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Volcano Corporation (NASDAQ:VOLC)

Q2 2008 Earnings Call Transcript

August 5, 2008 5:00 pm ET

Executives

John Dahldorf – CFO and Secretary

Scott Huennekens – President and CEO

Analysts

Michael Weinstein – JP Morgan

Tom Gunderson – Piper Jaffray

Jason Mills – Canaccord Adams

Operator

Good afternoon and welcome to the Volcano Corporation's second quarter 2008 conference call. During the presentation, all participants will be in a listen-only mode. Following the formal remarks, we will conduct a question-and-answer session. (Operator instructions) As a reminder, the conference call is being recorded Tuesday, August 5th 2008. A replay of this call will be available through August 11th by dialing 719-457-0820, conformation code 4988988 or via the Company's Web site at www.volcanocorp.com.

I would now like to introduce Mr. John Dahldorf, Volcano's Chief Financial Officer. Please go ahead sir.

John Dahldorf

Thank you and good afternoon everyone. With me today is Scott Huennekens, Volcano's President and Chief Executive Officer.

Scott will begin today's call with review of our second quarter which was marked by strong revenue growth for both IVUS systems and disposables and important progress in our strategic, product development, regulatory, and profitability initiatives. I will follow with a review of our financial results for the quarter. Before turning the call over to Scott, let me remind you that our prepared remarks contain forward-looking statements as defined under the Private Securities Litigation Reform Act of 1995. These include statements related to the guidance about anticipated financial results, growth strategies, product development and clinical trial programs, the timing and receipt of regulatory approvals, market acceptance of our product offerings, the functionality and capabilities of our products, any strategic activities as well as forward-looking statements that we may make in response to your questions.

Factors that could cause Volcano's actual results to differ from those forward-looking statements are described in our filings with the SEC including our 10-K for the year ended December 31st, 2007 and our 10-Q for the quarter ended March 31st, 2008. Volcano cautions you not to place undue reliance on forward-looking statements that speak only as of the date that they are made. Volcano undertakes no obligation to update publicly any forward-looking statements to reflect new information with events or circumstances as of the date that they are made. Scott?

Scott Huennekens

Thank you, John and good afternoon. As John alluded to in his remarks, the Company had a great quarter with record quarterly revenues that represent a 40% increase year over year resulting in six-month revenue growth in excess of 30% versus a year ago. This compares to Boston Scientific's announced IVUS growth in the second quarter of 7% year over year. The second quarter represents the ninth consecutive quarter that Volcano has exceeded Wall Street's consensus. In addition, we achieved improved margin and continue to leverage our operating expenses. As I'll discuss later, we also continue to realize progress on our product, market, and technology expansion initiatives including the integration of CardioSpectra OCT and the acquisition of Novelis' Forward-Looking IVUS technology.

As John will discuss in more detail during his presentation, our revenue growth occurred across all product lines in key geographies IVUS system sales increased 68% year over year and IVUS disposable revenues grew 31% year over year. We also continued our strong IVUS console placement track record, placing 178 IVUS console during the quarter versus 135 in the second quarter a year ago, and 121 in the first quarter of 2008. As we discussed in our last call, while our order activity from the US, European and OEM customers has continued to experience steady growth, many of our customers' held their purchase orders for consoles pending the full market release of their occasional catheter and FFR capability which occurred in the second quarter.

We were also able to ship a small number of IVUS consoles with their occasional catheter in Japan during the end of the quarter. As of July, we are now in full market release of the s5 family of consoles with Revolution in Japan. Our ability to achieve ongoing new product rollouts facilitates our (inaudible) strategy that leverages our growing installed base and builds upon our core businesses. Our s5 line multi-modality integrated system is the core of this strategy as the hub that we can leverage by adding new modalities that provide recurring disposable revenue streams. In addition to internal growth through our expansion of our existing product offerings are two new – are two recent acquisitions CardioSpectra OCT and Novelis' Forward-Looking IVUS are emblematic of this strategy.

While I will speak to our many exciting future opportunities represented by our pipeline in more detail shortly, we remain focused on our core business as evidenced by our financial results for the quarter, which (inaudible) gain with our IVUS and FM offerings and ended the quarter with more than 3500 installed systems. We also continue to realize growth across our key geographies enabling us to maintain roughly 50/50 split at revenues between the US and outside the US. The growth is being driven by our continued investments in our sales organization and effective market development programs, as well as the increasing value of our distribution agreements with the leading cath lab equipment manufacturers and stent companies.

