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Synovis Life Technologies, Inc. F3Q08 (Qtr End 07/31/08) Earnings Call Transcript

August 27, 2008 | about stocks: SYNO

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Synovis Life Technologies, Inc. (SYNO)

F3Q08 Earnings Call

August 27, 2008 11:00 am ET

Executives

Richard W. Kramp - President and Chief Executive Officer

Brett A. Reynolds - Vice President of Finance, Chief Financial Officer, and Corporate Secretary

Analysts

Greg Brash – Sidoti & Company

Ernest Andberg – Feltl & Company

Robert Cvengros – Next Generation Research

Stan Manne – Manne Family Investments

Unidentified Analyst

Presentation

Operator

Welcome to the third quarter 2008 Synovis Life Technologies Inc. earnings conference call. (Operator Instructions) I would now like to turn the presentation over to your host for today’s call, Richard Kramp, President and Chief Executive Officer of Synovis.

Richard W. Kramp

Brett Reynolds our CFO and I will present the highlights of this rewarding quarter. First, I will remind you that forward-looking statements made in the course of this phone conference are made pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. These statements can be identified by words such as should, could, may, will, expect, believe, anticipate, estimate, continue, or other similar expressions.

There are certain important factors that could cause results to differ materially from those anticipated by the forward-looking statements made during the course of this conference, and the company has no obligation to update its forward-looking statements. Reference is made to the company's annual report on Form 10-K for the year ended October 31, 2007, and all public filings made by the company thereafter.

Results presented today are for continued operations of the company and for the current quarter unless otherwise specified. Comparisons are always to the same period of the prior fiscal year unless specified differently. As is our custom, Brett will begin by providing the financial overview of the quarter.

Brett A. Reynolds

Thank you for participating in our third quarter conference call. The financial results of our third quarter continue the trends we have seen in the first half of the year. We have achieved another quarter of record revenue, our ninth consecutive quarter with record revenues, with the revenue growth resulting from broad-based unit growth across all of our primary product lines.

Our gross margin continues to expand and is close to the goal of 69% to 70% that we have set for the fourth quarter. And even with incremental operating costs due to additional sales people, more sales and marketing activity, increased R&D cost, and expanded new business development, our operating income has grown. Our operating margin this quarter was 17% as compared to 9% in the year ago quarter as the revenue and gross margin gains were leveraged to the bottom-line. Revenue for the first three quarters of fiscal ’08 totaled $37.1 million, an increase of 35% over the same period of last year, and nearly equal to the revenue we had in all of fiscal ’07.

Before I discuss the financial details of the quarter, I again want to remind everyone that we sold substantially all the assets of our interventional business as of the last day of our first quarter in this fiscal year. The result that I will discuss to day for the current quarter and all prior periods unless otherwise noted will be for continuing operations which excludes any amounts for the interventional business. We have re-classified all prior period financial statements to show the results of interventional as discontinued operations.

And now, more detail on our third quarter results. Revenue totaled $13.4 million in the third quarter, an increase of 35% or $3.5 million when compared to Q3 of last year, and all of our major product categories had increased revenues. Approximately $2.9 million of the revenue gain came from growth in unit volumes sold. As in prior quarters, this increase in unit sales reflects the growing effectiveness of our direct sales force and the expansion of our sales force by 15 representatives in the second half of fiscal ’07 as well as strong international growth due in part to realignment of our products with distributors based upon distributor call points. In addition, we had significant revenue in this quarter from products that were introduced in the new markets during fiscal ’07. Most notably, Veritas into the hernia and chest wall repair markets as well as PSD Veritas into the European markets.

The remaining $600,000 of the revenue increase was due to higher average net selling prices primarily due to various worldwide hospitalist price increases for certain of our products. On a sequential quarter basis, our Q3 revenue of $13.4 million represented an increase of nearly $1 million or 8% over the second quarter of fiscal ’08.

