Somanetics Corporation F3Q08 (Qtr End 08/31/08) Earnings Call Transcript

| About: Somanetics Corp. (SMTS)

Somanetics Corporation (SMTS) F3Q08 Earnings Call September 17, 2008 10:00 AM ET

Executives

Bruce J. Barrett - President, Chief Executive Officer, Director

William M. Iacona - Chief Financial Officer, Vice President, Treasurer, Controller

Mary Ann Victor - Vice President, Chief Administrative Officer, Secretary

Analysts

Analyst for Matthew Dodds - Citigroup

Charley Jones - Barrington Research

Gregory Brash - Sidoti & Company LLC

Jonathan Block - SunTrust Robinson Humphrey

Don Littlewood - Littlewood Burke & Company

Operator

Welcome to Somanetics Corporation’s third quarter 2008 financial results conference call. (Operator Instructions) With us today from the company are Bruce Barrett, the company’ President and Chief Executive Officer, Bill Iacona, Chief Financial Officer, and Mary Ann Victor, Chief Administrative Officer.

At this time for opening remarks I’d like to turn the conference over to Mary Ann Victor.

Mary Ann Victor

Statements in this call concerning our future business, operating results, expected net revenues, anticipated investments and other guidance are forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. Such statements are based upon management’s expectations as of today September 17, 2008. You are cautioned not to place undue reliance on these statements. Information contained in these statements is inherently uncertain and actual performance and results may differ materially.

Factors that could cause actual results to differ materially from any forward-looking statements include economic conditions in general in the health care market, market demand for our products, our dependence on the INVOS system and disposable sensors, distributors and independent sales representative firms for a substantial portion of our sales, single-source suppliers, potential competition, the effective management of our growth, our ability to attract and retain key personnel, the potential for products liability claims, government regulation, changes in deferred tax assets, equity compensation expenses, challenges associated with developing products and obtaining and maintaining regulatory approvals, research and development, the lengthy sales cycle for our products, employee turnover, changes in actual or estimated future taxable income, changes in accounting rules, enforceability and costs of enforcement of patents, potential infringements of others’ patents and other factors set forth from time to time in our SEC filings including the 2007 annual report on the Form 10K and our 2008 10Qs. The company undertakes no obligation to revise or publicly release the results of any revision to the forward-looking statements that may be made today.

I’ll now turn the call over to our President and CEO Bruce Barrett.

Bruce J. Barrett

I will begin with a brief review of our third quarter and year-to-date performance. Bill will follow with a detailed review of our results for these periods. Then I will discuss our plans and expectations for the balance of the year and answer any questions.

For the third quarter ended August 31, I am pleased to report solid financial and operational progress. Net revenues increased 22% to $12.4 million. Operating margin was 34% of net revenue and at $4.2 million was up 29% over prior year. Diluted earnings per share were strong at $0.23 and we exited the quarter with $66.2 million in cash and equivalents and no borrowings.

Year-to-date sensor dollar growth has been 23%. Sensor dollar growth has been 57% for pediatrics including pediatric, infant and neonatal sensors and 12% for adult sensors. With our recent successful launch into the neonatal ICU, we expect to continue to realize strong growth in pediatrics. Since initiating shipments of cerebral and somatic sensors for infants and neonates and our entry into the neonatal ICU in February, we have sold more than 14,000 of these new sensors worldwide. In the US we have sold nearly 9,000 sensors to 55 hospital accounts, well ahead of our expectations at this early stage in the launch. Covidien our distribution partner in Europe has purchased the balance of the sensors.

The neonatal ICU represents a significant new growth opportunity for us. Also, with the first to market advantage it represents an opportunity for us to extend our leadership position by pursuing technological, labeling and intellectual property advances that can sustain meaningful competitive advantages for years to come. To progress toward routine use and widespread adoption of the INVOS cerebral somatic oximeter in the neonatal ICU, we are continuing to pursue our neonatal piglet research.

We are also working with many clinical researchers studying use of the INVOS in neonates. Several clinical studies are underway to establish normal INVOS values in preterm neonates and to define how these values change for neonates of various gestational ages in differing clinical conditions and over time.

There are also numerous studies underway evaluating specific clinical applications of the INVOS system in neonates. One example of such research is a study led by Dr. James Moore of Emory] University in Atlanta that has been completed and is being readied for publication. This study evaluated the ability of the INVOS system to assess the severity of bowel ischemia in preterm infants diagnosed with surgical neck. Surgical neck or Necrotizing Enterocolitis is bowel ischemia requiring surgical intervention. The results of his study show that INVOS values correlate with the severity of neck. In other words, the lower the bowel INVO values the more necrotic bowel visualized at the time of surgery.

Given the lack of specificity in diagnosing neck the INVOS system may also play an important role in differentiating neck and localized intestinal perforation. For example, one patient in the study had normal bowel INVOS values in the 60s; however standard diagnostic methods including x-ray indicated that the baby had neck in need of surgical intervention. In surgery the bowel was found to be free of necrosis as indicated by the INVOS system.

In another of Dr. Moore’s study patients an abrupt drop in INVOS values alerted him to what turned out to be an acute bowel perforation. The sudden drop in INVOS system values prompted him to secure an x-ray and labs that led his team to proceed to surgery immediately.

These are only a couple of examples of numerous study results and case reports that are supporting our efforts to develop targeted value statements for the INVOS system and guide the clinical community on its appropriate use in the neonatal ICU.