We have a well-defined business model that leverages our growing installed base with our razor/razor blade strategy that continues to drive growth of higher margin disposable revenues. As we have discussed with you before, our revenue growth and profitability strategy is predicated on three drivers; increase in our combined IVUS and FM businesses by more than 20% and leveraging our operating expense to achieve profitability. Number two, expanding the reach of our technology in new markets to drive revenue growth above 20% and achieve increased profitability, examples including our Image Guided Therapy products, OCT, forward-looking IVUS with and without therapy, Intra-Cardiac Echo or ICE and specialized ICE catheters for new percutaneous structural heart therapies. And three, there will be now complete therapeutic solutions in focused areas such as CTO's, AMIs, bifurcations in vulnerable plex that may or may not incorporate Volcano visualization and our tissue characterization technology.

During the next few minutes, I'll update you on each of these areas beginning with our base business. The IVUS and FM markets have been one of the fastest growing areas of interventional cardiology over the past five years and we see that continuing. The four main growth drivers are; one, improved technology making IVUS and FM faster, simpler and easier to use. Number two, PCI growth. Number three, the growing body of clinical data’s supporting better outcomes with the use of IVUS and FM, and number four, expanded direct distribution that results in more trained physicians and staff on the fast and simple use of these technologies. As we have discussed with you in the past, there are now more than 4500 IVUS systems in hospitals in the US, Europe and Japan but they are primarily the older roll around versions.

There are more than 6000 cath labs in all three key geographies with integrated IVUS systems in less than 10% of them. We believe that IVUS penetration can potentially reach 90% within the next 5 years representing a very large growth opportunity. In addition to adding new customers, there are ongoing growth opportunities through upgrades for customers seeking new functionality of their existing systems including integrated FM, OCT, Forward-Looking IVUS and ICE as we move forward. In addition, customers want to buy the platform today that allows an upgrade path to these future capabilities that they see is important.

IVUS and FM markets grew 16% globally last year, despite a decline in US stenting activity in PCI procedures and continue to grow in 2008. We talked in the past about some encouraging trends in this regard and recent reports suggest that those are being realized. During the quarter, PCI volume in the US was reported to be up 3% year over year, and 7% outside of the US. Recently reported data indicates that DES use increased in June to 73% of the stent procedures in the US, while it was not seen February of last year when the concerns about safety first began to surface. Based on the 7% growth reported by Boston Scientific in their IVUS results for the quarter, we estimate that in the quarter the IVUS market grew approximately 20% year over year and that we continue to gain share versus Boston Scientific.

Helping to drive market growth is the continued release of data that demonstrates the value of IVUS. For example, recently published articles further reinforce the value of IVUS as well as a diagnostic and therapeutic tool that through its advanced imagining capabilities IVUS addresses a number of clinical issues leading to events such as restenosis, subacute thrombosis and late stent thrombosis. We also anticipate that publication of data on the IBIS-2 study in the near future along with the presentation of this data at the European Society of Cardiology in Munich at the beginning of September. IBIS-2 is our trial done in conjunction with GlaxoSmithKline using our IVUS VH tissue characterization technology. We are hopeful that the results will share the value of VH in monitoring plaque progress in total by tissue type and plaque type and result in future opportunities for the use of Volcano technologies in other major drug studies.

We are also looking forward to the release of two-year follow-up data from our PROSPECT trial at the TCTPROSPECT trial in October. As a reminder, PROSPECT is sponsored by Abbott Vascular and Volcano and involves the study of plaque in the correlation with cardiac events. Briefly updating our other important clinical studies, last quarter we announced Volcano's inclusion in the SATURN trial being sponsored by AstraZeneca. The trial is designed to study the impact of the Rosuvastatin 40 milligrams versus Atorvastatin 80 milligrams on the disease burden as measured by IVUS and is being run through the Cleveland Clinic Core Lab. There are now a dozen centers in the US that have initiated patients screening in enrollment activity and we expect to have several more centers active in the trial both in the US and Europe in the near future.

The adapt study which is examining the role of IVUS in ensuring accurate stent placement has now enrolled approximately 9000 of the 11000 patients including more than 250 in the IVUS arm. As you may recall, this is a cardiovascular research foundation study of patients with coronary artery disease undergoing PCI drug eluding stents. The IVUS sub-study will enroll 3000 patients and is expected to provide definitive evidence as to whether IVUS can identify patients have heightened risk for stent thrombosis.

