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Obagi Medical Products, Inc. (NASDAQ:OMPI)

Q2 2008 Earnings Call

August 11, 2008 8:30 am ET

Executives

Ina McGuinness - Integrated Corporate Relations

Steven Carlson - President and Chief Executive Officer

Preston Romm - Chief Financial Officer

Analysts

Katherine Lu - Oppenheimer

Larry Neibor - Robert W. Baird

Enrique Lribarne - Roth Capital Partners

Operator

Ladies and gentlemen welcome to the Obagi Medical Products Second Quarter 2008 Earnings Conference Call on Monday 11 of August 2008. Throughout the recorded presentation, all participants will be in a listen-only mode. After the presentation, there will be an opportunity to ask questions. (Operator Instructions).

I would now hand the conference to Ina McGuinness. Please go ahead.

Ina McGuinness - Integrated Corporate Relations

Thank you, operator. This is Ina McGuinness with ICR. Earlier this morning, Obagi Medical Products released financial results for the second quarter and six months ended June 30, 2008. Additionally, the company issued another press release announcing the launch of SoluCLENZ product line into the pharmacy Rx channel. If you have not received these press released they are available on the Investor Relations section of the Obagi Medical Products website at www.obagi.com. This call is being webcast and a replay will be available on the Company’s website for 30 days.

Before we begin, we’d like to remind you that today’s remarks contain forward-looking statements within the meaning of Federal Securities Law. These statements do not guarantee of future performance and therefore undue reliance should not be placed on them. We refer you to the risk factors contained in Obagi Medical Products SEC filings for more detailed discussions of the factors that could cause actual results to differ materially from those projected in any forward-looking statements. All information provided in today’s call is as of the date of the live broadcast, Monday, August 11, 2008 and Obagi Medical Products assumes no obligation to update any such information.

Participating in today’s call from the company are President and Chief Executive Officer, Steve Carlson, and Chief Financial Officer and Executive VP of Finance, Operations and Administration, Preston Romm.

And with that, I’d like to turn the call over to Steve Carlson. Steve?

Steven Carlson - President and Chief Executive Officer

Thank you, Ina and good morning everyone. We saw global sales in the second quarter rise approximately 7% to $27.8 million of net income increase 14% to $4.5 million or $0.20 per share. Domestically in spite of the impact economic conditions we are having on consumer spending, our business continue to demonstrate both stability across all our product lines, and growth will be at a modest 6.5%. It remains apparent that the macroeconomic factors continue to impact patient visits and the growth of the aesthetic procedures.

With that in mind, we are pleased to announce our investing in a new strategy initiative which we believe will drive significant future growth in our therapeutic business while reducing the impact of consumer discretionary spending. Today, based on our proprietary soluble benzoyl peroxide of BPO technology we launched our first product into the pharmacy dispensed channel branded as SoluCLENZ Rx Gel. SoluCLENZ Rx Gel is the same product that's found in the physicians dispense channel branding CLENZIderm M.D systems which is demonstrated to be as clinically effective without antibiotic exposure concerns as the leading BPO antibiotic combination drugs. Now, providing physicians with SoluCLENZ via the pharmacy channel simply gives physicians a flexibility and an option on a patient by patient basis and how they want to manage their patients acme therapy.

To the best of our knowledge we’re the first company to provide physicians with this flexibility in acme market. We believe this is the right strategy at the right time to further partnering with physicians to treat patients suffering for mild to moderate severe acne. In fact, Preston and I are speaking to you from our launch meeting where Obagi’s newly expanded sales force is being educated on the product, sales, and marketing strategies. Today, we have a total dedicated domestic sales team inclusive of a management of 130 people. We now have 45 sales reps in our therapeutic dermatology division as we have added 20 sales reps who would be focused on promoting SoluCLENZ to high prescribing therapeutic dermatologist who prefer to have their treatments dispensed by our pharmacy.

In comparison to our last call, this means we now have a 115 domestic sales people versus 93 at the end of Q1. As you know, the US market for prescription top class, I mean, treatments exceeds $1.5 billion in which BPO and BPO combinations account for nearly $500 million. We will continue to provide dermatologists with additional clinical proof in support of dispensing CLENZIderm M.D and now soluCLENZ Rx gel.

