

Larry Biegelsen - Wachovia Capital Markets

In the past you talked about you were uncertain about some of the spending related to the launches of your silicone hydrogel now that you have a better understanding of what your capacity is and what your launch plans might be, how should we think about SG&A spending relative to sales growth? Is that going to exceed sales growth over the next couple of years and if so, can you help us think about that? Could you quantify that for us a little bit better?

Robert Weiss

I guess the way I think about it is overall operating costs, if we were to do a product line P&L on Avaira we’re not going to make money on it this year. We probably won’t make money on it next year. You don’t try to make money from the get go as long as you know it has good legs. That translates to continuing to invest in fitting sets and it translates into investing in the distribution channels we have available, meaning our sales and marketing organization and it also translates, depending on how much blending there is between private label. The one thing that could happen is private label is a trade-off between operating costs and lower margins so its got to be win-win; a win for us and if we leverage a large chain through private labels, then there should not be a higher percentage of G&A associated with that.

Where we are going to continue to get leverage is the distribution centers that we’ve set up and G&A in those areas. So if we were to breakout SG&A I would expect our sales and marketing and the trial lenses to grow at least as fast as sales. I would expect to get a lot of leverage out of distribution and G&A and as Eugene indicated, we expect to grow our R&D at or above the revenue growth so net, net, net operating costs which are currently around 45% will drift down over a longer haul, I would say from 45 it will work itself toward the low 40s. From the point of view of gross margins, they’ll be somewhat influenced by the one-day mix coupled with how much private label going one way and then going the way is there’s a number of manufacturing improvements we expect to make that will keep trying to push the gross margin up as well as the shift to silicone hydrogel lenses.

Operator

Your next question comes from the line of Unidentified Analyst - Citigroup

Unidentified Analyst – Citigroup

On Avaira production, can you give us an update on Avaira production out of the UK plant and give us a sense of how yields and utilization levels are tracking in Puerto Rico versus UK and when you will see production out of Puerto Rico?

Robert Weiss

Yields in the UK on fast track are at or above that of that Biofinity already. So we’re already—there’s no risk to the way we view fast track and there’s no risk to our ability to support the $8 million to $10 million or the $10 million to $12 million. Relative to are we getting product from Puerto Rico, yes we are. They’re making--it sequentially they’re doing at or above our expectation and keep in mind with Avaira in Puerto Rico it’s an engineer challenge, it is not a chemist challenge. We already know the chemistry. We actually know 90% of the platform so a small piece of the technology gets a lot of attention and as a result of that, we get to do a lot more trial and error. So as we see it within 12 months, we expect to hit a level that we’re comfortable with on that technology which is to say that we think we will get the platform—a $30 million piece of equipment up to the level of making 36 million lenses a year or a ballpark three million and we’re proceeding in a very satisfactory mode.

To the extent we’re making more lenses then would support the $10 million to $12 million we may or may not sell those lenses given the fact that we have a lot of paranoia about going on back order with large chains, we would rather build some buffer stock. We’re going to play that conservative and not at all risk getting ahead of ourselves with certain or multiple large chains and then can’t deliver. Delivering is everything on that one.

Unidentified Analyst – Citigroup

On margins for Biofinity and Avaira do you care to share those with us or give us a range of where they are?

Robert Weiss

The only thing I can help you with on Biofinity—I’ll make two points. One is our gross margins for silicone hydrogel we expect to get to the upper 60s to low 70s over the next two years, by the end of two years. Relative to the ramp up of where we are, we’re making Biofinity well below what we thought we would make. The yields are north of the targeted 50%. When I did the math of the four million lenses compared to two million lenses at the same price that translates to 100% gross margin on those last two million lenses. If you blend that all it moves up your margins substantially. What we’re telling you is all those call-outs associated with the lenses made prior to January of this year, are substantially gone from the point of view of what’s going onto the balance sheet. So we pretty much have the visibility that our margins for Biofinity will move into the upper 60s. On Avaira we’re early in the game. While fast track has done spectacular compared to our expectation was easy to do. The real trick to gross margins is going to be the high volume one in Puerto Rico and we’re a little early to get to cocky about it.

Operator

Your next question comes from the line of Joanne Wuensch - BMO Capital Markets

Joanne Wuensch - BMO Capital Markets

I’d like to ask a question about Avaira, if you could go into a little bit more detail about your ASPs on Avaira and how you’re positioning the product in your launch, what’s your strategy there?

Robert Weiss

As far as ASPs, we list the product at $19.00 a six-pack and that compares to Oasis at $20.25. So we’re below that on the listing. I won’t get into exact average realized prices obviously for competitive reasons, but suffice it to say, if we get into large volume rollouts with retailers, it is likely to be somewhat below that $19.00. I don’t want to put too much color on where it is other then it’s not unusually low and if we were to do private label that obviously would be a full debate over how much the retailer is going to put behind the product. So other then to say we’re under Oasis, the product is in my opinion as good or better then--its 30% softer from the point of view not being as rigid a material. So it has a lot of features that are going its way and we think it will do well in the market.

