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Cyberonics, Inc. (NASDAQ:CYBX)

Q1 2009 Earnings Call

August 21, 2008 9:00 am ET

Executives

Daniel J. Moore - President and Chief Executive Officer

Gregory H. Browne - Vice President, Finance and Chief Financial Officer

David S. Wise - Vice President, General Counsel and Secretary

Analysts

Amy Sullivan - Piper Jaffray

Keay Nakae - Collins Stewart

Steve Brozak - WBB Securities

Bill Plovanic - Canaccord Adams

Anthony Petrone - Maxim Group

Jonathan Block - SunTrust

Assaf Guterman - Lazard Capital Markets

Operator

Good morning. My name is Courtney and I will be your conference operator today. At this time, I would like to welcome everyone to the Cyberonics Quarterly Investor Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. (Operator Instructions). Thank you.

Mr. Moore, you may begin your conference.

Daniel J. Moore - President and Chief Executive Officer

Thank you, Courtney. Good morning, and welcome to our Q1 fiscal year 2009 review conference call. I’m Dan Moore. I’ll be joined this morning with comments by Greg Browne and David Wise, our General Counsel, who will begin by reading the Safe Harbor statement.

David S. Wise - Vice President, General Counsel and Secretary

Thank you, Dan. This presentation includes forward-looking statements. Forward-looking statements may be identified by the use of forward-looking terminology, including “may,” “believe,” “will,” “expect,” “anticipate,” “estimate,” “plan,” “intend,” and “forecast,” or other similar words. Statements in this presentation are based on information presently available to us and assumptions that we believe to be reasonable. Investors are cautioned that all such statements involve risks and uncertainties.

Forward-looking statements in this presentation include statements concerning: achieving consistent sales growth of 10 to 20% per year and consistent earnings growth; revenue guidance for fiscal 2009; achieving an operating margin of 25% by fiscal 2011; growing our epilepsy sales, including growth through geographic expansion, evolving replacement cycle, increased market penetration, improved pricing, and new patient growth; executing the plan to set up and fund a separate entity for the depression indication; conducting and completing new clinical and R&D projects, including projects related to efficacy improvement, seizure detection, telemedicine and efficacy prediction; maintaining Medicare and third-party reimbursement for our products; and developing new indications and collaborations with partners. Our actual results may differ materially.

For a detailed discussion of the factors that may cause our actual results to differ, please refer to our most recent filings with the SEC, including our Form 10-K for the fiscal year ended April 25, 2008.

Daniel J. Moore - President and Chief Executive Officer

Thank you, David. For those of you who are joining -- watching the presentation from the website, I’ll begin with slide three and open up with the four topics that we intend to discuss today. I’ll open with the Q1 fiscal year 2009 overview where I’ll discuss our progress and the sales analysis. Greg will follow up on that topic by discussing the financials. He’ll move on to updates on a couple of projects that we have currently underway before I move into the epilepsy strategic focus. And then as usual, we’ll close with the questions and answers session.

First, in the area of progress. We’ve had another solid quarter of progress in the area of profitability. We’ve achieved quarterly net income for the second quarter in a row. We’ve improved our gross margins to approximately 85%, while continuing to control our expenses and positioning some of our funding in areas that will help us in the future.

For epilepsy, our base business, Q1 revenues were up 16% over the prior year. US unit sales growth was up 12% in Q1 fiscal year 2009 versus fiscal year of 2008. We again saw robust international revenues. Our DEMIPULSE launch continues, and with the rollout, we had about 31% of our global unit sales were in the DEMIPULSE product line. And once again this quarter, we did increase our average selling prices. In the area of new business development -- as you know, we’ve been searching for a partner for depression. And I’m happy to say that that search is nearing completion. Greg will be providing additional detail, but we are on schedule to have this done by the end of the year.

In the area of seizure detection, we talked about that being an important capability to add to our portfolio for epilepsy. We’ve signed an agreement on the R&D side for a partnership there. The Cyberonics team overall continues to execute on our strategic business plan, and we’re bringing improved quality of life for patients. When we speak about quality of life, there are a lot of ways to define success, and I’ll touch on more of those later.

As we add patients and improve their quality of life, we have a potential impact on growing our replacement business. Every time we add a patient, if we look back to the model 101, it would suggest that we have a two-in-three chance of that patient receiving a replacement down the line. Again, overall good progress by the Cyberonics team.

Looking specifically in the sales analysis, if you go to slide seven, the quarterly revenues -- you can see total revenues for the quarter were $33.7 million, a 16% increase over prior-year. Looking specifically at epilepsy, a 22% increase, with 23% in the US, over $25 million in epilepsy sales, and international, close to $7 million, a 16% increase.

Our depression sales were pretty much level with the prior quarter at about $720,000. Overall, our global epilepsy revenues being up 22% represented a $5.8 million increase in Q1 versus Q1 of the prior year.

Moving on to slide seven, quarter unit sales. Overall, our epilepsy units grew by an estimated 7% versus Q1 of 2008 that consisted of about 12% in US unit sales increase and international showed a 4% decline, primarily due to one large order that we had received in Q1 of 2008. Taking that order out, international would have grown by approximately 33%.

Moving on to slide nine, each quarter, we’ve attempted to provide an estimate of our new versus replacement units. And just a review of the assumptions, a simple assumption is that for each lead we sell, that’s indicative of a new patient being treated. Generators sold without leads then would reflect an estimate of the replacement units. And you can see for the second quarter in a row, replacements continued to grow to some 607 units for the quarter. So, we have strong growth in replacement units, but we do have a continued focus on new patients. There are twice as many new patients as replacement patients, but we want to continue to grow that new patient population.

Moving to slide 10 and looking at our average selling. As expected, our average selling prices grew. Domestic generators grew by nearly 19% over same quarter last year, while international grew by 21% for their generator business and 17% for leads.