We believe in the current clinical database with 800 plus patients in over a dozen clinical studies, this compelling evidence of our Soluzyl BPO efficacy and safety. As a results we are extremely optimistic that it will be successful in partnering both the physician dispense, in this new pharmacy channel.

Further, I’m pleased to announce, we recently received notice from the United States Patent Trade Mark Office for the first patent issuance protecting our Soluzyl BPO technology and products.

Turning to our existing product lines and segment performance, for CLENZIderm second quarter sales (inaudible) million which is flat on a sequential basis yet up 38% on a year-over-year basis, account re-order rates remained strong at 79%. ELASTOderm which includes our Decolletage system and our eye cream and gel for sales increase of 14% over a year ago. Our ELASTIderm account penetration indicates that over 3,300 accounts had now purchased ELASTIderm with approximately 225 new accounts ordering in the past quarter. Reorder rates were impressive 84% for the eye cream and nearly 40% for Decolletage.

Turing to our core products, sales in Nu-Derm segment continues to be stable at $16.5 million up $3.8 million or 30% on a sequential basis and 5% versus a year ago. Reorder rates for condition enhanced with 74% for the core systems. Sales of Obagi C Rx, Professional-C, Tretinoin and others equaled $6.2 million up nearly $800,000 on a sequential basis and up 5% versus a year ago. To further support future growth of our core Nu-Derm segment a week ago, we announced the investment in the launch for direct consumer awareness campaign for our condition enhanced systems. The campaign is featuring print advertising national beauty magazines, online banner ads on select websites as well as a new dedicated website www.condionenhance.com, which provides comprehensive information of state of the art skin care. We think this will be successful addition to our Obagi’s partnering’s programs which are designed to help patients partnering with our physicians as they seek results driven in aesthetic skin care.

The initial campaign goals to reach approximately $26 million aesthetically aware women between the ages of 25 and 55 and the initial feedback from our physician accounts has been extremely positive. Looking at sales by geography, shows the United States for the second quarter were up 6.5% from a year ago period and represented 84% of revenues. International sales grew 7% from last year representing 16% of total revenues.

Now, let me run through some of our key metrics of success.

During the second quarter, we established 320 new physician accounts, our total number of active accounts increased 15% to more than 5,500 year-over-year. These 5,500 active accounts encompass approximately 8,600 physicians who are now dispensing Obagi systems, and our basic dermatology accounts grew by 3% over the prior quarter and is now up 23% from a year ago. Also, today we announced the board approved a stock repurchase plan of up to $10 million in aggregate of stocks to remain in effect for the next two years unless revised by the board. This stock buy-back plan reflects our commitment to enhancing shareholder value, and reiterates our confidence on long-term future of the company. We believe that our continued focus on improving profitability and cash flow allow the pursuit of opportunities that enhance shareholder value such as this.

And last, let me give you a brief update regarding OTC hydroquinone tissues, just to be very clear the proposed roll initiated in mid 2006, is into address of the FDA regulates over the counter products that contain 1 in 2% hydroquinone and makes skin bleaching, skin whitening plants. Under the proposal there was a request for public and industry comments regarding the safety in efficacy of hydroquinone products, to the best of our knowledge over 700 responses received by the FDA with no consumer adverse events or safety issues reported. The FDA has now updated their calendar and is targeted May of 2009 as the next date for report a decisions on their findings. For clearly, Obagi Medical Products has never sold their marketed 1 or 2% hydroquinone OTC products, our hydroquinone products are and all as help them 4% prescription drug just regulated and the FDA does the drugs status in the United States.

We’ve been selling our prescription hydroquinone drug products for nearly 20 years available only through physician prescriptions. Similar to the responses received by the FDA, we have no adverse events or concerns for patient safety. Further, we’ve received no concerns expressed by our physicians or patients regarding the use of our 4% prescription hydroquinone drugs.

So, any changes in status by the FDA regulator over the counter 1 and 2% HQs would have minimal impact on our company. In conclusion, we’ve always complied with FDA and intend to continue to support and comply with FDA requirements as they evolve. So, all we sell no HQ products and then over the accouter OTC basis, we are keeping a price of the ruling status and same close to the process.

And, now let me answer to this Preston on, so, I’m pleased to welcome to our first earnings call as Obagi new Chief Financial Officer and Executive VP of Finance Operations and Administration. Preston comes to us with an extensive experience in the public arena and has already had a significant contribution to our organization. I know you’ll all appreciate and benefit from his experiences as well. Preston?