Finally, the BLAST study is on track to begin enrollment of patients in the fall. We have 15 sites that are in the process of completing their IRB approvals. Again as a reminder, this is a study looking at the value of grayscale and IVUS VH in the diagnosis of sclerotic [ph] plaque in bifurcation lesions. Another important element of our core IVUS growth strategy is our expanding sales and marketing programs. Globally we continue to build our sales force which at the end of the quarter numbered 132 versus 127 at the end of the first quarter. We also continue to build upon the strong relationships we have with the major cath lab and stent manufacturers including joint participation in trade shows and market development programs. These agreements are something our competitors do not have and they provide us a great present in cath lab.

As a result, we have become aware of IVUS systems opportunities are able to limit Boston's bundling capability and better our odds of winning the system placement by increasing the rate of the integrated cath lab adoption, resulting in Volcano winning 70% of new IVUS integrated cath lab business. During the quarter, we achieved a clinical milestone in our strategy to build out infrastructure in Japan. In late May, Volcano and Goodman terminated their formal distribution agreements and Goodman agreed to transfer all Volcano product regulatory approvals to Volcano. While Goodman has continued to distribute Volcano offerings under a purchase order arrangement, they no longer have legal distribution rights or ownership and control of Volcano products for (inaudible) and FM products. As a result, we will be importing all our products through Volcano Japan and then marketing them through our distributors Goodman, Fukuda, J&J, and Medtronic Vascular as well as selling direct to customers.

This agreement provides us with greater control over our business in Japan and compliments our strategy to increase our direct activity there providing us opportunity to celebrate our presence in Japan and grows up our sales. At the end of the quarter, we had 10 sales reps and 25 employees in Japan. Our plans for the second half of this year called for expansion to approximately 20 reps and 45 employees by year end. In 2009, we expect this direct expansion to continue. Junichi Osawa is the President of Volcano Japan and was formerly the head of Medtronic Vascular in Japan.

Before updating you on the last element of our growth strategy product development, I want to touch on a couple of developments in the reimbursement area. As many of you know, in early July CMS released proposed 2009 outpatient reimbursement codes that were contrary to the unanimous APC panel recommendation for unbundling IVUS reimbursement from total reimbursement for procedures such as diagnostic angiography or stent placement. While we had hoped an unbundling would foster future IVUS and OCT adoption for outpatient diagnostic and therapeutic procedures, we did not see the adoption of these proposals as having impact on our near-term business.

Additionally, in the second quarter, the Japanese government approved reimbursement for OCT that was consistent with IVUS reimbursement. This reimbursement is scheduled to go into effect this October. Another important growth driver is enhancing the value of IVUS through differentiated technology not only as Volcano made IVUS faster and easier to use, but continued to providing physicians innovative diagnostic tools. As I mentioned earlier, we are now in full market launch with our s5i with Revolution catheter and FFR, and recently initiated the launch of the s5 and s5i with Revolution in Japan. We are nearing completion of our regulatory submission for FFR on the s5 family in Japan and are looking to launch that offering in early 2009.

As I will speak to you shortly, this is just one piece of what is a very full pipeline of new offerings scheduled for introduction over the next three years. We also continue to enhance our FM offerings including the anticipated introduction this quarter of our prime wire and enhanced and updated version of our prior offerings that we believe will facilitate continued growth in our FM business during the balance of the year. I spoke earlier of our hub and spoke strategy, I want to conclude by updating you on our product pipeline designed to add new modality, each generating disposable revenues for s5 multi-modality platform. Our first offering in this regard will be Image Guided Therapy that combines IVUS with other therapies a balloon and IVUS on the same catheter with both coronary and peripheral applications.

Our lab testing program is going well and we expect their first use next quarter. We are targeting commercial launch of this device in the second half of next year in the US, Europe and Japan. This is a change bringing forward the launch time in Japan based on favorable regulatory assessments. As we had indicated the other potential product extensions in this area include combining IVUS bare metal stents and a balloon on a single catheter and we plan for the second half of 2010 launch. We are also making great progress with the OCT technology that we added at the end of last year through our acquisition of CardioSpectra. The combination of IVUS and OCT will position us as a leader in intravascular imaging and we are working on devices incorporating OCT functionality into the s5 platform and stand-alone OCT systems.