When we look at the US ASP increases, those ASP increases were primarily due to price increases and mix between DEMIPULSE and the Pulse Generator -- whereas with the international ASP’s, it’s been a combination of channel mix, price increases, and currency impact, which led to the overall increases in our average selling prices for the international business.

With that, I’d like to turn it over to Greg to discuss more on the financials.

Gregory H. Browne - Vice President, Finance and Chief Financial Officer

Thank you Dan. I’m going to comment on our financial results for the first quarter of fiscal year ‘09, including the income statement, balance sheet and cash flow. My first comments are directed to slides 13 and 14, beginning with the quarterly profit and loss. Clearly, we are pleased to report continued net income for the quarter. On our last call, I stated that we had to make this a consistent feature in fiscal year ‘09. The revenue growth of 16% overall and 22% for epilepsy represents a continuation of the trends that commenced in fiscal year ’08. Revenue attributable to depression accounted for only 4% of total revenue in the first quarter.

The solid international performance of $7.1 million comprised 21% of total revenue. Foreign currency movements contributed approximately $500,000 to the first quarter number when compared with the prior year. We began to see selected pricing improvements in certain European markets; and with the increase in sales through our direct sales force, from 66% to 75% of unit sales in this quarter, this combined to push up the ASP, as Dan discussed, for both generators and leads. The, significant improvement to our gross margin this quarter of 85.7% was attributable to higher production volumes, improved manufacturing efficiency, and higher average selling price, particularly for the DEMIPULSE.

The fact that we also saw a small decrease in inventory levels was indicative of better coordination between our sales and manufacturing groups. Our expectation is that the gross margin will be approximately 85% for the full fiscal year.

Overall, our expenses were $5.3 million or 17% lower than the first quarter of fiscal year ’08, although were approximately $1 million higher than the fourth quarter. In Q4, we had received the benefit of $1.3 million in insurance recoveries, and we received a further credit of $240,000 in the most recent quarter. Our first quarter also saw an increase in legal expenses when compared with the fourth quarter. The decrease in research and development expenditure was due to a slowdown in enrollment in the post-approval studies for depression, particularly D-21, and our expectation is that research and development activity relating to epilepsy will increase over the balance of this fiscal year.

Included in the expenses for this quarter were approximately $3.3 million directly attributable to depression, and we now expect this number to be between $9 million and $9.5 million for the full fiscal year. We also incurred equity compensation expense of $3.6 million in the quarter, and this is expected to be approximately $10 million for the full fiscal year. Selling, general, and administrative expenses of $21.5 million represented 64% of revenue, while research and development was 14% of revenue, resulting in an operating margin of 8.25%. Our interest income for the quarter amounted to $500,000, reflecting the conservative position we have adopted on investing our cash since last fall.

The tax provision includes the benefit of our tax loss provision, which would result in the payment of alternative minimum taxes only in fiscal year ‘09. We continue to expect that overall operating expenses will rise modestly in fiscal year ‘09, as we discussed last quarter, due to the continued emphasis on building our international capabilities, investments in the future of the epilepsy indication, and the ongoing clinical spending on depression. As stated on our last call, our plan for fiscal year ‘09 is consistent and growing profitability.

I’m now going to turn to slides 14 and 15, and comment on the balance sheet and cash flow. Our balance sheet -- which is included in the press release but not the slides -- continues to strengthen. Solid operating cash flow has led to higher cash balances, and a more stable level of sales throughout the quarter has given us the opportunity to reduce our day sales outstanding to 50 days from the 55 days at the end of last quarter.

The first quarter of this fiscal year showed operating cash flow of $6.6 million, assisted by the reduction in receivables and a further small decrease in inventory levels. We expect inventory to remain relatively stable in the current fiscal year. Capital expenditure remained at low levels and well below the depreciation and amortization expense of $650,000 for the quarter. Our continued expectation for fiscal year ‘09 is that capital expenditure will rise to approximately $3 million, and that depreciation and amortization for this year will be approximately $3.5 million.

There are two areas on which we wish to provide an update, and I’m now turning my attention to the slides marked reimbursement. As some of you have seen, CMS has published proposed rates for 2009, which would, if adopted unchanged, reduce the reimbursement that our customers receive from CMS for the implantation of leads. To summarize the reimbursement position, Cyberonics is not directly reimbursed by CMS. We sell to hospitals and other providers, and they in turn seek reimbursement from private insurers, CMS for Medicare patients, or state Medicaid authorities. We believe that approximately 25% to 30% of our cases are ultimately reimbursed by CMS, although we would caution that we do not have perfect visibility into that number. So, if the proposed change to lead reimbursement is finally adopted as is, it could have some impact on approximately 3% of our worldwide revenue. It is important to note that the proposed rate still exceeds our current average selling price for leads.

However, we believe that CMS has included erroneous data in calculating the proposed rate. And in order to address this on behalf of our customers, we have undertaken an effort with CMS to revise the rate. The final rates are expected to be published around November 1.

Secondly, with respect to depression, we have undertaken a comprehensive process with the assistance of Piper Jaffray over the last six months, which has included presentations to over 20 potential partners. In order to ensure that we have covered all our bases, we are now exploring options with possible strategic partners.

Our expectation is that this process will be complete by the end of calendar 2008, and to reiterate, we have no plans to commence a new depression study until a partner is in place. As stated by Dan on the last call, it is important that a new partner have an appropriate say in the study design.

I am now going to turn back to Dan for his closing comments on our epilepsy strategic focus.