Preston Romm - Chief Financial Officer

Thank you, Steve and good morning everyone. First of all, let me say I’m very pleased to become part of the Obagi medical family and oversee the financial and operational aspects of the business, I believe Obagi has a compelling portfolio products with the enormous growth potential. As Steve outlined today, there are numerous opportunities in aesthetic and dermatology market place, I look forward working with the team to capitalize on them.

And, now let me discuss our finance results for the second quarter. Despite the challenging -- current challenging economic condition towards our customers we’re not immune. During the second quarter, our net sales increase 6.5% to $27.8 million from $26.1 million in the second quarter of 2007 and grew 9.5% sequentially. For the six month ended June 30, 2008, net sales were up 8.2% to $53.1 million compared to $49.1 million for the six months of 2007.

Second quarter, net income rose $4.5 million or $0.20 fully diluted share versus $3.9 million or $0.18 per diluted share for the second quarter of 2007.

The first half of 2008, net income totaled $7.5 million or $0.33 per diluted share, compared with net income of $6.9 million or $0.31 per diluted share for the same period year ago.

Now, let me briefly discuss our second quarter operating metrics. Gross margin decreased to 81.8% from 82.5% for the second quarter of 2007 but was slightly up compared to 81.4% for the merely proceeding quarter. The year-over-year decrease is primarily attributable to decline in the higher margin license fee, partially outset by decrease in product cost related to our sales promotions during the quarter. Selling, General and Administrative expenses which include depreciation, amortization in non-cash compensation expenses, rose to 1.6% to $14 million compared to $12.5 million year ago. This increase is primarily due to the expense of our direct sales, marketing and operational personnel, severance in compensation expense related to the CFO transition as well as some increase in activity related to specific training, practice-building and patient acquisition efforts.

As, a percent of net sales, our selling, general and administrative expenses for the second quarter of 2008 were 50% as compared to 48% for the same quarter year ago. Obagi will be relocating its headquarters closer to the Long beach Airport in October. As many of you seen, we have well grown our current facilities and look-forward to improve communications and operationally efficiencies we gain by having everyone together.

However, this will negatively impact SG&A expenses during the impact SG&A expenses during the third quarter were approximately $400,000 that we will be paying double rent during this transition. Income from operations was flat year –over-year at $7.5 million as higher sales was offset by higher operating expenses. Interest expenses totaled $28,000 compared to $1 million a year ago as a result of reducing our outstanding debt during 2007. Income tax expense increased $400,000 to $3 million compared to $2.6 million for the second quarter of 2007. Our effective tax rate over the quarter was 40% for the second quarter 2008 up from 39.4% last year due to the exploration of the federal R&D tax credit. Congress will hopefully be revaluating the R&D tax credit by the end of the year and as an extension of the proof we’ve report the benefit as appropriate.

Our balance sheet continues to strengthen, as of June 30, 2008 we were debt free with cash and cash equivalents totaling $23.2 million up from $14.1 million at December 31, 2007. Working capital totaled $42.9 million as stock holders equity totaled $58.3 million.

In addition, we generated $10.1 million of positive cash flow from operating activities for the first half of 2008.

Turning to financial guidance, there are two major investments that are being made in this third quarter. Mainly, our direct customer’s awareness campaign in the launch of SoluCLENZ in the prescription Rx channel. Given that the third quarter is the weaker seasonally, couple with the likelihood that we will be able to recognize only minimum revenue from the SoluCLENZ based on our revenue recognition policy for that channel, as a need for remain cautious in this economic environment, we made the decision to revise guidance downward for the remainder of the year. We are revising our 2008 financial guidance to revenue in the range of a $110 to $140 million, an EPS in the range of $0.72 to $0.77 on 22.7 million fully diluted shares. This would represent a top line growth of 7 to 11% an earnings growth of 4 to 12% for 2008.