As we announced the first use of our IVUS imaging or using our OCT imaging catheter occurred in the Netherlands a couple of days after our first quarter conference call. Since then the procedure has been performed on several additional patients and the results have been positive. Our current plan is to begin the regulatory approval process later this year and initiate commercial sales in the US and Europe in the second half of 2009 with commercial launch in Japan coming about a year later. As we have indicated in the past, our initial focus with OCT will be stent placement but we believe the technology has significant potential in a number of other areas including thrombus identification and removal guidance in stent restenosis assessment, determination of coverage of stent with tissue and vulnerable plaque assessment.

We are also making good progress with our other spokes such as ICE and vulnerable plaque. Our most recent developments in the pipeline is of course the Forward-Looking IVUS technology resulting from our acquisition in May of Novelis. Since we spoke with you at that time of that transaction, I'll briefly reiterate the strategic fit of the Novelis technology. We expect the Novelis proprietary Forward-Looking IVUS will build upon our existing suite of products and enhance our already strong position in the market. The product line includes an image-guided crossing catheter that combines visualization, steerability and RF tissue ablation which is designed to enable clinicians to safely cross CTO in the coronary and peripheral arteries. In addition, we expect to develop an IVUS catheter that will facilitate current guidewire-based CTO crossing techniques as well as other potential product offering that address a number of minimally invasive procedures in the arteries or in the heart.

In the 10 weeks since completing the transaction, we have become even more excited about the potential of this technology as an important addition to our s5i multi-modality integrated platform. We are currently focused on the development of two offerings. The Preview is a Forward-Looking IVUS device and we expect first and main use in the first half of 2009 with commercialization in the US and Europe in the latter half of next year. The (inaudible) which is Forward-Looking IVUS incorporating RF that will dissolve the plaque is expected to have first in-man use in the second half of 2009 with US and European commercialization in the second half of 2010.

In summation, we have a very active and promising pipeline, the initial revenues from which we expect to start seeing in late 2009. These new devices will address very large market opportunities in the coronary, peripheral, and structural heart areas valued in an excess of $2 billion or approximately five time larger than our current IVUS and FM market. We are also developing total solutions that incorporate a number of our complimentary technologies to adjust market opportunities such as CTOs, AMIs and bifurcations. We look forward to reporting on our continued progress in these areas during the balance of the year.

Before I turn the call over to John, I do want to mention that we will continue to look for opportunistic, strategic acquisitions that support our efforts to build out complete therapeutic solutions in focused areas such as CTOs, AMIs, bifurcations and vulnerable plaque that may or may not incorporate Volcano's visualization of tissue characterization technology.

With that said, we expect any near-term opportunities will be in the weighing of CardioSpectra and Novelis acquisitions that bring us complimentary technology. As we have talked to you before, we have a very liable and proven business model that can able us to achieve our growth objectives without doing a major transaction and at this point in time we have no plans for doing any major acquisition. We are committed to achieving mandate growth and believe we can continue to leverage our model through the addition of new offerings that expand the capabilities of the Volcano hub and new coronary and intravascular therapies that target our existing customer base.

As Volcano begins is third year as a public Company, we continue our track record of execution as well as fully capitalizing on the opportunities available to us through our core business and developing a pipeline of new offerings that will drive revenue growth for the next several years and profitability. Thank you again for joining us today and I'll now turn the call over to John.

John Dahldorf

Thank you, Scott. Revenues for the second quarter of 2008 were 41.5 million a 40% increase over revenues of $29.6 million in the same period a year ago. Factors contributing to our revenue growth included strong IVUS console sales across all of our geographies, where we recorded a 68% increase versus the second quarter of last year. IVUS disposable sales increased 31% versus last year and we benefitted from particularly strong activity in the US and Europe. In addition, our FM business grew 34% year over year.

For the first six months of 2008, total revenues were $78.1 million compared with $59.1 million or a 32% increase over the same period a year ago, including a 40% increase in IVUS system revenues year over year. With respect to the revenue breakout for the quarter, consolidated sales of IVUS systems and related equipment were $10.5 million versus $6.3 million a year ago. In the US IVUS system revenues were $6 million versus $3.8 million a year ago. In Japan they were $1.4 million versus $575,000 a year ago, and in Europe they were $2.4 million versus $1.3 million. As we have discussed in the past, growing our installed base is the key driver of our growth. During the quarter, we placed 178 IVUS consoles versus 135 in the second quarter a year ago. We now have more than 3500 IVUS and FM consoles installed worldwide.