Daniel J. Moore - President and Chief Executive Officer

Thanks, Greg. On past calls, including the last one, we talked about our 2009 focus, and we’ve discussed our enthusiasm about improvements we can bring to the field of epilepsy, in particular, using medical devices. We thought it would be appropriate to share some additional detail on what we see as opportunity within the epilepsy franchise. I’m going to look at three areas in more detail -- market opportunity, the growth, and the profitability, and provide more detail there. Our three objectives around those three areas are one, to get to more and new patients. Number two is to expand our IP portfolio. And number three, of course, is to bring shareholder value.

I’m on slide 20. Specifically, I’d like to go into more detail on the market, the growth, and our goals. We’ve talked about the market opportunity here, and to summarize, there’s an annual incidence rate of over 100,000 patients per year added to the pool for which we could provide VNS benefit.

We believe our short to medium-term growth will be driven by our continued focus on epilepsy through products like DEMIPULSE and the Perennia lead, improved pricing, an evolving and growing replacement cycle, our geographic expansion, and getting new patients in current markets. Our longer-term growth will be driven by improving the efficacy with expanded be parameters and better patient selection, and also grow through seizure detection, telemedicine, and having VNS efficacy predictors. Our goals, as previously stated, are not complex -- consistent volume growth in the 10% to 12% range and achieving operating margins of 25% in fiscal year 2008. And we expect to continue to be the leader in medical devices for epilepsy. Again, while not complex, we believe these goals, if executed appropriately, will result in continued good return to our shareholders.

Let’s look at more detail on slides 21 and 22, detail around short geographical expansion, best practices, and R&D. In the area of geographical expansion, we’ve touched on restructuring our international organization for continued growth. We are managing the rate of expansion to ensure that our spin doesn’t get out ahead of where it should be as we build new infrastructure around the world. We now have managers in place in Europe, Middle East/Africa, Asia, and expect to have one in place in Latin America in the coming quarter.

Having that geographical presence will allow us to focus on key countries like Japan, China, and Brazil in a way we haven’t been able to in the past. And speaking of China, we did receive approval for our pulse product recently and have signed with the distributor to begin our efforts there.

We are going to expand in the area of best practices and that’s really publicizing the success of VNS. I mentioned earlier the definition around quality of life. As we talk to more customers, we find that there are many ways to define the quality of life brought to their patients by VNS. It can be a reduced number of seizures. It can be reduced intensity of seizures. It can be seizures with shorter duration or patients with faster recovery from their seizures. Some even report decreasing their drug requirement, even though VNS is adjunctive to drug therapy. And as we all know, drugs are very good, but can have some unintended side effects, including discussions that we have recently heard around the black box warning for some of the epilepsy drugs.

But quality of life, we know, is enhanced by VNS for many patients. For replacement we know based on the model that two in three patients come back for a replacement, and we expect that with better efficacy, we can improve that number as well. We have discussions and meetings with physicians, some of them coming to us in Houston and us going out to them, to see what they do every day in their practice and gain a better understanding of not only what they’re doing, but importantly, what they need for the future. We will use preceptors, physicians who welcome other physicians to come into their institutions and learn about their practice, as well as proctors, who will go out and teach other physicians about what they do and where they get their success with VNS.

Specifically, in the area of information sharing, just going to offer one example of what we’re doing. Between now and the end of this fiscal year, we will have 10 regional meetings that are already scheduled, where we will bring in two thought leaders who will meet with other physicians and lead discussions about VNS and their practices.

Moving on to slide 22, in area of growth, looking specifically at product developments. As you know, the Company has had a lot of success in the area of hardware, including being in the midst of launching our fourth-generation on the generator side, the DEMIPULSE. We have the Perennia lead out, which is a more durable lead than the former designs. And we have recently, during this quarter, also submitted for US regulatory approval on a Perennia flex lead. It will also be not only more durable but also flexible. We’ll continue to try to tap the generator capabilities that are within DEMIPULSE as we develop products for the future.

In the area of software, there’s plenty of work going on in the area of parameters. We’re looking at more than six different types of parameters that may enhance efficacy. Seizure detection, we announced we have one partnership in place and we’re working on others. We expect with seizure detection that we will be able to respond with therapy, once a seizure is detected, we can alert the patient that a seizure is coming, and notify a caregiver, and then record seizure activity.

Each one of those areas can represent a product or a business. In the area of telemedicine, we want to bring telemedicine to VNS for epilepsy to allow us not only to monitor the patient’s implant, but also eventually to be able to program remotely. We also are striving to identify predictive variables for VNS efficacy. We’re working on data mining projects now to help in the area of patient selection, potentially parameters that may work better than others. And we do have one partnership in place to explore the idea of being able to predict in which patients VNS will work.

Finally, on slide 23, in the area of profitability -- as mentioned earlier, we expect 10% to 20% volume growth plus increases in our average selling prices, leading to improved revenue growth over time. And while we’re improving the revenues, we also expect to achieve improved operating leverage. We’ll target consistent growth in our operating margins; we will maintain tight expense controls; and we will use our existing spending in more and more productive ways.

As we generate more profit, we will generate more cash. And we expect to invest that cash in our future in areas that will help us accelerate our product development, areas that can areas that can expand our product offering, and/or to improve our earnings per share, like the stock buybacks we did during the last quarter.

The bottom line, our team is focused on managing this business for the short, medium and long-term, and we believe we have a plan that will lead to continued success. While, we’re managing the business where we also intend to lead the sector into the future by unlocking the potential of devices to improve care for patients with epilepsy.

And the bottom line, we will continue to execute to that plan quarter-by-quarter. I want to take this opportunity to thank the entire Cyberonics team for helping to make this happen, and you, our investors, for your continued confidence.

With that, we’ll open it up to questions. Courtney, are there any questions?

Question-and-Answer Session

Operator

(Operator Instructions). Your next question comes from the line of Thomas Gunderson with Piper Jaffray. Your line is open. Please state your company name.