Prior guidance for 2008 was revenue of $113 to $117 million an EPS of $0.81 to $0.84 per share. For the third quarter we expect revenue to be in the range of 25.5 million to $27.5 million an EPS to be in the range of $0.13 to $0.15 reflecting the historical third quarter seasonality in sales. These results include the two investments that we discussed an expense in double rent for the third quarter which when combined will impact operating expenses by approximately $1.6 million EPS by $0.04 a share. We believe we are making the right strategic investments in the new consumer awareness campaign and a loss of SoluCLENZ in the pharmacy channel. The full benefit of these investments is expected to be realized in 2009. Our fourth quarter guidance takes into account the following factors. Historical seasonal strength at year end, during holiday season, the potential for economic – for the current economic conditions to continue and the initial benefits of the successful launch of SoluCLENZ in the benefits of the DTC campaign.

Based on these factors the company expects fourth quarter revenue to be in the range of $31 to $33 million an EPS in the range of $0.26 to $0.29 per share.

Finally, I want to explain a revenue recognition method for the pharmacy channel. We will initially recognize revenue based on sales through to the pharmacies or the appropriate reserves; actually has an up history to estimate certain factors we can recognize revenue on sales to the wholesalers.

That concludes my comments of the company’s financial performance. Now, I would like to turn the call back over to Steve.

Steven Carlson - President and Chief Executive Officer

Thanks Preston. I would like to close the highlights and we have made a good deal of progress this quarter, and position the company for growth. We’re the clear leaders in the physicians dispense skin care market and we are the stable and still growing businesses by the current economic conditions. We have strong financial fundamentals in our balance sheet and are continuing the strategically invest in opportunities which leverage our sales and marketing organizations and our new products and technologies. We believe we are starting to see early success in our investments in the international markets and look forward to reporting on our initiatives and accomplishments in coming quarters.

Lastly, we believe we are well positioned continuing to grow as a leader in topical medical aesthetics in a strong competitive and therapeutic market.

With that operator, please open up the call for questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions). Thank you. Our first question comes from Katherine Lu of Oppenheimer. Please go ahead with your question.

Katherine Lu

Hi, good morning. Thank you, for taking my question. First of all, I just want to ask a question regarding to your sales force deal in the pharmacy channel. Now, with SoluCLENZ Rx Gel launched. Do you see and we should be expecting more sales force deals for the rest of the year or you think the sales force number is picking up and to take care of the product.

Steven Carlson

Thank you Katherine, this is Steve. In response to your question, we believe we are right sized, the sales force on the therapeutic dermatology does support SoluCLENZ with the 45 people, we have done that by specifically targeting through IMF, the high volume therapeutic dermatologists that write the majority of prescriptions in this segment.

Katherine Lu

Okay, thank you. And with this product launch, is it good for us to assume there will no new product launches for the rest of the year?

Steven Carlson

As we have discussed before Katherine, we don’t provide guidance on timing of new products, what we have committed to is at least new product launches per year. If another opportunity represents itself within our pipeline to launch additional products, we’ll do so, and as we have in the past announced that at the time of launch.

Katherine Lu

Okay, I see. Then I would like to ask a question on the Nu-Derm and the growth of Nu-Derm seems to come back a little bit compared to the first quarter. I am just wondering; have you seen anything different in the second quarter compared to the first quarter in terms of the ordering pattern. If it’s just a result of the sales force refocus and also if you can give a little bit more detail on the DTC awareness campaign about, like how long it will last and what kind of financial impact it will make to SG&A that will be great? Thank you.

Steven Carlson

Yeah, in reference your questions relates to Nu-Derm’s trend from Q1. I think as we’ve reported, Katherine, in Q1, we had a change in ordering volumes with our larger accounts, as we’d indicated, we certainly were feeling some impacts of the economy at that level. I think, we had a very excellent Q2, as it relates to focus of our sales organization and coupled with that as you had indicated, we’ve invested strategically in a direct consumer awareness campaign at multiple levels between print advertisement as well as web-based and we think that’s an appropriate investment to continue to drive growth in this segment and create overall awareness to the Obagi brand and specifically to the condition and enhanced systems. Again at this point in time, we are not providing any outlook as to how long we will continue the DTC campaign awareness, we expect to see good returns on those investments and we’ll adjust expenses going forward accordingly.

Katherine Lu

Okay, great. Thank you.

Steven Carlson

Thank you, Katherine.

Operator

Thank you. Our next question comes from Larry Neibor from Robert W. Baird. Please go ahead with your question.

Larry Neibor

Thanks. Good morning.

Steven Carlson

Good morning Larry.

Larry Neibor

How do you think incremental 20 sales people already the hit the income statement or they are going to be entering the statement in the third quarter?