Advancing our product labeling has also been an important focus in 2008. We entered the year with FDA labeling to monitor changes in the oxygen saturation in the blood in the brain and skeletal muscle tissue. In May we received important labeling changes. Our labeling was expanded to include monitoring changes in the oxygen saturation in the blood and the brain and somatic tissues of any type beneath the sensor. When the sensors are applied in neonates over the abdomen the somatic tissue beneath is largely bowel. When the sensors are applied over the flank the somatic tissue beneath is largely kidney. In addition to the brain, clinicians have evolved to applying our technology in neonates to learn about these other vital organs and the new labeling allows us to promote our technology for these monitoring purposes.

In August we filed a new 510(k) with the FDA to continue to advance our labeling. The focus of this 510(k) is to add new language that reflects the current state of the literature with the INVOS system. For example we are asking to add labeling that, and I’m paraphrasing, pre-operative INVOS system values correlate with patient outcomes following surgery and management of patients using the INVOS system has been shown to improve outcomes after surgery. We believe these and other similar labeling requested in this application more accurately reflect the current state of the literature involving the INVOS system, and if cleared would add significant weight to our market development efforts and our leadership position.

Also, our activities in the neonatal piglet research in the neonatal ICU have led to new discoveries that we believe represent opportunities to advance our intellectual property position. We have filed new patent applications for certain of these concepts and are in the process of filing patents for others.

In summary, I’m very pleased with our financial results as well as the progress we are making to position the business for the future. I am particularly pleased with the progress of our launch in the neonatal ICU and the potential for this new market segment to contribute to our growth.

And now Bill will review our financial results in more detail.

William M. Iacona

As we reported in our earnings release this morning we achieved strong third quarter results with a top line of $12.4 million and diluted EPS of $0.23 per diluted share. Our net revenues for our third quarter were up 22% over 2007 and for the nine months ended August 31 increased 24% to $33.8 million. US net revenues increased 22% in the third quarter to $9.4 million and increased 23% year-to-date to $27.1 million.

For the quarter and year-to-date US sales represented 76% and 80% of our net revenues respectively. For the quarter US disposable sensor revenues increased 22% to $8.1 million and our INVOS hardware revenues increased 26% to $1.3 million. For the nine months ended August 31 US disposable sensor revenues increased 23% to $22.2 million and INVOS hardware revenues increased 22% to $4.8 million.

Our international net revenues were $3 million and $6.7 million respectively for the quarter and nine-month periods ended August 31. These represent increases of 20% and 28% respectively over the same period of 2007.

In Q3 we placed 116 INVOS monitors in 52 hospital accounts in the US. Internationally we sold 212 monitors. Year-to-date we have placed 344 INVOS monitors in the United States and 418 monitors internationally. As of August 31 our installed base of INVOS monitors in the US grew to 2,350 being used in approximately 700 hospital accounts.

In Q3 our sensor unit sales increased 15% to 75,938 and year-to-date unit sales increased 17% to 212,246. In the US pediatric sensor sales represented approximately 35% of total sensor revenues and 28% of total sensor units for the quarter and approximately 33% of total sensor revenues and 27% of total sensor units for the nine months ended. Total company sensor unit sales increased to 117,528 in the third quarter and increased to 313,326 for the nine month period.

In the US our average selling price for sensors increased 6% for the third quarter and 5% for the nine months ended August 31. The increase in ASPs is primarily attributable to increased sales of our pediatric sensors which sell for a higher price than our adult sensors.

Gross margin was 86% for the third quarter and 87% year-to-date. As we’ve stated we expect our gross margin to be 87% to 88% for the year 2008 depending on the mix of sales between US and international.

For Q3 operating expenses increased 16% compared to the same period a year ago and year-to-date operating expenses increased 23%. These increases are primarily related to our addition of sales and marketing and R&D personnel and increased expenditures in sales and marketing activities.

Third quarter operating income increased 29% to $4.2 million and year-to-date operating income increased 22% to $9.1 million. Q3 income before income taxes increased to $4.7 million from $4.2 million a year ago and increased to $11.3 million for the nine month period. Net income was approximately $3 million or $0.23 per diluted share for the quarter and for the nine month period was $7.1 million or $0.51 per diluted share.

While we do not expect our recorded income tax expense to reflect material cash tax payments for the foreseeable future. Given our previous NOLs we have begun making state income tax payments. Our recognized income tax rate in Q3 was 36% and we expect our effective tax rate for fiscal 2008 to approximate 36%.

In April we initiated a $15 million stock repurchase program, expanded the program in May to $30 million and then further expanded the program in July to $45 million. To date we have purchased 1,805,129 shares at an average price of $17.42 per share for approximately $31.4 million including commissions.

As of August 31 our cash and investments balance was $66.2 million and we had no borrowings. Our cash provided by operations for the first nine months of 2008 was $11.2 million.

I will now turn the call back over to Bruce, who will talk about our business for the remainder of the year.

Bruce J. Barrett

As we enter our fourth quarter we believe we are positioned to finish strong and in the mid-range of our guidance for net revenues of $46 million to $50 million and as previously forecast our operation margin should come in at the high end of the range of 25% to 27% of net revenues or above.