From a product line perspective, Q3 revenue can be summarized as follows. Peri-Strips revenue reached $4.8 million in the third quarter, an increase of nearly $1.3 million or 37% from the year ago period. This increase was driven by our direct sales force growing product sales in the US, with increased penetration of our existing accounts, as well as a significant increase in the number of new customers. Internationally, PSD revenue increased 77% over Q3 of last year as our international distributors had been very effective in communicating the benefit of PSD Veritas, which again was introduced in Europe in Q3 of last year. On a sequential quarter basis, Peri-Strips revenue increased by $466,000 or 11% when compared to Q2 of this year.

Revenue from our tissue patch products which include the Tissue-Guard product line as well as Veritas Collagen Matrix totaled $5 million. This represents an increase of $1.2 million or 31% when compared to the third quarter of last year. The growth of Veritas in the hernia and chest wall repair markets, various hospital list price increases for certain of our Tissue-Guard products in early ’08, and incremental worldwide unit sales of Tissue-Guard were the drivers of this increase in revenue. Veritas sales in the quarter achieved an annualized sales rate in excess of $5.1 million, which is triple the revenue from one year ago. On a sequential quarter basis, Veritas sales for hernia and chest wall repair were up 10% in dollars while unit volumes were up 20%.

Revenue from our microsurgery product line was $2.2 million in the quarter, an increase of almost $800,000 or 55% over the prior year. This increase is attributable to the fiscal ’07 transition to a direct sales force focused on our microsurgery products as well as greater international penetration in Europe. The revenue growth was led by a 77% increase in sales of the coupler. Microsurgery revenue was 22% higher in the third quarter when compared to the second quarter of this year.

Our gross margin was 68.8% in the quarter, up 4 percentage points from Q3 of last year. The margin improvement in the current period is due to favorable product mix with increased sales of high-margin Veritas and Peri-Strips products, higher average selling prices, lower obsolescence expense, and improved labor and material utilization.

SG&A expense during the third quarter totaled $6.1 million, an increase of $1.2 million or 26% from the same period of last year. The SG&A increase was driven primarily by $927,000 in incremental sales and marketing costs related to the expansion of our direct sales force, various product initiatives, and increased sales meeting, convention, and related activities. The remainder of the increase is driven by higher investment in new business development activities and information technology. As a percentage of revenue, SG&A costs were 45% in the current quarter compared to 49% in the same period last year.

R&D expense totaled $847,000 in the quarter, which is an increase of $165,000 or 24% from the prior quarter driven by increased project activity this quarter. As we have previously stated, our fiscal ’08 R&D activities are focused on expanding the indication for our Veritas technology, improving the delivery system of our Peri-Strips products, and advancing the technology of the coupler.

Operating income was $2.3 million in the quarter with an operating margin of 17%. This is a significant improvement over operating income of $900,000 in Q3 last year as well as a meaningful increase from the operating margin of 11.3% that we had in both Q1 and Q2 of this year. Interest income was $430,000 in the quarter compared with $490,000 a year ago.

While we have a significantly higher investment balance due to the proceeds from the sale of the interventional business, two items have resulted in lower interest income this quarter. First, we are experiencing lower overall market rates. Our money market accounts were yielding almost 5% a year ago compared with just 2% to 2.5% at present. Second, we have a higher proportion of our investment in tax exempt securities. At the end of the current quarter, approximately 50% of our investments are in tax exempt securities compared to 30% a year ago. We presently expect to maintain approximately 50% of our investments in tax exempts.

Our year-to-date effective tax rate is 35% consistent with our tax rate recorded in the first half of the year. Our ’08 rate is higher than our ’07 tax rate of 30% due to higher expected taxable income in the current year combined with a similar amount of permanent items.

Q3 net income from continuing operations was $1.8 million or $0.14 per diluted share as compared to net income of $1 million or $0.08 per share reported in the third quarter of last year.

And now the balance sheet. As of July 31, 2008, we had $50.4 million in cash and cash equivalents as well as $2.9 million of restricted cash and $26.7 million in investments. These totaled to $80 million in cash and investments, up from $53.7 million at the end of fiscal ’07. The overall increase in cash and investments was due to the receipt of $30.4 million in proceeds from the sale of our interventional business. In addition, operating activities from continuing operation generated cash of $1.9 million in the third quarter and $4.2 million year-to-date. Offsetting this were operating cash flows from our discontinued operations which used cash of $5.2 million year-to-date primarily related to the income tax payments on the gain on the sale of interventional.

