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Executives

Stacy Feit – Financial Relations Board

Gerard E. Puorro – President, Chief Executive Officer

Robert E. Quinn – Vice President of Finance, Treasurer

Analysts

Dalton Chandler - Needham & Company

Anthony Vendetti - Maxim Group

Eric Apple - Asol Capital Management

Jack Holleran - Capital Management

Candela Corporation (CLZR) F4Q08 Earnings Call August 20, 2008 5:00 PM ET

Operator

Welcome to the Candela Corporation fourth quarter and full fiscal year results conference call. (Operator Instructions) I would now like to introduce your host for today’s program, Stacy Feit with the Financial Relations Board.

Stacy Feit

I’d like to introduce Gerry Puorro, President and CEO of Candela.

Gerard E. Puorro

Here with me this evening is Bob Quinn, Candela’s Vice President of Finance and Treasurer. Bob is going to review the requisite safe harbor statement, go over the financials for the quarter and for the full year and then I have some brief comments. After that, we would be happy to take your questions. Bob?

Robert E. Quinn

In addition to historical information contained in this call, we will discuss forward-looking statements within the meanings of the Private Securities Litigation Reform Act of 1995 including but not limited to statements related to the future success of the business, marketing and technology strategies, future market opportunities and the market acceptance of, and the demand for the company’s products.

The company’s future actual results could differ materially from the forward-looking statements discussed or implied because of risks and uncertainties including but not limited to those risks identified in the press release issued earlier today and those factors discussed from time to time in the company’s periodic reports filed with the Securities and Exchange Commission.

Results for the quarter were as follows: Revenue for the quarter was $37.8 million versus $39 million for the same quarter last year. This resulted in a net loss of $2.7 million, or $0.12 per share, compared to a net loss of $727,000 or $0.03 per share for the same quarter last year.

For the full year ended June 28, 2008, revenues were $138.2 million compared to $148.6 million for the prior year. This resulted in a net loss for the full year ended June 28, 2008 of $9.1 million or $0.40 per share, compared to net income of $6.3 million or $0.27 per share for the same period last year.

As stated, our revenues have remained relatively flat over the year but we have seen a change in the breakdown of our revenue mix through the course of the year. At this point, it appears that our ASPs have stabilized.

The revenue split this quarter geographically was 32% U.S. and 68% international, compared to 44% U.S. and 56% international last year. The revenue split for the full year was 38% U.S. and 62% international compared to 44% U.S. and 56% international for the prior year.

To break down the core versus the non-core customers, it was 54% core and 46% non-core for the year. The product line split for this quarter was 32% service and 68% laser-related compared to 25% service and 75% laser-related for the same period last year. The product line split for the full year was 28% service and 72% laser-related compared to 24% service and 76% laser-related for the prior year. This regional and product line mix has been major contributors to our lower gross margin of approximately 41% this quarter compared to 52% a year earlier.

Gross margin for the full year was approximately 45% compared to 50% last year. The other factor bringing our margin lower has been our product reliability problems that we have mentioned in prior quarters. The reliability issues have had an impact on both our service margins and our product margins due to increased warranty costs.

Legal expenses remain high in this quarter as we incurred approximately $3.7 million compared to $2.2 million last year and $14 million for the full year compared to $5 million for the comparable period last year.

Now some key factors related to our balance sheet. We maintain a strong cash position with $38 million in cash. Our inventories remain high due partly to lower than expected sales and our increased service locations in the U.K. and Australia.

As for accounts receivable, our DSO is at 97 days which is a slight improvement from last quarter. Contributors to the higher than desired level is impacted by a larger percentage of international sales which typically have longer payment terms than the U.S, also we are noticing that it is taking a little bit longer for our customers to finalize their financing arrangements.

Gerard E. Puorro

Obviously, we have a poor Q4 and a poor fiscal year. Overall revenue was flat, as Bob said, at $148 million.

Our device business for the full year was down 6.3% while our service-related business was up 19.3%. Margins in the device business decreased from 57% to 53%. This decrease was attributed to higher warranty expense and somewhat lower but as Bob said, stabilized ASPs.

In our service-related business, margins decreased from 32% to 21%. This decrease was attributed to the reliability issues identified last quarter that are likely to continue and decrease in a favorable direction for the remainder of the calendar year.