Amy Sullivan

It’s actually Amy in for Thom. Congratulations on a good quarter. I was hoping maybe you could give us your thoughts and maybe share some feedback from either your salespeople or the doctors on to what extent the shaky economy could be impacting the volume of VNS procedures? And, if there’s a difference maybe between replacement procedures and new patients?

Daniel J. Moore

Amy, any discussions I’ve had with doctors have not been around the economy; it tends not to come up in what we do. Much of what we do, it’s obviously reimbursed, though. There’s very little self-pay in this business, whether it’s for new patients or for replacements. So it’s not something that I’ve either had conversations about or am hearing that the salespeople or sales managers are hearing about either.

Amy Sullivan

Okay. So you’ve been with co-pay type things increasing and stuff, you haven’t heard any of that?

Daniel J. Moore

No.

Amy Sullivan

Okay. And then if you can share any more color as far as what you guys are working on in predicting which patients are more likely to respond to VNS therapy, that would be helpful?

Daniel J. Moore

One thing I did talk about was the data mining project. We have talked about that in the past, that we are going back and looking at data that we had in studies, like E05, for example. So that’s one area where we’re going back and looking at the data and what it could be telling us about patient selection and who responds better than others. And then we just have one partnership that is very early and probably too early to give any detail on.

Amy Sullivan

Okay, thank you.

Daniel J. Moore

Courtney, is there another question?

Operator

And your next question from the line Keay Nakae, Collins Stewart.

Daniel J. Moore

Thank you. Keay are you there? Why don’t we move on to the next one?

Operator

Your next question comes from Steve Brozak with WBB Securities.

Daniel J. Moore

Courtney, we are not hearing any of the questions. Do we have the line open.

Operator

Yes.

Daniel J. Moore

Can you hear me.

Steve Brozak

I can hear you now.

Daniel J. Moore

Okay.

Steve Brozak

Thanks for taking the question. I have two quick questions. The first one, I know that the primary focus is obviously on epilepsy, but for refractory depression, there were certain requirements that the FDA placed on you in terms of follow-ups and basic work that has to be done. Can you give us any color on what you still have to do in vis-à-vis the FDA in terms of that? And what -- I know that it’s not going to be a focus, but there’s obviously a minimum amount that you have to do and expend in order to make sure that you satisfy what the FDA had initially asked of you. Can you give us some color on that? And then I have a follow-up question on overseas?

Gregory H. Browne

Yes, this is Greg Browne. In terms of the FDA post-approval studies, there are two that we are conducting. One is a registry, which includes a VNS and a non-VNS arm. That study was predicated and put together at a time when both the FDA and Cyberonics expected for widespread reimbursement. And over the last year or so, the enrollment in that study has slowed really dramatically. But it is a study that would follow patients for approximately five years. The D-821 study is a dosing study, which includes a high, medium and low dose arms. We are continuing to enroll patients, although that was a little slow last quarter. We are slightly more than halfway through the anticipated enrollment in that study. And when you look at the expenditure for the quarter, I mentioned that about (inaudible) of our total expenses were related to depression. Of that, slightly more than half relates to those clinical studies -- around $1 million quarter on 21 on $6,000 related to the registry. Those numbers -- absent any partnership arrangement would continue through the end and in the case of the registry, for several fiscal years; and for D-21, the enrollment would be expected to be concluded in fiscal year (inaudible).

Steve Brozak

Okay. On the overseas sales, obviously you’ve got the domestic market pretty much down obviously you’ve got the domestic market pretty much down part in terms of understanding how it works and you’re able to maximize and manage growth. When I hear a place like China, where there’s obviously several tiers -- medical assistance that are possible, what would you see in terms of revenue, any kind of harvesting of revenue out of places like that, where you’re talking about there’s basic infrastructure flaws. Is the number of units that you’re going to put into something like that really going to provide you with the return, even in the long run? What’s your thoughts about that? I mean, there are -- Asia, ex-Japan, is a lot different, so I’m just trying to focus on how you look at that?

Daniel J. Moore

I think how we look at it, Steve, overall is that we are believers in the international businesses, both from a revenue standpoint and a profitability standpoint. James and I and others here have run international businesses where you can get them to grow quite well. And you can return good operating profit to the Company in doing that. To speak to China specifically, we -- it’s most important that we do it right. So I think it’s a bit early to be talking about how much revenue that we will get out of China. We are going to go as fast as we can but to ensure that we do it right. So, for example, in the opening here, in the opening quarter, we’ll look at five centers in China and get our bearings in those five centers, and ensure that we’re getting the technology off to the right start in China. And then we will determine how far and how fast we go after that.

Steve Brozak

I just have one follow-up on that. I assume that there was some statistical breakdown on work that you did in terms of patients coming from overseas to have the procedure done here in the states. Was that one of the triggers that basically gave you insight into the overseas demand?

Daniel J. Moore

I don’t even have those numbers. And again, it’s not the way we would look at it. I just look at good companies and say, good companies can push up to half of their revenues outside of their home-base country. And when we look at international, it’s a portfolio of countries and a portfolio of opportunities. So, the strategic direction is we are going to expand internationally, and how quickly and where, part of the reason of putting a regional manager in Asia, so he can look as a whole and decide where do we go and where do we start to build our infrastructure in Asia. So what we can say for sure is that we will continue to expand internationally because we’re convinced that it’s a good way to grow both revenues and profitability. And we have the regional model where we have broken it down from being a total international group into four subgroups. And then we’ll start breaking it down to the country level and create our priorities that way. And that will be an ongoing exercise for years to come.

Steve Brozak

Great thanks for answering the question.

Daniel J. Moore

Courtney, your next question?

Operator

Your next question comes from the line of Bill Plovanic with Canaccord Adams.

Bill Plovanic

Great, thank you. Good morning.