On a consolidated basis IVUS disposable revenues were 25.2 million versus 19.3 million a year ago or 31% increase. In the US, IVUS disposable revenues were $13 million versus $9.4 million, a 39% increase. In Japan they were $7 million versus $6.6 million, up 6% from a year ago, and in Europe they were $4.4 million versus $2.8 million a year ago, a 57% increase. I should point out that disposable IVUS revenue in Japan was impacted in the quarter by Goodman's transition to a purchase order basis and the reduction of its phased array catheter inventory in anticipation of the rotational launch and ramp up in the third and fourth quarters.

FM revenues in the quarter were $4.4 million versus $3.3 million in the second quarter a year ago. In the United States, FM revenues were $2.1 million versus $1.5 million a year ago. In Japan, they were 201,000 comparable to last year, and in Europe they were $1.8 million versus $1.4 million a year ago.

Other revenues on a consolidated basis were $1.4 million versus $737,000 in the second quarter a year ago. Gross margin in the quarter was 62% versus 58% a year ago and 63% in the prior quarter. Contributing to our improved margins versus last year was our growth in sales volume and the favorable impact of our expense reduction programs that lowered our cost of goods. Operating expenses in the quarter of $40.1 million including $12.2 million of in process research and development charges related to Novelis acquisition. This compares with $22.2 million a year ago and $25.8 million in the prior quarter excluding $2.9 million of acquisition due diligence costs.

Our operating expenses for the quarter reflects increased spending in sales and marketing including higher head count globally, a 184 versus a 136 a year ago, higher commissions and promotional costs. Our higher G&A expenses reflect increased investments at our infrastructure and higher stock compensation. Research and development expenses increased approximately $600,000 year over year, reflecting our expanded product development costs related to our recently acquired OCT and Forward-Looking IVUS technology.

On a GAAP basis, we reported a net loss of $13.5 million or $0.29 per share. In the second quarter of last year, we reported a net loss on GAAP basis of $3.9 million or $0.10 per share. Excluding in-process research and development expenses related to Novelis acquisition of $12.2 million and stock based compensation expense of $2.4 million, we reported net income of $1.2 million or $0.02 per diluted share. In the second quarter of 2007, excluding stock based compensation expense of $1.5 million; we reported a net loss of $2.4 million or $0.06 per share. Weighted average diluted shares in the quarter were 47.2 million versus 38.4 million a year ago, reflecting the impact of our equity offering that was completed in the fourth quarter of 2007.

Turning to the balance sheet, we ended the second quarter with a $178.3 million in cash, cash equivalents and short term available for sale investments versus $189.1 million at the end of 2007 and $188.1 million at the end of the first quarter of 2008. We generated cash flow from operations during the quarter, but our cash balance was impacted by the approximately $12 million payment for the Novelis acquisition. As we discussed in our last call, we have no exposure to auction rate securities in our portfolio.

Our guidance for 2008 does reflect an expected expense – expected reduction in interest income due to declining interest rates and investment returned and a lower cash balance. We are reconfirming our guidance for revenue and gross margin for fiscal 2008 that we have provided in our last conference call. However, we are updating our guidance for operating expenses and per share results on a GAAP and non-GAAP basis to reflect the impact of the Novelis acquisition. We now expect that operating expenses will be 74% to 765 of revenues including stock based compensation, the due diligence costs recorded in the first quarter, in process research and development costs at $12.4 million incurred in the first half of the year, ongoing expenses associated with the development of Novelis technology at approximately $3.1 million of intangible amortization. This compares with prior guidance of 55% to 66% of revenues. We continue though to expect to be leveraging our operating expenses to 58% to 60% of revenues during the fourth quarter. As a result of the Novelis related acquisition charges and ongoing Novelis related expenses, we now expect on a GAAP basis to record a net loss of $0.33 to $0.37 per share versus prior guidance of a net loss of $0.06 to $0.10 per share. We still expect to sustainably – we still expect to be sustainably profitable on a GAAP basis in the fourth quarter. Excluding stock based compensation expense of approximately $10 million due diligence expenses and in process research and development costs, we expect to report non-GAAP net income of $0.14 to $0.18 per diluted share. This compares to prior guidance for non-GAAP net income of $0.16 to $0.20 per diluted share. We expect weighted average shares outstanding at year end for 2008 to be approximately 47.4 million basic and 50.4 million on a diluted basis.