Operating expenses increased $10.5 million with G&A leading the way with virtually all of it, $9 million of that being in the legal spending category. The remainder was labor-related more to our opening up of the U.K. and Australia. As well, sales expense increased $5 million in the U.K. and Australia and labor increases in the selling area. R&D, while down from last year, is where we expect it to be going forward.

What does all this mean? Where are we headed financially? As you all know, we don’t provide detailed guidance, but we will tell you what we expect. The remainder of this calendar year we will see continued yet decreasing service and warranty expense. Following the September trial in Texas, our legal spending will obviously drop off. We expect the September quarter that we are currently in to be a loss. We expect the December quarter to break even or be a marginal profit with the March quarter coming in at a meaningful return to profitability and the June quarter to be even higher than that.

Let me now turn to our outstanding litigation. First with respect to Palomar, we have received which we believe is a favorable Markman ruling as we prepare for the September 29 trial in Texas. There are no trial dates established yet in Boston.

Second, in a securities class action filed by the Western Pennsylvania Electrical Employees’ Pension Fund, Judge Woodlock has appointed the lead plaintiff counsel and required an amended and consolidated complaint filed no later than August 25, next week. Candela at that point will either need to file an answer or a motion to dismiss by October 1. Nothing material has occurred in the derivative lawsuit by Mr. Forlorenzzo. We will not answer that complaint and do not need to do so until October 31.

The fourth and final item in the litigation area was the suit brought by Cayou Focus. We filed with the PTO and were granted a re-exam of all of the Cayou Focus patents in the suit. We also filed for a stay of lawsuit pending the PTO’s re-exam and we are waiting on the court’s decision of whether or not they will stay the case. As it relates to these four litigation matters, we have no further comment.

Let me move into the business a bit. As for the body shapings cellulite product, last quarter we said we will launch this in the latter part of calendar year 2009. That has not changed. As for our home-based product initiative, we are now nearing completion of the proof of concept phase for two specific applications. Based on the final outcome of these two proof of concept applications, we are deciding on next steps. This decision is likely to be in the December time frame which in turn meets our consistent goal to launch a product during calendar 2009.

With that, we will take questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Dalton Chandler from Needham.

Dalton Chandler - Needham & Company

On the reliability issue, where do you think you stand with the resolution of that?

Gerard E. Puorro

I think we identified all of the problems. Last quarter we were in the identification stage. We’re beyond that. We’re in the fix stage but given the size of our install base, Dalton, which is pretty large; this is going to be with us through the remainder of the calendar year. In a decreasing sense, we will be out from under by the holidays but we need to go out and be certain that all of our customers to the extent that they need to be are upgraded or whatever the case may be. We know what we need to do. We know what the fixes are. We know what the cutting dates are for the fixes, both in production and upgrades. By the calendar year, it should be behind us.

Dalton Chandler - Needham & Company

Can you give us a sense of what the magnitude or the impact was where we might expect the gross margin to go back to when the issue is resolved?

Gerard E. Puorro

I can tell you that year-over-year, the gross margins; the blended gross margin was down 500 basis points from a little over 50% to 45%. It’s not unlikely that by the end of our fiscal year, we’ll be back there, when the reliability issues are behind us. That coupled with the decreased legal spending and some of the newer sales subsidiaries that we put in place is one of the reasons that we expect a return to profitability in the first calendar quarter. That alone was 5 percentage points of $148 million, its $7.5 million of expense to fix the problem. Add to that $9+ million in legal expenses, or $14 million, excuse me. When you look at a loss of $9 million for the year, those two categories made up $22 million.

Dalton Chandler - Needham & Company

Just moving on to the legal expense. Obviously, this is going to come down when the trial ends which I assume will be in early October, right?

Gerard E. Puorro

Yes, they think it’s a four or five day trial.

Dalton Chandler - Needham & Company

But you still have the suits with Palomar in Massachusetts so not all of that spending is going to go away, right?

Gerard E. Puorro

No, I would suggest to you that you cut it in half, approximately, plus or minus. That’s how effectively we’re modeling it.

Dalton Chandler - Needham & Company

Last question, if you can update us on the sales force, I think last quarter you said you had 39 reps with 9 openings. Has that changed?

Gerard E. Puorro

No, it hasn’t. It has not changed. Is that accurate, Bob?

Robert E. Quinn

Yes.

Gerard E. Puorro

We’re still holding that.

Operator

Our next question comes from Anthony Vendetti from Maxim Group.