With our launch into the neonatal ICU we now participate in three market segments that we estimate represent more than $800 million in annual disposable revenue potential worldwide. These market segments are adult cardiovascular surgeries, the pediatric ICU, and the neonatal ICU. Our goals remain to establish the INVOS system as a standard of care in these markets and sustain a substantive competitive advantage through clinical research, customer service and education, technological advance, and intellectual property.

We are about 20% penetrated in adult cardiovascular surgeries except in congenital heart surgery where we enjoy a much higher penetration. While we have focused our resources in 2008 towards pursuing our entry into the neonatal ICU, we remain optimistic about our prospects in the adult cardiac surgery market as we obtain additional data and further expand our sales and education team to better serve each of our target markets.

In recent weeks the annals of thoracic surgery accepted for publication a study led by Dr. James Slater, cardiac surgeon at Morristown Memorial Hospital in New Jersey. This study in cardiac surgery demonstrated that low INVOS values during surgery were the most predictive of subtle adverse neurocognitive outcomes after surgery. The next most predictive parameters were advanced age and a history of smoking, neither of which can be managed at the time of surgery. Because this study was led by a cardiac surgeon and will be published in one of the key cardiac surgery journals, we believe this study will be helpful to our efforts. As we have discussed many times before, we have been most successful in adult cardiac surgery when the cardiac surgeon drives adoption.

Also, data continues to be collected in the STS adult cardiac surgery database. Sometime in the first half of 2009 there should be sufficient data to review. If this data is consistent with the other data presented and published about the INVOS system, we believe it can contribute greatly toward establishing the INVOS system as standard of care.

Based on our early experience in the neonatal ICU we are very bullish about the contribution this opportunity will have to our business in the coming years. To date we have focused our efforts towards the 100 or so hospitals that already use our pediatric sensors and congenital heart surgeries and in the pediatric ICU. It is most efficient for our sales and education team to cover these centers because we have built in referral networks with the pediatric clinicians who can offer positive endorsements for the INVOS system with their neonatal colleagues. These are also the right centers to be partnering with on clinical research because these include the premier academic centers.

We have a significant body of literature from our experience in neonates undergoing congenital heart surgery. This data gives us a solid start towards developing the value proposition for the neonatal ICU. We will build upon this foundation by securing additional data that directly targets the wide range of clinical issues found in the neonatal ICU, and positive clinical data supporting use of the INVOS technology in this vulnerable patient population will be key to driving market adoption just as it has been in our other market segments.

In the pediatric ICU we continue to make solid progress. Clinical data is now routinely presented and published that validates the usefulness of the INVOS system in this market segment. For example, at the upcoming European Society of Intensive Care Medicine and American Society of Anesthesiologists annual meetings, several abstracts will be presented discussing the use of the INVOS system in pediatrics.

Among these presentations is an important abstract by Dr. George Hoffman from Wisconsin Children’s Hospital. In this long-term study of congenital heart repair patients Dr. Hoffman shows that neurocognitive outcomes tested several years after surgery are improved with the use of the INVOS system to avoid low cerebral oxygen saturations at the time of surgery.

Also, a study submitted for publication by Dr. Mark Hall at Nationwide Children’s Hospital in Columbus, Ohio demonstrates the INVOS values from the region of the kidney correlate with kidney function in septic pediatric patients.

These are just examples of the types of clinical data that continue to come forth demonstrating the relationship between INVOS value and outcome.

2008 has been a busy and productive year for us. We have made steady progress across our business including our efforts to advance our technology, product labeling and intellectual property, and we’re looking forward to a strong fourth quarter close as we also position our business for continued growth.

And now we’d be glad to answer any of your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Analyst for Matthew Dodds - Citigroup.

Analyst for Matthew Dodds - Citigroup

I actually just want to start off and go through a few financial questions. Certainly some impressive leverage on the SG&A. I’m just wondering with respect to the sequential decline on the absolute spending, what would you attribute this to and maybe you could just characterize how you would like us to think about this as a percent of sales going forward? Obviously you lended a little bit of visibility on that when you commented on the EBITDA margin guidance for the full year perhaps being above the 27% high end, but if you could just give a little more detail there that would be great.

Bruce J. Barrett

Essentially I think what you’re seeing in terms of the sequential is just that the springtime quarter is a more expensive quarter for trade shows and other sorts of activities, plus we were in the very early part of the neonatal launch so there were increased training and promotional activities associated with that in the second quarter. So the third quarter just wasn’t quite as expansive of a quarter.

As you look moving forward though we’re basically going through a bit of a process here, and what that process is is where we’re launching into the neonatal ICU where we’re getting our initial experience, we’re developing our value statements, we’re getting involved with the clinical research that we think the data from which is going to be positive but we also think we need it in our hands to have the kind of impact with an investment in sales and marketing that we want. So we’ve not been aggressive in advance of this time continuing to add resources.

We obviously added sales and education resources at the end of 2006 and in through 2007 to prepare for the launch but we still have another level of investment that we’re going to start making here as we go into the fourth quarter in sales and education in the US for us to better accommodate all our markets. And I think you see that throughout our numbers.

The INVOS units placed in the US were similar to what they were last year in the third quarter and adult sensor unit growth is not as strong as what it has been historically albeit it’s getting on a bigger based, but I think part of that is it took a lot of effort to get 55 accounts started up in the neonatal area with these new sensors and it’s just a little bit of a reallocation of resources. So you are going to see us investing.