Joanne Wuensch - BMO Capital Markets

Can you comment on what you’ve seen so far in terms of reorder rates and comment on whether or not any of Avaira is on backorder with any of your customers?

Robert Weiss

I can’t comment on reorder rates, it really is—we’re a little over a month into it and by and large the job is getting it out there onto the shelves where the ODs of some of these chains—hope I didn’t come across as saying we’re only selling it to the large retailers. We are treating our loyal independent private practitioners. They are also being targeted by our sales guys. But having said that at the reorder point we’re way too early to have any read on that. I would say one thing, everyone that has tried it loves it. We hear rave reviews--I can’t translate that into financial dollars and cents at this point.

Joanne Wuensch - BMO Capital Markets

You said that you are constrained on Avaira but not on the other lines?

Robert Weiss

We are capacity constrained on Avaira and will probably be capacity constrained on Avaira for the next I’d say at least the next 12 months.

Operator

Your next question comes from the line of Lawrence Keush - Goldman Sachs

Lawrence Keush – Goldman Sachs

As it relates to the call-outs, you did about $26 million year-to-date, you’re talking $35 million, I just want to get a sense of the gating, is 80% of the remaining call-out in the third quarter and a little bit left in the fourth? I just want to get a feel for how you’re thinking about that?

Robert Weiss

I think it’s accurate to say, I don’t know if it’s exactly 80% but there is a huge drop-off after the end of the third quarter and that’s nothing more then if you use the seven month factor you’ll see how a lot of that will drop off.

Lawrence Keush – Goldman Sachs

You went a little fast with the cash flow expectations I’m wondering if you could just run through that quickly with your comments for 2008 and 2009.

Robert Weiss

Basically we’re out the door about $64 million year-to-date, $16 million this last quarter. Our expectation is that for the balance of this year we’ll be net positive to and including in the third quarter we expect to be net positive—it’ll be close but my bet if you will, is that we are positive. Going into next year, we expect to generate free cash flow in excess of $50 million. Relative to gating of capital requirements, there will be a huge drop-off after the first quarter of next year and that’s because all of our—the money we’re now spending was pretty much committed over the last six to 12 months. A lot of these equipments have 12 month to 18 month lead times. In the case of the large Avaira line, it would be 18 month lead times as well as CapEx on building expansion. So the visibility is once we’ve flushed through those existing commitments we know that we have more then enough capacity on Biofinity, on the one-day modality and the only one we’re continuing to source if you will in terms of CapEx requirements is primarily Avaira and then just wrapping up one building expansion in Puerto Rico that will be pretty much money out the door by the end of this calendar year.

Lawrence Keush – Goldman Sachs

With the revolver and obviously not contemplating the put of the convert here, where do you stand with the available borrowings on that and where are you with your EBITDA covenant right now?

Robert Weiss

As far as we have adequate capacity under our revolver to convert the debt from 2 5/8 to the—underneath the revolver. On EBITDA coverage, let’s say we’re comfortably there. We’re monitoring—we obviously are keenly aware of our covenants and monitor that very religiously.

Lawrence Keush – Goldman Sachs

You don’t have your kind of where you wound up at the end of the quarter with what’s available on that revolver?

Eugene Midlock

I can give you that exact number, I think it was like $225 million, something like that available.

Operator

Your next question comes from the line of Peter Bye - Jefferies & Company

Peter Bye - Jefferies & Company

On guidance, I guess you’ve got some visibility on gross margins because of the inventory you’re going to work through and you know what your margins were on this product earlier this year, if I just sort of add up what you did the first half of the year on pro forma EPS and if I assume no expansion from back half last year’s pro forma EPS, I get to $217. Now I understand interest expense a little bit higher and that’s only $0.03 or $0.04 and I was just wondering where—perhaps what’s precluding you from raising up the bottom end of the range? Well if you keep pro forma EPS flat from a year-ago even though you’ve had a fair amount of progress on the manufacturing front, why would EPS conceivably even possibly be flat from the back half last year?

Robert Weiss

I think that’s a fair question whether or not it should be flat with the prior year. We do have the investment in Avaira that’s going on. And quite frankly we took a position where we didn’t think we had enough change to want to change our guidance every quarter. So we’re kind of sticking with the range. The range is a little broader then it should be right now, you can argue we could have tightened it a bit. But I think those two factors are number one the Avaira launch and two is the fact that we just didn’t change the range.

Peter Bye - Jefferies & Company

The Avaira launch, is it just the SG&A cost of launching the product or do you mean just because you’re not calling out the incremental cost of goods sales or both?

Robert Weiss

The Avaira launch start-up costs, we’ve made a decision not to flush that into the world of the call-outs. Is there start-up costs flowing through the P&L? Yes there is particularly as it relates to the—was we start hitting the P&L in the first six months with the Puerto Rico line equipment. That is a factor that will put some burden on gross margins that are not being called out.