And now, an update on our auction rate securities. Included in our total investment of $26.7 million as of July 31, are the seven auction rate securities that we own, which at the end of the third quarter were recorded at their estimated fair value of $8.3 million. We had previously recorded these investments at their par value of $10.3 million. Here in August, subsequent to our quarterly end, one of our auction rate securities with a fair value and par value of $1.3 million was called and redeemed by the issuer at par. My comments that follow relate on the remaining six auction rate securities that we still own.

Auction for our securities continued to fail in the third quarter, which means our abilities to convert these securities to cash is limited. In addition, the third party insurance companies, MBIA and Ambac which ensure 5 of our 6 remaining securities against default had their credit ratings downgraded from AAA to AA during the third quarter. Due to the sale of auctions and the credit rating change, we earned interest at contractual maximum rates which are higher than the rates we otherwise would earn. The rates we are currently earning on these securities are 150 to 200 basis points above LIBOR. As we are unable to determine when auctions for these securities would be successful and thereby provide liquidity, we have classified these securities as non-current.

Our third party broker dealer has not provided to us an estimate of fair value for these securities, and there is limited to no absorbable market information on the auction rate securities we own. In the absence of such information and taking into account the recent credit rating change of the third party insurers and the complexities in estimating fair value, we retained a third party valuation firm in the third quarter to help provide us an estimate of fair value for our auction rates.

Based on both the external valuation and various internal valuations, we have estimated the present value of the auction rates we owned at July 31^st to be $8.3 million. This is approximately $2 million lower than our par value and we have recorded an impairment charge for that amount. We have classified this impairment as temporary, and as such, the impairment is recorded as accumulated other comprehensive loss in the equity section of our balance sheet and has no impact on net income or earnings per share in the quarter or year-to-date period. This impairment is primarily due to the lack of liquidity for these securities, and we have no reason to believe that any of the underlying issuers or third party insurers are at risk of default.

We have continued to receive all interest payments when due and we believe that we will ultimately be able to liquidate these investments without significant loss primarily due to the underlying collateral of the securities and the third party insurance. However, market conditions as well as other facts and circumstances could change in the future and may have significantly changed the estimated value of our securities as well as the determination that any impairment of the securities is temporary.

Just recently, a number of auction dealers have announced settlements with various state regulators regarding the underwriting and the sale of auction rate securities. In general, these firms have agreed to buy back certain of their clients’ auction rate securities at par over the next several years. While most of the repurchases focus on individual investors and small businesses as opposed to institutional customers, it is nonetheless a positive development which would ultimately benefit all holders of these securities. Our broker dealer has not publicly stated their intentions if any to repurchase any of their clients’ auction rate securities.

For other balance sheet items, we have almost $3 million of restricted cash. This cash was received as part of the proceeds from the sale of the interventional business, and per the sale agreement, must be held in Escrow until July 31, 2009, which is when we expect to have access to this cash. Our accounts receivable continue to be in good shape with our day sales outstanding at the end of this quarter at 45 days compared to 47 days at year end. Inventory has increased about $520,000 year-to-date in support of higher revenue levels.

In May we announced that our board approved a program for the company to repurchase up to 1 million shares of our common stock. The timing and extent to which we buy back shares will depend on market condition and other corporate considerations. During the third quarter, we repurchased 87,585 shares for a total cost of $1.6 million or an average price of $17.82 per share.