Anthony Vendetti - Maxim Group

I was wondering if you could give us a little bit more color on the home-based products. You said you have two that you’re hoping to launch in calendar ’09. That’s a little ahead of schedule and I didn’t know that there would be two that you had. So I was wondering if you could discuss that a little bit.

Gerard E. Puorro

If you remember, we had said we looked at several clinicals ongoing. Two have advanced pretty well. They’re just at the end of what we categorize as proof of concept. Once we get there and right now it’s looking pretty decent, that looks to be around December, which we will be at the end of that. Then the decision making process begins, how to launch, how to partner, who to partner with. We obviously spent some time identifying some of those answers. Two applications will tell people around that time frame what those applications are. They’re laser-based as you can imagine. We’ll tell you more about it in December.

Anthony Vendetti - Maxim Group

So you expect to have partners lined up by the end of December as well?

Gerard E. Puorro

We have identified partners. We expect to be talking to people. Whether we have a deal with someone, I can’t answer. We’ll be working at it.

Anthony Vendetti - Maxim Group

Any other products in the pipeline that you can talk about at this point?

Gerard E. Puorro

No, I think with a body shaping cellulite product out there, there are others in the market and in that sense; we are late to the market. It’s a huge market. We are going to rely on the science and we like what we see from the science. When we get there, we hope to have something that is very, very competitive so we can take advantage of the very large market. It’s okay for us to be late. We got to the hair removal market probably three years after everybody else and three years after we get into it, we take the lion’s share of it. We think this market is as big as the hair removal market. We are going to dot our I’s, cross our t’s and get there in the appropriate time with the appropriate science.

Anthony Vendetti - Maxim Group

The domestic sales force, can you speak about where that’s at right now, what your plans on to either maintain it, downsize it –

Gerard E. Puorro

Last quarter we were at 39. Dalton just asked and we’re still at 39. There are nine territories that we can fill. As soon as we have these reliability issues behind us, we’ll start to fill them probably again at the end of the calendar year. If you can imagine, when a sales guy has a reliability issue, it just absorbs some time that he should be selling. We are going to get this stuff behind us and it will also make us more attractive to go out and get 9 or 10 folks who are .400 hitters.

Anthony Vendetti - Maxim Group

But you are not looking to do that until the end of this calendar year?

Gerard E. Puorro

That’s correct.

Anthony Vendetti - Maxim Group

Out of the cash on your balance sheet, is any of that also in securities?

Robert E. Quinn

No, it’s not.

Anthony Vendetti - Maxim Group

Anything that you’re actively doing, Bob, to continue to bring DSOs down?

Gerard E. Puorro

We’re working with the customers. We talk to leasing companies all the time. We try to increase our number of leasing companies this year so we can try to get the most attractive rates possible. So we’re giving our customers as many options as possible. That’s what we are attempting to do right now.

Robert E. Quinn

The international business is a major impact, Anthony, and the LC’s are a 90-100 day type of thing.

Anthony Vendetti - Maxim Group

That’s obviously become a large part of your sales. Can you talk about any of the benefits that you’re getting from foreign currency exchange at this point?

Robert E. Quinn

Well, clearly as far as revenue goes, our revenue for the year from ’07 to ’08, we clearly got close to $4 million in additional revenue, but also expenses have gone up the same way. So our profitability is not significant from that aspect.

Gerard E. Puorro

The net-net is probably a million, million and a half, Bob?

Robert E. Quinn

Right, exactly right. Maybe a million dollars.

Anthony Vendetti - Maxim Group

Any change in the international mix? Any countries surprising you on the up side?

Gerard E. Puorro

Australia. It’s still very new but they are doing a lot better than we expected.

Anthony Vendetti - Maxim Group

That seems to be across the board because another company mentioned Australia as well. What’s the dynamics occurring there that’s causing that market to be particularly robust relative to some of the others?

Gerard E. Puorro

The economy is relatively stable and in the major cities, Sydney and elsewhere, they have a very robust healthcare presence, healthcare system and highly educated folks. Now that it seems that the vanity side is starting to kick in as you saw in the States a few years ago. We’re watching it. I have to be honest with you; we are surprised so far at how well we have done so far.

Anthony Vendetti - Maxim Group

Last question on the gross margin. Gerry, you mentioned by the end of the fiscal 2009 you would be back up to 45%, or 50%, can you just go through quickly again how you are going to get there?