Daniel J. Moore

Good morning, Bill.

Bill Plovanic

Great, you can hear me. A couple of questions here. First, any commentary on seasonality? Would this be the quarter that you would see it and revenues would be up sequentially? I know you’re not providing guidance at this point, but just trying to get a little feeling, considering there’s no historical pattern upon which to base expectations.

Gregory H. Browne

I think what we’ve said in the past and I think we’d reiterate is, traditionally what we’ve seen is that the best quarter of the year is the fourth quarter. And clearly, we hope that would continue this year. First and second quarters are roughly the same, and the third quarter is a little bit lower here in the US, particularly because of the fact that Thanksgiving and Christmas falls in that period. But, obviously, internationally, it’s affected by other things, particularly where the buying -- the customers are government authorities and have different fiscal year-ends and different markets and so on, so that’s going to move around a little bit. But that’s generally what we see.

Bill Plovanic

And when you -- on your numbers, you’re talking on your fiscal year, not on calendar year. Correct?

Gregory H. Browne

Correct.

Bill Plovanic

Okay. And then just any color on the taxes? You pay an AMT at this point; at what point in time would you expect to switch over to a fully taxed rate?

Gregory H. Browne

Well, okay. For fiscal year ‘09, I suggested alternative minimum tax. For fiscal year ‘10, our preliminary look is that it would remain the same, although we do have to do some more work around that concerning the [200] limitation on the turnover in shareholders. So without going into too much detail, that’s where we’re looking at the moment. But hopefully by the next call, we’ll be able to come up with a more precise number for fiscal year ‘11. And then we would gradually start to expect fiscal year ‘11 and so on to start paying a little bit more on the tax side. Obviously, profitability, with the recent turn to profitability, tax planning has become more important here and we hope to get more insight into that over the next quarter.

Bill Plovanic

Okay. And, then just a little color on your stated goal in terms of operating margins in 2011. This quarter, you’re already at an 8% operating margin. I mean, can you -- is there any guidance you’d give us in terms of where you might be for ‘09 in an operating margin range, in ‘10?

Gregory H. Browne

I don’t think we’re in the position -- you know, we said we wouldn’t give income guidance for the earnings guidance for this year. But in general terms, what we expect to do, as Dan said, is increase our top line, maintain or improve the current gross margin number that we saw in this quarter of 85% plus, control our operating expenses; and take advantage of what we believe is operating leverage within the business.

You know, we do have a significant ongoing spend in depression that if we are successful in bringing a partner to the table, we’ll take some of that off the income statement. And of course, on the flipside, we do expect to increase our investment in research and development in the epilepsy indication. So, we expect to control our expenses, take advantage of the operating leverage we have, and with top line increases that we’re expecting, that will give us a reasonable chance of achieving those goals.

Bill Plovanic

Greg, I’m going to ask one more question and then I’ll jump back into queue. But can you quantify for us what a potential partner -- the impact it would be on the financial statements, in terms of if you’re spending $9 million to $10 million a year now in depression, and let’s say you move forward with the pivotal study, I believe however that’s set up, you’d still have to run it through the P&L, whether it’s above the operating line or below the operating line. But would you really see a significant drop in the total expenses running through the full P&L? Or is this likely to stay about the same but we just have the potential for depression coming back into the story? How would you characterize it?

Gregory H. Browne

We have discussed in the past the difficulty of quantifying that, if only because the final structure of any relationship is still unclear. In simplistic terms, if we spend $9 million this year and we were, and obviously, the timing is very important, as well, in terms of the impact on earnings. But if we’re spending $9 million this year and somewhat less next year as some of those studies run down, and you would add to that an amount over a three-year period of around $12 million for a new pivotal study, and then apply some percentage ownership to it, I think that’s the way to look at what the impact would be on the income statement. But of course, as I said, the timing and the structure of a relationship have an enormous impact here and that’s why it’s difficult to be more precise.

Bill Plovanic

Right. And it’d be $12 million per study and likely to be multiple studies, correct?

Greg Browne

Well, I don’t think I’d make the assumption there would be multiple studies. There would certainly be at least one. And then it would be up to the new entity, the partner, and Cyberonics to decide whether more studies would be required.

Bill Plovanic

Okay, thanks. I’ll jump back into queue. Thanks so much.

Operator

Your, next question comes from Anthony Petrone with Maxim Group.

Anthony Petrone

Questions on -- first, just want to start a high level discussion on epilepsy drugs and any impact you may have seen in the business. I mean, is there anything identifiable really that, I guess, commentary from neurologists, is there more inquiries into -- or has this been generating more interest from perhaps your existing neurologists and other than the neurologists that you do not currently deal with?

Daniel J. Moore

Are you specifically referencing the discussions around the black box warning?

Anthony Petrone

Yeah, that’s correct.

Daniel J. Moore

Yes. Obviously, because we’re in the epilepsy business, we do hear some about it. I do think it probably gives neurologists and epileptologists a good reason to just think -- give the whole treatment paradigm another level of thought as to what they do with drugs and how long they continue with drugs before moving to VNS. But a specific impact on the business, we can’t measure at this point.

Anthony Petrone

Okay. Moving on to more, I guess, specific questions here. Greg, can you isolate the impact in gross margin and overall pricing from the actual pricing campaign? In other words, specifically from price increases that the Company has put forth into the marketplace?

Greg Browne

Well, there has been some impact from the price increases on gross margin. Perhaps somewhere between 50 and 100 basis points of the gross margin increase might be related to price. We haven’t yet driven down the costs of manufacturing the DEMIPULSE to make it to the levels that we would hope to achieve in future. But it’s complicated by what’s going on internationally, with changes in country mix as well as currency movements and product mix as well. But, somewhere in the region of 50 to 100 basis points of the gross margin improvement.