I think we’ve said in the past we certainly wouldn’t encourage people to forecast that as you look onto 2009 that our operating margins are going to continue to increase. In fact depending on what the data in the neonatal ICU says, which the early data especially; we’re very excited about this data out of Emory because neck is a very large opportunity for us and if our product can quickly be shown to add value there, it’s worth going after. So I think the jury’s still a little bit out as we get into the fourth quarter and start seeing this early data come out of clinical research just how heavily we’ll invest next year. But I certainly wouldn’t be taking operating margins up in 2009 because we do have investments to make.

Analyst for Matthew Dodds - Citigroup

And as a follow on, just maybe looking a little bit higher in the P&L on the sales, with one quarter remaining it’s still a fairly significantly wide range and I’d just like to get a sense as to how you’re thinking about the guidance for the year and what gets you to the high versus the low end with respect to looking at either the OUS sales, hardware or a pickup in sensors because the growth in the pediatric and NICU side have been impressive but you said the base certainly still significantly larger on the cardiac surgery? So if you could maybe just fine tune that if you’re comfortable doing so?

Bruce J. Barrett

We kind of said we think we’re going to end up somewhere in the middle of the range so if you want to narrow the range down and focus it in more toward the middle, that’s where we think we’ll end up. We didn’t have as strong a Q3 in hardware in the US as we had Q2 obviously. Now if you look at last year, we were still up I think 26% in the US on hardware versus what last year’s Q3 was. We do have volatile periods in hardware in the US so if we have a really strong hardware quarter in the US, that would be something that would push it higher rather than lower.

And then the other thing will just be what happens in our international markets. We’re expecting to have a very solid contribution from our international markets here in the fourth quarter and if we do, that helps. If purchase volumes aren’t quite as high regardless of activity in the field, that hurts our numbers. But the key I think internationally regardless of what happens quarterly is that Covidien reports having very, very solid growth.

But in the European market well in excess of the - they’re on a smaller base albeit - but well in excess of the type of growth that we’re showing. And we know that Japan’s been doing very well this year as well with Edwards Lifesciences with them having their first full year of launching the four channel cerebral oximeters. So we’re poised to have a very solid quarter and those would be the things that would most likely impact it.

You’re right. Sensor wise we’re involved in the evaluation and clinical research phase and the neonatal ICU to a large extent and a lot of what we’re selling is also people just upgrading from the pediatric sensor to these new sensors at a higher price. So that doesn’t materially change our revenue picture when they upgrade at a higher price. It’s really going to be getting new accounts up and running and get them to start routinely using the product on a wider base of patients.

Analyst for Matthew Dodds - Citigroup

It looks like you guys have now at least seven quarters of sequential improvement on an absolute basis on your sensor ASPs in the US. Would you expect that progression to continue through next year as there’s a higher portion of PICU and NICU sensors?

Bruce J. Barrett

If you look at the mix in general, if the NICU makes the contribution that we expect it to as we get a couple more quarters under our belt here of the early phase of the launch, I would expect that you would see our overall mix of sensor ASPs continue to rise. If you look at individual segments, for example in the adult market segment, just the adult sensors themselves are still up on ASP a couple of percent this y ear in the US both in the quarter and for the year. So we’re still enjoying a little bit of price there but predominantly the price is coming from mix because we’re growing at a faster rate on our higher priced sensors.

Operator

Our next question comes from Charley Jones - Barrington Research.

Charley Jones - Barrington Research

Did you say you filed for an expanded labeling in neonatal? And if so, when did you file that?

Bruce J. Barrett

As you know we received expanded labeling in May that allows us to talk about the use of our technology to monitor any tissue beneath the sensor not limited to the brain and skeletal muscle tissue. And the importance of that is the vast majority of clinicians in congenital heart repair for neonates as well as in the neonatal ICU are applying the sensors over the abdomen thinking they’re looking at the bowels and over the kidney thinking they’re looking at the kidney, and we now have piglet data where you can really do well controlled studies to prove that you’re actually looking at those tissues which was a part of that 510(k). So we’re able now to say that you’re monitoring whatever’s under that tissue within the light path and in the neonates that’s clearly bowel tissue if you put it over the abdomen and that’s tissue if you put it over the kidney. Not 100% but the majority.

The 510(k) that we just filed in August is looking more at outcomes. We have numerous studies now. A couple prospective and randomized when you look at Merck study in the adult cardiac surgery and the [Casadi] study that was done in the elderly patients undergoing general surgery and a variety of other studies that show improvement in outcomes with use of INVOS in surgery. And we have a large number of studies that show correlations between INVOS values and outcomes as well as several studies that show that your INVOS value before surgery is predictive of your post-op outcome. So we’ve basically taken all that data and used it to summarize in the few labeling statements what we think the current state of the literature supports in a label claim and we’re asking FDA to clear a label with those sorts of claims in it.

Charley Jones - Barrington Research

So for the 510(k) you received in May, was that just one turn of the document or did it require a couple? And would you expect a couple of turns of this 510(k) document?

Bruce J. Barrett

The one that we got in May we actually got without questions. And that 510(k) covered expanding our labeling to cover monitoring whatever tissue’s beneath the sensor. It went a little further in terms of clarifying some of the language, because we had our cerebral and somatic language before was a little different. They were two different statements. One said that for cerebral we were cleared for any individual and the one for somatic said we were cleared for infants, children and adults I think. So we clarified and combined that language to say that it’s cleared for any individual for cerebral and somatic and went further in the document to say that any individual includes neonates, infants, children and adults. And then we caught up any changes in that 510(k) related to changes that we’d made in our monitors since the last time we had a 510(k). So there were a variety of things in that but it went through without questions.