Before turning the call – before opening the call to your questions. I want to mention we will be appearing at the Canaccord Adams conference next week and the Thomas Weisel and AmeriMed conferences in September. We also are planning to hold an investor event at the TCT on the morning of Tuesday, October 14th of which we will be providing further details in the near future.

Thank you again for joining us today and we will now open the call to your questions.

Question-and-Answer Session

Operator

Thank you. (Operator instructions) We'll go first to Michael Weinstein with JP Morgan.

Michael Weinstein – JP Morgan

Good afternoon, guys. Nice quarter. Let me ask you just a couple of items, just on a better read on, you obviously had a very strong quarter on your top line and your gross margin was strong which was actually much better than we are modeling. So, can you give us a little bit more on that? I would like to see if you could tease out the impact of upgrade kits both on the top and bottom line and just understand your thoughts on gross margin going forward. Thanks.

John Dahldorf

Yes. In the gross profit impact that we've talked about in the past Mike is really going to be related to the rotational introduction in Japan, that's going to happen in Q3 and Q4. So, the margin that we had this quarter really does not include any material upgrade kits per se.

Michael Weinstein – JP Morgan

And is that because – you just versus where you thought you would be three months ago? Is that that you shipped out your upgrade kits and that's why?

John Dahldorf

No. We always talked about that we felt the bullish of the rotational upgrade kits that we are going to sell to Japan; we are going to be in the third quarter because we didn't expect to get regulatory approval until the end of the second quarter. We got it a little bit earlier so we were able to ship out some consoles as we noted in our remarks as well as a few upgrade kits. So, we still expect that substantially all of the upgrade kits that we have talked about in the past in Japan that happen evenly between Q3 and Q4.

Michael Weinstein – JP Morgan

Okay. So, it's a mix with think about it right then. So, in terms of the gross margin impact in the back half of the year, we had been modeling it more second quarter, third quarter but you are saying third quarter, fourth quarter. So, we should assume that gross margins are down obviously in the third quarter, and is that what you are suggesting as well for the fourth quarter?

John Dahldorf

Yes. I think that in the past when we've talked about the upgrade kits in Q3, we were talking about margins potentially 500 or 600 points lower than that we had recorded in the first half. Because we are going to now be spreading the upgrade kits evenly across Q3 and Q4, I think that you won't see a single dip in Q3 in the margin but you may see it dip say a couple of 100 basis points but it will even between Q3 and Q4. But overall, we still expect to finish put the total year to 60% to 61% range and as you take out the upgrade kits in Q4, that would definitely be exiting Q4 at 63% which sets us up well to achieve our – through the 300 basis point improvement that we talked about in 2009.

Michael Weinstein – JP Morgan

Yes, understood. So, it's just to finish up on this one issue, so the amount of revenues you expect this year from upgrade kits still in that $3.5 million range?

John Dahldorf

No, no. The upgrade kits that's the total impact that we believe we could realize in the rotational introduction in Japan. So, as we noted in our comments, we did see the distributors pull back on inventory a little bit in the quarter in anticipation of orders on the disposable side. So, I would say about $1.2 million, the $1.3 million of the upgrade kits and then the balance will be in rotational catheters.

Michael Weinstein – JP Morgan

Okay. That's helpful. Let me switch gears and then just two things I want to talk about, one was pipeline and I guess the other is the spend in degree in anticipation of some of these new technology launches that you've got in front of you in 2009. We're obviously which you just commented on, we are expecting to see gross margin step up because we'll have cleaner numbers as we move into 2009. To what degree do you think we'll see SG&A leverage in '09 despite the past – you are adding obviously a lot of parties in Japan and you've got all those big launches ahead here?

John Dahldorf

As we talk about, we believe that we will be sustainably profitable by Q4, and then I'm going basis from an annual perspective. We believe that in 2009 that we will start getting some operating expense leverage in spite of the investments that we are going to be making in Japan to continue our initiatives to go direct as well as the spending that we expect to see in R&D as we work on the Image Guided Therapy products that Scott talked about OCT Forward-Looking IVUS and really the rest of the spokes of that – of the hub so to speak. So, but we do believe that we will start to get operating expense leverage in 2009 and then even to a greater extent in 2010.