Anthony Petrone

Okay. And then I guess moving -- before I move on to CMS, moving on to R&D, is the Company really waiting for to announce the majority divestiture of depression before really increasing R&D on the epilepsy side? Is it waiting for that event and then we’ll see the increase in R&D? And then if you look at the expected reduction in expenses related to depression, are you looking at almost an even swap of expenses? In other words, R&D, we could expect R&D to increase by a similar amount in lieu of the reductions in depression?

Daniel J. Moore

Good question. We’re not waiting for anything on the R&D front. We started -- we came in, in May of last year and went to work on the business in understanding the opportunities in epilepsy. And I think by December, we had laid out what our projects were. And fortunately, when we came in, there were already projects underway, things like DEMIPULSE and the Perennia lead; those two products now being on the market and other projects as well. But by December, we had refined our R&D plan. What we started doing in addition to saving some $12 million out of the plan last year -- the operating expense plan, at the same time, in addition to that $12 million in savings, we were also moving money around the P&L. So, because of the line item of R&D including, being broad-based and including depression clinicals and epilepsy clinicals and pure R&D, you don’t see every, you can’t see all the movement that’s happening there. But we are far from being in a wait-and-see mode on R&D for epilepsy. Our projects are underway and we’re feeling good about the pipeline that we’re creating for the future.

Anthony Petrone

Okay. Greg, I guess, moving on to -- I appreciate the commentary -- moving on to CMS, you mentioned 3% worldwide impact if, indeed, the proposal goes through. One, what is the proposal that’s currently on the table in percentage reduction terms? And if you could just walk a little bit through the 3% worldwide specifically, what OUS assumptions and new patient implant assumptions go into that outlook?

Gregory H. Browne

Yes, be happy to. Look, CMS has proposed that the 2009 rate for our leads be approximately $6,700, which is obviously significantly down from the around $10,000 that they are currently reimbursing. So, it’s a significant change. And I would point out that back in 2004, they proposed a similar reduction, and that was subsequently reversed by the time the final rates came out. In terms of the impact, what I said is or at least what I hope I said is that the impact would be on approximately 3% of our worldwide revenue as opposed to 3%. And the reason we focus on that is that the leads that we are selling, obviously this only impacts the United States market; it impacts the 25% to 30% that are ultimately reimbursed to our customers by CMS; and it would directly impact the leads only. So, when you break that down in terms of revenue, there’s only about 5% of our worldwide revenue is impacted by the reimbursement change.

Anthony Petrone

I see. If the focus is on new patient implants and that would -- new leads would be there. I’m just trying to see if we can extrapolate like maybe a trend here or something in the outlook. But that’s certainly helpful. And lastly, just last question, and I’ll hop back in queue -- if you can just give us an idea where along the current replacement cycle we are. And thank you for taking my questions. I’ll hop back in. Thank you.

Daniel J. Moore

On the current replacement cycle, we’ve said in previous calls, I think it was Q3 of last year, where we showed by model number how many implants we had had. And the model 100 we thought had been through its re-implant cycle. And I think at that point, we had replaced about two-thirds of those. We also talked about the model 101 having a slightly longer battery life, while the model 102 came after that. And we’re entering the replacement cycle now for the 101’s and some of the 102’s. So, some have predicted that we are at the front end of a replacement cycle. But again, I think what we look at is we’ve implanted roughly 10,000 patients. And if we keep implanting patients, which we intend to do, and bring benefits to those patients, that even at today’s rates, which we would like to improve, we’ve got a two-in-three chance of each one of those in the pool going for a replacement. So, our intention is to continue to keep the replacements business growing, and at the same time, focus on those new patients.

Operator

Your next question comes from Jonathan Block of SunTrust.

Jonathan Block

Hi, you guys. Good morning.

Gregory H. Browne

Hi, Jonathan.

Jonathan Block

Just first question maybe on the international, the ASP’s certainly look very impressive. And I think you mentioned that direct sales accounted for about 75%. So, just trying to size this up going forward, should we look for a continued improvement in the ASP due to DEMIPULSE, but maybe at a slower rate because you’ve got the direct’s now approaching 80%. And I’m assuming that the FX comps are just going to get a little bit of tip-topper over the next couple of quarters?

Gregory H. Browne

I think we should expect that the ASP’s internationally will come back a little bit over the next couple of quarters for a couple of reasons. One is I think we would expect that our sales to distributors will pick back up over the balance of the year. Secondly, the FX issue seems to have turned around a little bit now, over the last few weeks, and we might see a little bit of it go the other way. So, I would expect that the ASP will decrease slightly over the next few quarters internationally.

Jonathan Block

Okay, great. And then Dan, maybe this one’s for you. Just in terms of depression, I guess it’s now maybe roughly six or nine months after you announced the intention to spin off or to look for a partner. And maybe, I know that process is being finalized, and maybe you can just update us, how that process has gone? Did it fall in line with your expectations, if it deviated how so?

Daniel J. Moore

I would say that -- we thought from the beginning that we would do this in a very thorough way to explore all of our options for our shareholders, and to ensure that we make the right decision around this business and this opportunity. So, as Greg mentioned, we presented to over 20 potential financial partners. And when I said we were close to wrapping it up, we’re just going through the strategic partners now to see what’s there. And I think we, again, expect by the end of the year, by the end of this calendar year, we will know exactly what we’re doing and have the depression thing solved.

Jonathan Block

Okay. And maybe just the last two, if I may. First one, you did beat us on the top line. I think the mix was a little bit different between new patients and the replacement cycle, so, if I just had to ask you, what’s the one variable that lacks in terms of being able to poll down from that new market opportunity that you allude to? Is it the clinical data? Or why can’t we just sort of see continued growth in terms of new patients coming into the queue?