This one we just submitted in August so you would anticipate that within 90 days you’ll either get clearance, questions to go forward with it. And we’ll see. Even if you look at things like blood pressure and pulse oximetry, there’s never really been any outcome data to show that they make a difference. So there aren’t a lot of examples of monitors asking for outcome labels so we’ll have to see what we get in our first response here.

Charley Jones - Barrington Research

Thanks. That’s helpful. Can you tell us how many patients were in the Slater study, if you know or can tell us, and whether it was randomized in perspective?

Bruce J. Barrett

The Slater study was randomized in perspective but the data that he’s reporting is correlative between drops in oxygen saturation on our monitor during procedure and what they found was subtle post-op neurocognitive testing compared to pre-op neurocognitive testing. The number of patients involved was something in the order; 243 rings a bell but it was somewhere in the 250 range.

Charley Jones - Barrington Research

You talked about your pediatric hospitals beginning to adopt the higher priced neonatal sensor. Can you give us any more anecdotal information whether it’s a very small number and whether or not you expect it to become more widespread and how you expect that to kind of roll out? Are there any manufacturing constraints on the sensor?

Bruce J. Barrett

At the moment we’re building inventory because we’re just trying to anticipate the uptick. Dominic Spadafore who runs US sales and marketing is of the belief that the vast majority of customers are ultimately going to switch from the pediatric to the newer sensors. There are some nice features on them for the smaller children. They’re just a lot more flexible. There are no pressure points where the optics are. They’re just designed for the smaller patient population. And a lot of what has been used, even though it’s pediatric ICU or pediatrics has been on neonates for congenital heart repairs so that’s where a large part of these pediatric sensors are used. So this is just a better solution for that population. So we expect that to be the case as we move forward.

Charley Jones - Barrington Research

Have you figured out your pricing on the neonatal sensors? Is it still listing $195 or are you getting close to that? What have you learned over the last quarter?

Bruce J. Barrett

I believe our average selling price in the quarter on the sensor was something above $170. What was it Bill?

William M. Iacona

$173.

Bruce J. Barrett

$173. We’re listing it at $195 in the US. We’re still in that phase where there’s no reason to take the price down. There’s no question that anyone would view that as an expensive sensor with no data. So our view is that we’re going to collect the data and gain the experience to establish our value propositions and then we’ll be discussing what the price level ought to be. But right now we feel pretty comfortable with where we are at least for this early phase of the launch. And I think over time what we’ll be pursuing though is more of a per day monitoring sort of expense. Rather than the sensor costs X; it’s going to be the sensor costs X per day of monitoring as we move into the future.

Charley Jones - Barrington Research

How many sales reps did you add in the quarter and could you talk about whether or not they were clinical and specifically for neonatal?

Bruce J. Barrett

We did not expand the sales team in the quarter or the clinical team in the quarter. We’ve wrestled with that. We argue amongst ourselves, “Should we go ahead and just start adding the people so they’re up and running when the data starts coming out because we feel so good about it?” or should we be a little bit more measured and wait. We’re probably going to end up hitting it somewhere in the middle. I think we’re already seeing a positive enough clinical experience in data like from Emory that’s so positive that we are going to start adding more resources so that we make sure that we’re capitalizing on the opportunity and not taking so much time away from our other markets which can grow if we just spend enough time on them. We added resources but we wanted to see how those resources settle in and how the market develops here in the neonatal ICU and see some of the early data. And now we’re in a position to take the next step up and add additional resources.

Charley Jones - Barrington Research

A couple questions for you Bill. Can you give us the US and international sensor units again? And then I’m curious within the 55 neonatal accounts how many monitors they bought? And then one further, within those 25 hospitals that first ordered the neonatal monitor, have many of them reordered?

William M. Iacona

Let me take the first one because that’s probably the most straight forward. For the quarter you’re looking at the US sensor number was 75,938 and the international number was 41,590. The answer to your next two questions is somewhat vague in terms of when you look at the hospital accounts that are buying, whether it’s for the pediatric ICU or the neonatal ICU, we won’t be breaking out necessarily where those units are going. And in some instances we may not even know because we may not know when the order is placed which department’s placing the order for the unit. So there has been reorder on units. As Bruce mentioned we’re still focusing mainly on those 100 accounts where we have a presence already. So that answer’s a bit more vague and I don’t know that we have the color to give you and we probably won’t be breaking it out that specifically.

Bruce J. Barrett

I’ll add a little bit more color for you though. The reality is we just started in this market over the last few months so as it relates to the neonatal ICU itself, other than a few examples where people saw the product coming and went ahead and put it in their budget or had ready access to some capital dollars, the vast majority of them are not going to be players for purchases until next year as it relates to capital because they’re going to have to get it in their budget cycle.

Charley Jones - Barrington Research

Can you just give us an update on the competitive environment? Whether or not you’re seeing anything from Terumo or whether CAS is out there in a larger way?

Bruce J. Barrett

With those two in particular, we don’t know specifically what’s going on with Terumo. We have heard on the street that they’ve hit another bump in the road in their development. Historically our input on those sorts of things has been pretty accurate so we’re hopeful that’s the case but we honestly can’t say that we know for sure. But they’re not active in the market.