Michael Weinstein – JP Morgan

Let me see if Scott's still on the line. As I – actually make him do a little bit of work. Scott, the tree really isn't modeling, some of the (inaudible) at this point people really don't know what to say or had a model OCT Image Guided Therapy, IVUS balloon or Forward-Looking IVUS the Preview or Mach [ph], can you or may be just help everybody out in terms of how you guys were thinking about it, if it's to what degree – is it premature for people to start putting this in for their models but how do you want to people to be sizing up the not their market opportunity but what it potentially means to Volcano next year or the year after that?

Scott Huennekens

As we have talked about, if that we grow our base IVUS and FM business 20%, and that these other – in over 20%, we've continuously done that for 5 years and now we are close to 30% but over 20% these new market opportunities would push itself to 30% or greater. So, that's the way we look at our business. We are not guiding to that. We don't – we haven't – we'll provide guidance after the end of the year in the light. But that's how we think of things as base business over 20 and these other things push itself over 30.

Michael Weinstein – JP Morgan

And if you were to rank the potential impact of these products that the new initiatives of the next say two to three years, how would you think in terms of the most impactful?

Scott Huennekens

The Image Guided Therapy products, OCT and Forward-Looking IVUS are all equal, and that also is part of the benefit I think as well. It's not like we have one – they can't be on home run and then if we strike out on it or gets delayed or market adoption takes longer or behind it. We have three that we think are all solid doubles that can grow into being significant home runs over time.

Michael Weinstein – JP Morgan

Okay. I'll let some others jump in here –

Scott Huennekens

For example Mike, OCT may have the biggest impact in Japan where it is already reimbursed and already IVUS culture. It might be the Image Guided Therapy but the balloon of bare metal stent has more impact in the US and Europe. So, there's some geographic hedge there as well. Okay, other questions, next.

Operator

We'll go next to Tom Gunderson with Piper Jaffray.

Tom Gunderson – Piper Jaffray

Good afternoon. Two and only two I think interrelated questions. I'll ask them both. One is, Scott could you comment mid-year how you think things are looking as far as IVUS penetration in the US and in Japan? And then the sub set of that question is, have you seen any change in the US in the adoption or in the pushback to your sales forces with the entry of both endeavor [ph] enzyme?

Scott Huennekens

Yes. In the US, our marketing group has the penetration at about 15%, 16% based upon market data for total PCIs, and Japan has over 65%. We don't have Q2 data yet for them, but based upon on best guess – based upon our numbers and trends in the like. As it relates to adoption in any pushback, we are doing endeavor enzyme absolutely none. What we see is an increasing adoption of integrated IVUS that people – and some of the integrated IVUS any more as we've talked about it there in integrated multi-modality hub where it becomes just part of a cath lab. To have a cath lab, you have to have integrated IVUS sets the standard. So, you are having people accelerate their adoption of the technology whereas they get new labs adding it as standard. So, at Cleveland Clinic in their heart center that has 8 labs opening in October, its standard as part of that will have integrated IVUS. And with that integrated IVUS, comes this increased use as the guys use IVUS, use it more, the guys who having used IVUS as much. They are more likely to try it and then they see how easy it is, so they have started to use it more. But we are still at the very beginning, the infancy of that process that they mentioned with less than 10% of the 6000 cath labs that have integration and we see – we are going to have 800 to 1000 a year that are going to happen continuing to go forward and that's going to continue to fuel more use.

Tom Gunderson – Piper Jaffray

Thanks. Thank you.

Operator

We'll go next to Jason Mills with Canaccord Adams.

Jason Mills – Canaccord Adams

Thanks Scott, and John. Congratulations on a good quarter. I have a couple of questions as well. First, John or Scott, you have put up 39%, I think you said John 39% year-over-year growth in disposable IVUS catheters in the US and nearly doubled in Europe Are those obviously two areas where you are less penetrated than you in Japan, however could you – may be could remind us what the mix in Japan is of rotational versus phased array and really perhaps how much in revenue, is it hypothetical, it's a tough one but how much of revenue perhaps didn't get in the quarter vis-a-vis the customers holding back on purchasing in light of the upcoming launch of Revolution on the s5i? And then when we look sort of a year from now, again another hypothetical but when you are participating in two-thirds of the market you aren't in, what could we see although in a more penetrated market, what could we see your IVUS disposable growth (inaudible) just seem to be sort of a drag on what was in otherwise great quarter and sort of the normalized quarter would have been even better as far as I'm getting that?