Peter Bye - Jefferies & Company

The range on GAAP is $0.45 and you’ve got $0.25 on non-GAAP and I guess certainly a $3 million on the put amortization expense explains some of it but there’s another $7 million there. Given how far we’re through the year and they really fall off the cliff after September, I’m just wondering what that delta is? Where that $7 million could fall or in call-outs?

Robert Weiss

In terms of where it’s going to fall, it’s going to fall heavily in the third quarter.

Peter Bye - Jefferies & Company

I just meant there’s—you’ve got a wider range for your GAAP and non-GAAP right and its pretty much most of its in Q3 so I’m just wondering what’s accounting for the $10 million and sort of delta net income. Certainly $3 as you said could be the—potentially for the convertible put, I’m just wondering what the other $7 million delta could be. Or what sort of plays into that wider range?

Robert Weiss

A lot of that is start-up costs from a manufacturing point of view, not the put.

Albert White

If I’m understanding you right, we did take a look at altering guidance just to bring them together but rather then change guidance every single quarter, we just held it.

Peter Bye - Jefferies & Company

On the toric that you have going out there, are the monthly and the two-week going to be on the same platform? Are they both sort of out of the Biofinity type platforms on the UK or are—can you just explain a little bit?

Robert Weiss

Biofinity will go first, that’s the one that goes into production this quarter and will be launched in the calendar year first quarter next year, 2009. And then towards the end of calendar year 2009 will be an Avaira platform. The big difference is the Biofinity product can be produced on the existing Biofinity lines. The Avaira toric will not be on a Gen II, the one we have in Puerto Rico.

Operator

Your final question comes from the line of Jeff Johnson - Robert W. Baird

Jeff Johnson - Robert W. Baird

It looks to me adjusted CVI gross margin this quarter hit a five year low, I understand your comments that gross margin improvements can be seen with dailies and Biofinity over the next few quarters, but I also, at least in my model, I have to factor in start-up Avaira costs, potentially some start-up toric [inaudible] costs, and private label gross margin drags on the Avaira, so I guess my question boils down to where do you see gross margin on a CVI basis going on an adjusted basis over the next six to 18 months? And Eugene, you noted a low 60% gross margin for CVI this year, I thought prior guidance was a little more defined at 61% to 63%, should we assume low 60% could mean below the low end of that 61% to 63% for this year and maybe into 2009?

Eugene Midlock

No, 61% to 635 is still accurate.

Robert Weiss

The only thing I’d add to that is why we’re hedging a little on the wording 61% to 63%, low 60% is given the robustness of our expansion of the one-day—the 62% growth in one-day for the quarter was eye-popping and obviously if we aggressively shift into that modality while we’re catching up with the silicone hydrogel pulling it the other way, that could keep us at the low end of that range of the 61% to 63%.

Jeff Johnson - Robert W. Baird

And the low end of that range not just over the balance of this year but probably as we go through 2009 as well?

Robert Weiss

I would say as we go through 2009, I think what’s going to happen is you’re going to start seeing the silicone hydrogel pulling the other way and then there’s ongoing cost reductions that are occurring but there’s kind of a race between the two horses and the more the one-day modality wins out and I’m not saying its going to continue to win out at that rate, we’re not projecting that type of a growth rate. That’s the one that causes me to hesitate; which is it. Private label if we got big into private label, that would push the silicone hydrogel from the upper 60s low 70s into the low, probably the low to mid 60s so that would have a mix impact but it would be favorable on the operating cost line. We’re not going to be the one that goes out and does all of the leg work like Viscon may do or someone that does a lot of commercial work, undoubtedly that would be the private label company.

Jeff Johnson - Robert W. Baird

On the Avaira toric will that not go on the Gen II line or can you just maybe finish that answer a little more clearly?

Robert Weiss

The Avaira toric will go on existing type of equipment we have in-house, modified for that product but it will not be on a Gen II type, it will not be on a high volume. It’ll be a low volume high SKU production level.

Jeff Johnson - Robert W. Baird

Your comments on the Wal-Mart agreement and that you are shipping to both maybe retail locations and private practitioner, some of the channel feedback we’re hearing is that at least a good number of private practitioners or other ways of getting lenses on the private practitioner side are kind of being told they may not have access to Avaira for the next three months or so as most of that product is being diverted to Wal-Mart. Does that have a near-term margin impact I’m assuming and can you just clarify that combined with your comments that private practitioners are still getting the Avaira product?

Robert Weiss

Everyone is on allocation including the retail or the chains so each sales rep has got an allotment to go out to the market with and we’re not going to expand beyond our reach that we’re capable of supporting but we’re not diverting it all from one channel or the other. Whoever we sign up as a customer we will support that customer and that’s—when I talked about holding back inventory even if we’re making more currently, it doesn’t mean—it just means that until we have enough buffer stock to expand beyond our first pass intentions of who gets it that we won’t go beyond it. You’re right, there are accounts being told you have to wait because there’s only so many units to go around at this juncture.

Albert White

We’re going to wrap it up. Thank you to everyone who called in and talk to you next quarter.

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