As far as CAS is concerned, we saw their results for their second quarter about $380,000. We understand or at least it’s our belief about half of those were sales into our accounts and about half were sales to places that we either haven’t gone or haven’t been. When they’re in our accounts, it’s pretty much running its course. The product’s not terribly competitive but once they realize that, they’ve started lowering prices and trying to buy some share without a great deal of success as evidenced by their numbers. But there have been examples of places that we’ve had to lower our price. Obviously it’s not reflected in our overall numbers because our overall adult ASP in the US is u a couple of percent this year despite the fact we didn’t take across the board increases like we had in previous years before we had competition.

So they are out there. They’re very active. They’re kind of at that last stage of what this kind of course tends to run, which is depending on price because there’s really no other way to get the business. It’s just very difficult. I think they’re trying very hard. It’s just very difficult to walk into a new technology market like this where you’ve got an established leader with 10 years of data and hundreds and hundreds of abstracts and published articles that says their product works and makes a difference. And you want to walk in and say “I’ve got something better but I’ve got no data to support it.” Clinicians are more interested in taking care of their patients than figuring out which product they’re going to use. And they’re going to pick the one that’s got the data usually.

Operator

Our next question comes from Gregory Brash - Sidoti & Company LLC.

Gregory Brash - Sidoti & Company LLC

I’m curious on the percent of monitors sold. Is it around 40%?

Bruce J. Barrett

Yes. Pretty much spot on Greg.

Gregory Brash - Sidoti & Company LLC

And I’m just curious, are you still selling or the majority selling into the ICUs or have some of them started to ask for sort of the no cap model? My thought was you’re selling more into the NICU. You may get a higher percent sold than what you sold in the quarter.

Bruce J. Barrett

I think near term until people have a chance to budget, we provide them any way they want to use them so they’ll use the sensors. So we try not to let the capital process be an impediment to getting sensor adoption and technology adoption. Most of what we placed in the neonatal ICUs so far we probably just haven’t counted yet. When we report our monitors, it’s what we actually sell and then it’s whatever units the sales teams tells us are there, the evaluation’s over, and they’re going to continue to use them so we count them. So a lot of the hardware we put out this quarter in the neonatal ICU we consider still to be in evaluation we haven’t counted yet. But I think as we move forward, it’s volatile quarter-to-quarter and that’s probably not going to change but we do think we’ll have success selling hardware into the neonatal ICU and most of what we put into the adult area is in exchange for sensor usage. And we still sell quite a lot of the hardware that goes into the pediatric ICU.

Gregory Brash - Sidoti & Company LLC

So the ones that are being used on sort of a trial basis in the NICU, is there a chance that they’ll come back in a month and say we like it and we’re going to purchase it or would you most likely let them keep it for free and charge them premium pricing on the sensors?

Bruce J. Barrett

We’ll do either but predominantly we try to sell the hardware in the pediatric and neonatal markets. But we recognize that I think a lot of companies are complaining that capital dollars aren’t flush right now in the hospital environment. So we’re not giving up the opportunity to sell sensors while people go find their capital dollars. And I think for the vast majority of accounts it’s probably unrealistic to think they’re just going to find them within the current budget. They’re going to have to budget for them and prioritize and plan for them.

Gregory Brash - Sidoti & Company LLC

That leads into my second question as far as competing for the hospital’s dollars. I know you guys don’t compete directly with the pulse oximeter and you’re more complementary to that device but I know one of the leaders in one of the leading pulse oximeter manufacturers is rolling out a new next generation product. Do you find yourself competing against them just for the overall dollars, whether it be the NICU or the OR?

Bruce J. Barrett

I’m sure we’re competing with the entire basket of capital equipment and operating budget that’s out there to try to convince people that they ought to use our technology; it’s a new technology that can improve outcomes. And that’s why the data is so important. There’s money there in most situations for new technology that they think ultimately is going to improve patient care and save costs, and that’s where the data comes in. You’ve got to get the data that shows that.

Now if you get data that shows that you can help identify the babies that are at risk of developing neck, because it’s not just neck. In the US maybe there are 25,000 babies a year that get neck but then there are a whole lot of babies who you’re trying to figure out if they’ve got neck or they don’t have neck and there are a whole lot more babies that you’re scared to feed because you’re afraid they’re going to cause them to develop neck so they’re being withheld nourishment.

So depending on how far down that continuum we can go and show that we help for that one particular application, there’s a lot of money to be saved and a lot of benefit clinically. So if you can show that with your data, then you’ve got a value proposition to sell and people will pay for it. But if you don’t show it, then it’s just another piece of information that they can gather that they don’t know what to do with or whether or not it has any value, and then it’s going to be very difficult to get the dollars.

Gregory Brash - Sidoti & Company LLC

Bruce, do you think it’s necessary to build data on exact parameters? I don’t know if it’s even possible but to say the INVOS shows a 10 digit drop in oxygen saturation and it means this such and such risk to the patient and the doctor needs to do such and such.

Bruce J. Barrett

I think that’s exactly right. You’ve got to be able to document, and I think we’ve done a very good job of it so far, what normal values in certain clinical circumstances and at what point should you be concerned. For example, in this abstract that Dr. Hoffman’s presenting that I referred to, in addition to showing that managing people’s cerebral oxygen saturation following the type of congenital heart repair surgery that he was talking about in his study, those people have better neurocognitive results when they’re four years old. He also showed that the people who didn’t have good results had cerebral saturations that fell below the 45% to 50% range. The 45% to 50% range for a saturation in the brain that causes injury has been shown many times in human MRI studies; it’s been shown in animal studies. So we know that cerebral saturations below 50% portend pretty bad things happening.