Daniel J. Moore

I think you ask an important question, but at the beginning of your question, you identified what’s most important to us. There are a lot of levers that we can pull in this business to continue to keep the top line growing and improve the bottom line. And the question about ASP’s and mix for example, I don’t care if ASP’s fall some from the international group because of mix, as long as we’re focusing on improving our ASP’s in our direct countries. And as we go to a distributor country that we ensure that we’re getting appropriate ASP’s for our product and continuing to improve those overall ASP’s. So, when the ASP’s come together from international, I’m not as concerned about the mix as our direction overall. And I think that’s the same for our business overall. What we’re most concerned about is continuing to grow this business on the top line and the bottom line. And we will do that by getting more replacement patients. We will do that by continuing to focus on new patients. I don’t think its one clinical study. I think, for example, getting physicians who have good practices with VNS and have worked hard on VNS to understand where it works with patients and which patients it doesn’t; getting them together with their peers in an environment where they can talk to others about what works and what doesn’t and why; sharing those best practices is a fine example of how I think we can improve our new patient pool over time. But again, that happens over time. I remember, it was just four quarters ago that we took a sales force that was really focused on depression, moved them back to epilepsy, began programs like I’m talking about, and we expect those to bear fruit over time. So, I do, I’m bullish about the revenue line overall. The mix doesn’t concern me as much, because if we’re doing the right things in each area of our mix, the top line will grow, the bottom line will grow faster, and the new patient pool will pick up over time. We’ll get there. Our R&D and other things will help us get there as well. So, it’s a mix of sharing current best practices with clinical work, with R&D to improve efficacy.

Jonathan Block

Okay, perfect. And maybe just last one, Greg, for you -- just if I take the quarter results and I annualize it, I guess I get almost to the midpoint of your annual finance. So, maybe just building on an earlier question, is this being a little bit conservative here? Or any seasonality that we should look at going forward? Thanks, guys.

Gregory H. Browne

Yes. Look, in terms of the -- we’ve only recently got back into the guidance business here and we gave guidance for the full year. I would expect that perhaps next quarter we’ll update that. But at this stage, we feel comfortable with the original guidance we gave. I’ve given a bit more color around gross margins for this quarter and around the operating expenses. So overall, I think we feel comfortable with what’s out there.

Jonathan Block

Perfect. Thank you.

Operator

Your next question comes from the line of Assaf Guterman with Lazard Capital Markets.

Assaf Guterman

Hi guys good morning. And, just following up on the previous question, the replacement versus the new patients. If we look at the previous year or so, most or all of your growth came from the replacement. I understand that for now, you don’t really care where the growth comes from, but longer-term, definitely new patients is going to have to grow in order for you to meet your goals. The, question is, in your discussions with physicians, do you get any feedback that you can share in terms of what is required or what the physician would like to see from you guys in order to drive up their usage rate? Is it, again, more clinical data? Better understanding of the mechanism? Anything that they came back to you in order to drive up their usage rates in the future?

Daniel J. Moore

Yes, let’s keep in mind, first, that two out of three patients are still new patients. So, we are still feeding new patients into that pool of 10,000 patients or so. Second, keep in mind that when we go to China and we go to Japan or Brazil, these other countries where we haven’t been, all of those will be new patients, again, going into the pool. Third, I think to answer your question directly, I think physician to physician information is the best kind of information we can give.

And if we can facilitate those meetings, like the ones I mentioned, I think that goes a long way. Physicians want to hear from their peers about what’s working and what’s not. That brings the most credibility, I think. When I mentioned clinical, I don’t think we have to do FDA-type trials here where we’re having 20 centers involved and randomized controlled trials that are meant to show safety and efficacy. The clinical work is going into some of those centers that have supposedly better results and trying to reproduce those results in a small, multi-centre trial. So, I think they first want to hear from their peers who are being successful. Second, they’d like to see a level of clinical evidence, but it’s not a New England Journal type of level of clinical evidence. It may be a multi-center trial; that would definitely help. But, I think overall, when you come back to new patients versus replacement, we’re getting new patients now, and we will continue to get new patients, whether it’s by penetrating in our existing markets or by going to new market. And we’ll get further new patients when we get more clinical results and when we improve our efficacy with some of the R&D-type things that we’ve talked about.

Assaf Guterman

Okay. Now, have you been getting any feedback from physicians that making their request or they would like to see -- to get some kind of better understanding of how exactly the mechanism works? I mean, the feedback that we’ve been getting is that most of them actually agree that it works in specific pools of patients, but very few people told us that they feel comfortable using a device without fully understanding how exactly does it work or at least somewhat understanding it.

Daniel J. Moore

I think you’re right. What’s most important is that they know that there is proof in their patients that the product is working. Everyone like -- or most people like to understand how things work. And there are thoughts around how VNS works for epilepsy patients. But I’ve also heard physicians say that the most used drugs, the GABA drugs -- and I am not a Pharma expert, but they don’t know mechanisms of action for the most used drugs in epilepsy. So, if they know something works, they’ll use it. And I think there’s evidence of that with their GABA drugs. There’s evidence of that with VNS. And sure, we’ll do more to try to understand a mechanism of action, but we don’t have a lot of physicians saying, the reason I’m not using this, even though I think it works, is because I don’t know how it works. We use a lot of (multiple speakers) in our life that we don’t know how they work, but we use them every day.

Assaf Guterman

Right. Now quickly on the DEMIPULSE. So, about 30% of the units sold during the quarter were DEMIPULSE?

Daniel J. Moore

Yes.

Assaf Guterman

Right. Are those -- are DEMIPULSE still being priced at about 25% premium? Is that quarter?

Daniel J. Moore

That’s our objective, is to obtain a 25% premium on our average selling prices.