Preston Romm

Larry, this is Preston. Not a Q2 event that will be impacting third quarter.

Larry Neibor

Okay. And what is your DTC budget for the balance of the year?

Preston Romm

As Steve said, we have entered Phase I, we are spending some money in the third quarter and we will see how that goes and what kind of initial feedback we get to determine weather we you know, continue spending money into the fourth quarter and what I said is that event compared to these 20 sales people and inclusive of double rent for three months, we are looking at about $1.6 million for all of that or $1.04 a share.

Larry Neibor

Okay. Who is going to be your distributor for your pharmacy product sales?

Stephen Garcia

Yeah, we are using group called DDN that is a fairly large operation of logistics and distribution, we are going through multiple wholesalers including that large three ones.

Larry Neibor

Yeah. How long do you think you will take before you have enough return experience on SoluCLENZ for you to report sales?

Stephen Garcia

No, it really don’t know Larry. It’s debatable whether we have enough by the end of this calendar year to have a good history. It depends how tightly the results come in and also work with PWC on that.

Larry Neibor

So, we shouldn’t expect SoluCLENZ revenue recognition until 2009?

Stephen Carlson

Probably fourth quarter, we are going to recognize revenue initially on sales through to the pharmacy with reserves for some returns and etcetera. I think we will have enough history to maybe in the fourth quarter push that to revenue recognized to sales to the wholesalers would be appropriate reserves but if not, there is still should be a good flow of product during the fourth quarter.

Larry Neibor

And, how you are going to handle the manage care situation for SoluCLENZ and you are clearly targeting the patients who are treated by traditional dermatologists who don’t do office dispensing?

Steven Carlson

Larry, this is Steve. We’ve already filed and are being accepted on contentious so for the next six months. We are grandfathered in and we are dedicating resources in the sales and marketing, we need to focus on manage care thereafter.

Larry Neibor

Thank you.

Steven Carlson

Thank you, very much Larry.

Operator

And our next question comes from Greg Dust from Roth Capital Partners. Please go ahead with your question.

Enrique Lribarne

Good morning. Actually this is Enrique Lribarne, good morning gentlemen.

Stephen Garcia

Good morning Enrique, how are you?

Enrique Lribarne

Good, thank you, couple of questions. On the double rent, is that on going through the end of the year is it just a second quarter event?

Preston Romm

Middle of October, we will be in the new facility and not at our existing one.

Enrique Lribarne

Okay. Then on the -- you might have answered this earlier but the additional sales force, is that going to have a full quarter effect or when they hired?

Preston Romm

They are hired now, we will see a pretty descent impact in Q3 and then fourth quarter we have full quarter.

Enrique Lribarne

Okay. And lastly, Steve could you comment on the performance of international market?

Steven Carlson

Sure. As you know Enrique, we invested in a new international strategy which has placed people regionally on the ground in those regions one in Europe, in Asia and in South America and our focus is to do a better job of partnering with the appropriate distributor in channel and to accelerate our efforts through the ministries of health as it relates to getting our products registered. As we reported in the earnings release, we’ve seen early successes already from those efforts in the UK and in Russia, and we anticipate on non-going basis reporting, getting products registered, identifying the right distributor and seeing the early successes of those distribution launches.

Enrique Lribarne

Okay, thank you very much.

Steven Carlson

Thank you, Enrique.

Preston Romm

Thank you.

Operator

(Operator Instructions). Thank you. We have a follow up question from Katherine Lu of Oppenheimer. Please go ahead with your question.

Katherine Lu

Hi. Thank you for taking my question again. I would like to ask if you could share with us a little bit more on your share repurchase program. Would you be able to share with us what is the watermark for this repurchase?

Preston Romm

Yeah, Katherine, this is Preston. Yeah, we put aside $10 million with the team between Steve and myself and one member of the board to make purchases at various times in the open market depending on needs for cash, for growth and investment and where the stock prices and what’s in the best interest of the shareholders. So, it’s open for up to 2 years for $10 million and obviously at the discretion of the board to make changes to that.

Katherine Lu

Okay, great. Thank you.

Steven Carlson

Thank you, Katherine.

Operator

(Operator Instruction). Thank you gentlemen, we have no further questions at this time. That concludes today’s conference call. Thanks for participating. You may now disconnect.

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