But you’ve still got to know what to do with it. And as we get into these new applications, they’re seeing the data for the first time so with neck we have to understand what does saturation look like? You have a preterm infant who’s obviously in the neonatal ICU because their organs are undeveloped, they’re premature. You’re concerned that they may develop neck which usually develops a week or so after they’re born. What should their saturations look like when you put the monitor on their abdomen?

Well, what we’re finding certainly is that in general preterm infants have very low bowel saturations in the early days of life that start working their way up toward more normal values as you get into day 3, 4 and 5. And if they develop neck, obviously we’ve already shown that t hey have very low values. So what you’d hope that you’d be able to demonstrate, and we think we will, is that you put the sensors on and if they have low values starting out, that’s what you expect but you expect them to recover over a few days. And if they don’t, you’ve probably got a problem. If they do, then you’re moving toward normal development of the bowel.

That is the sort of thing that we want to be able to prove with the data so that people understand how to use the technology. And that’s just one example of many applications. There are other applications for the brain and the kidney and just using the numbers in combination.

Gregory Brash - Sidoti & Company LLC

You broke out the growth by market. I think you said 12% in adult. What was the PICU/NICU growth?

William M. Iacona

57%. That’s US.

Operator

Our next question comes from Jonathan Block - SunTrust Robinson Humphrey.

Jonathan Block - SunTrust Robinson Humphrey

Bill, just one for you. I always bother you on this one. Can you just split out I think you said $3 million international. If you can just split what was the equipment component versus that of the sensors please.

William M. Iacona

Sure. About $1.8 million in hardware and about $1.2 million in disposables.

Jonathan Block - SunTrust Robinson Humphrey

So just to follow through on a question earlier. I think when I do the math and you get international sensors of right around 42,000. I’ve got that down year-over-year. Why would that be? I think Bruce you mentioned just how Tyco and Edwards were pretty good customers in the quarter. Was that just on the hardware side or what would explain the international sensors being down? I’ve got it about 4% year-over-year.

Bruce J. Barrett

The hardware was particularly strong in Europe. With Covidien in Europe we know that I would suspect last year just because September is the final year of their fiscal year that for whatever reason they probably got ordered up on sensors last year in the third quarter. We’ve always had volatility with them third to fourth quarter not knowing if they’re going to order up for their year-end close or not. This year they didn’t so we expect to have a solid fourth quarter sensor period out of Covidien, but I think you have to look at it just a little over a longer period of time. The reality is Covidien’s growing Europe faster than 40% we understand this year and that’s got to play through to our purchases over time. Maybe not in any particular quarter depending on what their inventory levels are.

Jonathan Block - SunTrust Robinson Humphrey

When I look at it over a nine-month period, sort of that mid-teenish international sensor growth like you said that helps smooth for any of the lumpiness?

Bruce J. Barrett

Yes. But it also suggests that we’re not recognizing probably because maybe there was some overstocking last year. It’s not recognizing the growth that we’re actually seeing in the European market if the European market’s growing much faster than that.

Jonathan Block - SunTrust Robinson Humphrey

Moving over to the US side, I think you said 12% here in CV on the revenue. You’re getting a little bit of a lift I think on the ASPs. So my math shows a continued sort of mid-to-high single digit. I think it was about 6% on a unit basis last quarter. I’ve got maybe 8% on a unit basis this quarter. Bruce, how do we reaccelerate that? I think you were still talking 10% to 20% growth. I’m’ just curious what the gaining factor is? I mean, it doesn’t seem like much noise from CAS. So is this additional papers and if so, is that an 09 event? Is that 2010? Any color there would be great.

Bruce J. Barrett

I think it’s a couple of things. I think catalysts will obviously help and the primarily one that we’re building toward is trying to get some kind of a movement amongst the Society of Thoracic Surgeons if they get the data out of the STS database that would help establish this as a standard of care.

In the meantime we think when Dr. Slater’s publication gets published, it gives us another reason to go talk to people who may have been on the fence before.

And I think a big part of it frankly is that we just have to spend more time there. I think we’ve spent more time than we thought we would, which is probably why we’re further ahead than we expected to be, in the neonatal ICU. It’s a little bit of a reallocation of effort that maybe is above and beyond what we would have liked to have seen and that has impacted our ability to spend the time in the other markets. And I think as we add resources and that settles out that you’ll see that help as well.

So it’s a combination of focused effort in the market as well as just additional catalysts which are generally data. If we can get this new FDA labeling, I think that would be a nice catalyst too to be able to show that the FDA agrees that the literature suggests that this ting supports improvement in outcomes in surgery.

Jonathan Block - SunTrust Robinson Humphrey

Just an SG&A question. I think you mentioned very few reps added this quarter. Where are you in terms of the sales force specific to the NICU/PICU opportunity? And then I think you said you’re going to add at times that you deem appropriate, but what do you think critical mass there is? Is it 20? Is it 40? Does it have to be a similar size to your CV?