John Dahldorf

So, Jason let me comment first. You are absolutely right, the quarter could even have been better if Japan launched Revolution at the same time. But it's a quarter later, so it's pretty much in line with our expectations that they would use up the inventory as they legalized and as they move forward and position that their balance won't be 100% in zero Revolution but will move to be in a more and more Revolution as they participate in that part of the market and even some of the Eagle Eye which is the Revolution there. So, we see it as a huge opportunity where we got 25% share in Japan and we can go after the other 75% of the market. So, when you see Japan grow at the 6%, it's not indicative of the growth the Volcano seeing in it's more indicative of the switch of the distributor to a purchase order basis and then letting their inventory levels go down in anticipation of taking more Revolution catheters starting in Q3 but –

Scott Huennekens

And Jason that last point is what I was going to comment on just from an operational perspective that as we now control the show and we now have regulatory and import responsibility, we are now basically supplying our rotational FM products as well as the Eagle Eye products throughout Volcano Japan, a subsidiary and our Volcano Japan logistics group. So, whereas we have the same amount of inventory in Japan that we've had before, but the distributors have shifted some of that inventory to where we carry it in our logistic center versus than carrying it in theirs as they get ready for the rotational introduction. And so we did see some of that phenomenon in the quarter.

Jason Mills – Canaccord Adams

Okay. That's helpful. And with the launch of Revolution as well as the – with what's going on here in the US and Europe, the question is whether our ASPs are working like this quarter relative to where they have been specifically on the IVUS disposables, John?

John Dahldorf

Yes. The ASPs has continued to hold to what they have been historically.

Jason Mills – Canaccord Adams

Okay.

John Dahldorf

And so, we have not – we have not seen any Revolution's in the US or Europe and then obviously in Japan it's all distributors, so it's pretty fixed.

Scott Huennekens

Okay. And you see the benefit of that in the gross margin where pricing has been stable and so our cost reduction programs that result in gross margin expansion.

Jason Mills – Canaccord Adams

Okay. And last question, more of 20,000 question, Scott if without patient reimbursement at least this time around not being unbundled for IVUS, perhaps think about that being many inflection point if you will for penetration of IVUS in the United States, which you say is around 15% relative to Japan which is over 65%. If that isn't going to be at least for this year, what do you see as a potential inflection point at some point in the future given I think what you see in terms of the number of IVUS systems that are out there, but the relative under-penetration of integrated IVUS and the new products coming down the pipe. I'm trying to get a sense for whether in the – what happened in Japan at some point in the past that could happen here in the United States especially given all of the new products that you are launching to help folks do their job better in the cath lab?

Scott Huennekens

Yes, you guys will get your priorities with my broken record which for 5 years we've said reimbursement matters, but it's always been 6 or 7 relative to adoption, and technology has been number one and technology covers a lot of space, it means everything from always there, always on versus 400 pound rolling systems and easy to use so you can interpret the images if you are in position and not be afraid of IVUS. That will be bucketed [ph] the most important impediment historically to IVUS adoption and that's where our continued improvements matter OCT where those people who've seen the images will realize what I say my 9-year old can easily them, will believe and understand that. The second thing is that data continuing to expand. The third thing is distribution continue to expand when 5 years ago Boston and Volcano in the US had 100 reps combined, so in IVUS versus today where we both have in combined well over 200, it's twice as many people training staff, interpreting images versus positions making it fast, simple and easy to use. So, you guys may be talked about out patient being in inflection point and I never encourage that or saw it as a big inflection point. It's an important factor but it's one of 6 or 7 factors. So, back to, there's no silver bullets with IVUS but there can be nice 30% to 40% growth like we have delivered. If you do all of these things together technology, data, distribution and reimbursement improvements.

Jason Mills – Canaccord Adams

Great. Thanks guys.

Operator

And that concludes our question-and-answer session. I’d like to turn things back over to our speakers for any closing remarks.

Scott Huennekens

Thank you guys all for joining the call and we look forward to another great quarter and talking to you again on our Q3 earnings call.

Operator

Thanks everyone. That does conclude today's conference. You may now disconnect.

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Source: Volcano Corporation Q2 2008 Earnings Call Transcript
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