Gerard E. Puorro

If you look at the comments that we made and you look at the numbers, you’ll see that, first of all, the service margins dropped from 32% to 21% or 11 percentage points on 32% of our business. That’s totally related to reliability or pay as you go, if you will, fixes in the field. However, because of that, the warranty that we include in our systems, as we shipped them out the door, so in terms of an accrual basis, in anticipation of what might happen is based on what is happening. We have increased all of the rates of warranty built into the systems as well. That margin which was 57% of the boxes is down to 53% on 68% of the business. We expect to put those fixes in place. Once we see they’re in place, not only will service margins rise but then we will decrease the rate that we will include in the factory margin of the unit to bring that down as well. The blended rate should return to where it was a year ago.

Anthony Vendetti - Maxim Group

You think from the product side, you said that ASPs were lower this year but you believe that they have stabilized?

Gerard E. Puorro

Yes, Bob has those. Go ahead, Bob.

Robert E. Quinn

Throughout all of the regions, they basically stabilized from last quarter to this quarter.

Anthony Vendetti - Maxim Group

Could we expect some of the newer products that you have in the pipeline such as the body shaping cellulite product that carries higher margins?

Robert E. Quinn

You can absolutely expect that.

Anthony Vendetti - Maxim Group

What about on the home-base? What kind of margins there would you expect?

Gerard E. Puorro

I’m not going to speculate, Anthony. It really depends on the partnering and how that plays out. There’s a ton of different models, everything from royalty streams to sharing so we’ll wait until we get there.

Operator

Our next question comes from Eric Apple from Asol Capital Management.

Eric Apple - Asol Capital Management

Regarding the market hearings, I’ve been through a lot of these things and it’s usually one party that seems to defeat but in this case both companies are saying that the outcome of the hearings were positive for their own companies. Tell me a little bit about why it would be positive for Candela so I can understand your point of view.

Gerard E. Puorro

I think I am not going to talk about the legal matters further on the call but I would refer you to our press release on that where we attach the Markman write-up by the court itself and you can read it and draw your own conclusions.

Eric Apple - Asol Capital Management

The second to last question, in the trial where you are the defendant which is going against Candela Laser, are there new products that you would have ready through R&D pipeline that may alleviate your need for future royalties?

Gerard E. Puorro

That’s a real hypothetical and it gets into litigation strategy. I’m not going to discuss it with you, unfortunately.

Operator

Our next question comes from Jack Holleran from Capital Management.

Jack Holleran - Capital Management

The first question is what are the options related expenses for the quarter?

Robert E. Quinn

Yes, there was approximately $600,000 worth of expense related to share-based compensation.

Jack Holleran - Capital Management

The second question is Cynosure mentioned that they had contacted two companies in regards to infringements. Are you one of those companies?

Gerard E. Puorro

No, we’re not.

Operator

Our next question is a follow-up question from Dalton Chandler from Needham.

Dalton Chandler - Needham & Company

Just a quick follow-up in the service revenue. You had a nice jump the last couple of quarters. Do you think that’s a permanent jump or are you getting some actual revenue benefit from the reliability issue?

Gerard E. Puorro

There’s no revenue unfortunately associated with our reliability issue. It’s all expense. There may be some tweaking in the service revenue as it relates to currency.

Robert E. Quinn

A certain portion of it is internationally our service revenue but we don’t, I would argue that in this quarter it was a big number but we expect it to be over $10 million in the future quarters.

Dalton Chandler - Needham & Company

I thought most of this was annual service contracts. Is there a significant component that is sort of one-off?

Robert E. Quinn

We do clearly have POTS timing material type of activity. We also have a lot of rare consumables that are out there also that it is dependent on. Cryogen is clearly something that is consumable that people use that is dependent on when they’re ordering it can have an impact on the revenue for service.

Dalton Chandler - Needham & Company

Just on the home use product, since you have advanced as far as you can, have you started to talk to some potential distribution partners?

Gerard E. Puorro

No, we identified specific partners. We haven’t begun discussions.

Operator

I’m not showing any further questions in the queue at this time.

Gerard E. Puorro

I thank all of you folks for calling in. We look forward to talking to you again. Stacy, Bob and I are available for questions during the interim. Thank you and good evening.

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Source: Candela Corporation F4Q08 (Qtr End 06/28/08) Earnings Call Transcript
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