Bruce J. Barrett

Well, we’re multi-tasking in terms of the sales force so we’ve got 28 sales reps and we still have three or so independent reps who help us in the cardiovascular market. And we have about 25 or so clinical education managers. Of those 25 or so, six or seven are specifically out of the neonatal ICU environment and others are capable of selling into that environment because they’ve had a past experience or they’ve just got enough experience with CV and with our technology that we’ve been able to train them to cross over into the neonatal ICU.

As we look forward though we’re looking at adding somewhere in the 10 to 20 range in the US. More education than sales because the heavy lifting it seems in the neonatal ICU is going to be the education. When you walk into one of these large academic centers that do congenital hearts and have a 60 bed or 80 bed or 100 bed neonatal ICU, there can be 200 to 250 nurses to be trained; three shifts; weekends. So it’s the educational component that’s going to be key to us and we’re going to try to make that more efficient by developing tools that can be used to do the education in lieu of just manual labor. But in the meantime there’s a lot of effort there and that’s going to be the focus of our addition.

We’re also going to have to add some management. I mean we’ve got a pretty broad span of control right now in the regions so as we add people we’ve got to add the infrastructure to manage those people effectively. So that’ll be a component of it as well.

Jonathan Block - SunTrust Robinson Humphrey

It seems like there is some heavy lifting that goes in NICU/PICU and like you said a lot of people to train and to get educated. So is that part of the reason why when I look at the number of NICU/PICU hospitals that you entered, I think the number I believe was eight in 1Q. I think you went into an incremental 25 in 2Q and around the same, actually I think the number came in a little bit to 20 3Q. When I look at this going forward, should that be about the number of hospitals that you think until you hit sort of that critical mass number that you’ll be bringing the INVOS technology into? Sort of a 20 to 25 clip?

Bruce J. Barrett

Anyone who buys the new sensors gets added to that list. So there are going to be people who buy it just for their current pediatric patients who we may not actually be in the neonatal ICU yet. So you may see that for another quarter or two. But frankly with the resources we’ve got, what I would expect at the moment I would almost be surprised if the clip doesn’t slow a little bit in terms of the number of accounts we’re adding because we’ve got to deal with the 55 we’ve got started. So we’ll be adding accounts certainly but I wouldn’t pretend to be able to tell you for certain that we’re going to keep adding at this clip or a faster clip. We’ve got to absorb the activity that we’ve got now and turn them into routine users and then start trying to build their usage from there.

Jonathan Block - SunTrust Robinson Humphrey

I think maybe I’m confused here. Last quarter, this goes to Greg’s question earlier, I think at 148 monitors in the US last quarter. I have footnoted that about 2/3 were sold and this quarter I think the number was right around 115 and I believe 40% were sold. I thought part of the lure of the whole NICU/PICU was that a greater percentage of these monitors are going to be sold. So why would that number come in as you make greater inroads into these NICU/PICU hospitals? Is there some capitulation going on there where you’re saying, “Okay, take the monitor and that’s no longer going to be a $30,000 game?”

Bruce J. Barrett

It’s not yet. That could occur in the future but at least in the moment all it is that a lot of the activity right now is at the early phase of evaluation cycle in the neonatal ICU. So people weren’t sitting there with checks waiting to buy the hardware. They’re evaluating the technology; they’re studying it, they’re understanding the value and how to use it. And if they find it valuable, then they’ll budget for it. So I think if you just look at our hardware revenue, it was still up 26% over last year in the third quarter in the US and it’s been volatile as we all know quarter-to-quarter. I don’t see really any change there. I think the change can be as we get into let’s say the middle of next year when these neonatal ICUs who have been evaluating it this year have an opportunity to get through the budget cycle and get some dollars allocated to start buying them at a higher level. In the meantime we do sell some. There are people who come up with money quicker than that but on average people have to go through a budget cycle.

Operator

Our next question comes from Don Littlewood - Littlewood Burke & Company.

Don Littlewood - Littlewood Burke & Company

A question on a subject that I haven’t heard discussed for some time. In September of 2006 you entered into a development licensing agreement with Neurophysics for which you paid a $1 million initial fee and you were then obligated for monthly license fees up to $30,000 a month beginning in April. I’m wondering what’s going on there?

Bruce J. Barrett

What we’re doing with Neurophysics at the moment is we’re working through an arrangement where we would bring in the primary technology that we’re interested in which is the photon storage technology, which is an alternative way of making the same measurements that we make that may have some advantages for certain applications. So that’s our primary focus. We’re also discussing with them for the other technologies that we’re a part of the package that we’re in our primary interest at the time, whether or not we’re going to continue with those technologies or do something with them that allows them to pursue their commercialization elsewhere.

Don Littlewood - Littlewood Burke & Company

It’s been two years now since this agreement was signed. Has anything come to you that’s of use?

Bruce J. Barrett

Not yet as far as the commercialized product but we didn’t expect that at the time. They were all pre-feasibility phase projects. Our primary interest was that they did have a patent for an early stage feasibility work that looked promising in this photon storage area that we wanted to control. So that was the primary purpose of our interest and that’s continued to be developed at some pace. But it’s also not been the focus of our interest to invest heavily in that at the moment but we are going to hopefully be able to bring that in-house and start working at somewhat of a heavier clip on that as we move forward.

Operator

Gentlemen, we have no further questions at this time.

Bruce J. Barrett

Thank you for joining us this quarter. We hope to be back with you in January with our year-end results and hopefully they’ll be equally as positive. Thank you.

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