Assaf Guterman

Okay. And your ASP grew at an average of 19% year-over-year. So, is it safe to assume that about -- if you take 30% of the 25% premium, that’s about 8%. So is it safe to assume that about 8% out of the 19% or 8% out of the 19% came as a result of the DEMIPULSE launch?

Gregory H. Browne

I think that’s approximately right. As you know, we took a price increase on the model 108 in January, which was just less than 19%.

Assaf Guterman

All right, perfect. Thank you very much.

Operator

Your next question comes from Bill Plovanic with Canaccord Adams.

Bill Plovanic

Great, thanks. I promised I’d come back. In DEMIPULSE, just kind of curious -- it was 31% of unit sales globally. Do you still think you can reach 50%? And is the reason it’s only 31% because you’re holding it back? Or because the market is pushing back on price?

Gregory H. Browne

That was 31% globally. In the US, it was slightly higher; it was around 33%. We are, as we said, doing a phase launch. I don’t think we’ve necessarily put a goal out there for this year of 50% or any other number. We’re doing it as is appropriate for accounts. We want to make sure that where necessary, appropriate training takes place and so on. So, we have not seen pushback on price except for maybe one or two isolated instances. Internationally, it’s slower, as we’ve discussed in the past, although we’ve managed to push through some increases in Scandinavia and a couple of other markets in Europe. So, it will continue to proceed at a measured sort of pace that the original plan called for.

Bill Plovanic

When are you in full launch that every account has the opportunity to purchase DEMIPULSE?

Gregory H. Browne

Well, I would think that will be sometime in fiscal year ‘10, at least in the US market, perhaps somewhere towards the end of fiscal year 10, but we haven’t.

Bill Plovanic

Okay. And then could you help us out on what the US new patients versus US replacement patients were for epilepsy?

Gregory H. Browne

I do not have that immediately in front of me. I would be happy to give it to you at a later date.

Bill Plovanic

Okay. And then in seizure detection, why would you need a partner there? What exactly are they doing and when could we expect the product on the market?

Gregory H. Browne

We don’t have to have a partner. I mentioned that -- you know, I came from an environment where we grew and we grew fast; and the way we grew fast is we recognized that we wouldn’t have all the best ideas. And by doing everything ourselves, we could choose that path, but it might go slower. So, we are opportunistically looking around the markets globally to see where the programs are that may have the most promise. And we saw one that we liked, so we formed a formal partnership with that group. And I think it’s just, it’s too early to give the details on what we’re doing there, but I am not, I mentioned, I think, in my first call, that we would look for partnering that would go beyond just the commercial aspects of a partnership. So, if we can find ways to accelerate our vision of bringing medical devices to epilepsy patients that benefit those patients and improve the efficacy, so we increase those new patient rates or create new businesses, we will do that. And we’ve been on the hunt and we found something we liked, and we’re continuing to look and try to do some more.

Bill Plovanic

Okay. And then your answer to a previous question, Greg, just your objective on the DEMIPULSE, is it 25% premium. Are you close to that objective?

Gregory H. Browne

We’re fairly close to it, yes.

Bill Plovanic

Okay. And then, you mentioaned on the…?

Gregory H. Browne

Just to answer the previous question you asked about the new patients and replacements in the US market. I do have some data on that. And it would be around 70% of the leads that we sold the last quarter would be applicable to the US market.

Bill Plovanic

Perfect. That’s helpful. Actually, that’s all I have. Thanks a lot.

Daniel J. Moore

Thank you. Okay, we’ll take one more question and then I think we’ll wrap it up. Courtney, do you have one more?

Operator

Your next question comes from Anthony Petrone with Maxim Group.

Anthony Petrone

Just a couple of quick follow-ups, I guess for Greg. One, on interest income going forward. Do you plan on that ticking up toward the end of the year? Do you have anything variable? Are you going to move some cash around? And then what was the actual NOL value as to the quarter-end? And then, one quick follow-up on the Ethicon agreement?

Gregory H. Browne

As far as interest income is concerned, our average cash balances for the quarter are around $95 million on average. We finished the quarter at over $110 million. And as you can see, we reported interest income of around $500,000. So, you can assume from that that we’re earning around between 2% and 3.3%. We don’t anticipate at this stage that -- everyone obviously has their own view on interest rates, but we don’t intend to change the way in which we’re investing our money in the current environment. As far as NOLs are concerned, we have the benefit of well over $200 million in NOLs, although we are limited presently to approximately $60 million in any one year. And that’s the number that we’re currently reviewing to see whether that needs to be changed. And I’d have to provide some more color on that in the next call.

Anthony Petrone

Okay, great. And then actually, when does distribution in China begin? And just any update on where Ethicon is in regards to its obesity, the obesity patents they license from you folks?

Daniel J. Moore

On the China situation, it’s underway now; identifying the first five centers and training the distributor and getting underway. As far as Ethicon goes, and anything with obesity, I’d ask you just to refer your question to them, because I think they can answer it much better than I can.

Anthony Petrone

Great. Thank you.

Gregory H. Browne

So, with that, again, I’d like to thank the Cyberonics team for another quarter of good progress here, and thank all of you. We believe that over the past few quarters, we’ve put together a compelling case for not only the current growth in epilepsy, but to bring additional medical devices to the field of epilepsy and improve patient care overall for the medium and long-term growth, as well. And that in itself is a strategy within which we can diversify product offerings; we can diversify geographically; and we believe we can continue to build and bring a lot of shareholder value while we continue to look for other products and things that might be applicable to neurologists and neurosurgeons. So, thanks for your continued support as our investors as well. And we’ll talk to you again in the quarter. Have a good day, everyone.

Operator

And at this time there are no further questions. This concludes today’s conference call. You may now disconnect.

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Source: Cyberonics, Inc. Q1 2009 Earnings Call Transcript

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