While we do not have formal guidance, each quarter this year we have provided some thought on our expectation for financial results for the full year of fiscal ’08. The expectations for the full year that we discussed a quarter ago still apply, and these expectations include revenue growth of at least 30% for the full year. As our year-to-date revenue growth has been 35%, we fully expect to be above 30% for the entire year. Gross margins range from 69% to 70% in the fourth quarter. We have made steady sequential quarterly gains in gross margin this year, and we believe that our fourth quarter expectation is achievable, dependent in large part upon sales mix. SG&A did grow for the full year somewhere between 25% and 27% over fiscal ’07 and this remains our full year expectation; R&D to be in the range of 7% to 8% of revenues for fiscal ’08. With R&D spending through 3 quarters being approximately 6.3% of revenues, we may end up slightly lower than we previously expected for the full year; and interest income to be lower in the second half of the year compared to the first half due to lower interest rates, investing a higher proportion in tax exempts and the use of cash to repurchase our shares.

We will be providing our general expectations for fiscal ’09 during our fourth quarter conference call. Growing our top-line is and will remain the top strategic priority for the company. Synovis is in a great position with our products, our technology, people, and cash, and we will focus in fiscal ’09 on increasing our share in each of our main product markets and on growing the business. This will come with a variety of investments in the short-term, but will continue to position Synovis very well for the future.

Now, I’ll turn the call back to Rich.

Richard W. Kramp

We have had a strong third quarter as the financials Brett has presented demonstrate. This is the ninth consecutive record revenue quarter for Synovis, and as we continue to raise the bar, we also continue to recognize the importance of having excellent products, markets with room to grow, talented and dedicated employees, and a clear mission. Over the last 2 years we have clarified our mission as a medical products company or more specifically as a surgical products company, and within that realm, we are building our reputation as a surgeon’s partner in surgical repair and reconstruction. We have a truly unique technology platform for our tissue products and an impressive array of mechanical products, all directed toward improving patient outcomes, reducing complications, and thereby providing meaningful value to our surgeon customers and their patients.

Looking back over these last 9 quarters, Synovis has clarified its focus on the surgical market by moving away from OEM manufacturing and concentrating its financial and human resources on the repair and reconstruction specialties. We move closer to our surgeon customers by establishing a direct relationship through our own sales employees in United States, and have grown our cash resources while investing in more efficient operations, new tissue and mechanical devices, and a new focus on acquisition activities. These strategic moves have brought clear results in the form of increased penetration in the markets we serve with all of our product lines.

Looking at the big picture, over the last 9 quarters, our overall revenues have grown 116% while gross margins improved from 59% to 69% and operating income soared from a negative $719,000 to a positive $2.3 million. Performance in each product category has provided this broad-based and sustained growth. Revenues for our Tissue-Guard product line for neurovascular and cardiac applications have grown 72% or a compound growth rate of 6.2% per quarter. Please note that I said and truly meant per quarter and not per year. One of our major product lines, Peri-Strips for bariatric and thoracic applications is up 132% at a compound rate of 9.8% per quarter. Another of our major product emphasis is Veritas Collagen Matrix for hernia repair and breast reconstruction. It was introduced 6 quarters ago and in that time has grown 976% at a compound quarterly rate of 49%. Finally, the products of our micro group have grown 162% moving ahead at an 11.3% compound quarterly rate.

We have come a long way and realized significant accomplishments in a relatively short time, but we are only now in a position to set our sights on becoming a major player in the repair and reconstruction market. Taking all indications into account, this is a billion-dollar plus market with a healthy growth rate. As you would expect, an attractive market usually draws more interested parties and we expect to see competition intensify.

Over the next several years, top-line growth will be our focus and will be a key metric indicating our progress in accomplishing our goal of being a major supplier in the surgical repair and reconstruction markets. Veritas is a well-differentiated product in the hernia market, and we believe it has significant performance advantages over its competitors both with respect to pre and intra-operative handling as well as postoperative performance. The complex ventral hernia market is $155 million in USA alone, and Synovis currently only has a small percentage of this market leaving us a lot of room to grow for several years into the future.

To support our continued growth in this market, Synovis invested approximately $300,000 in a comprehensive in vivo study in 2008 to further demonstrate the unique performance characteristics of Veritas relative to the products of our competitors. We expect to see measurable and meaningful differences which will help our sales people more fully present the scientific story which sets Veritas apart from other products in this attractive market. This is a long-term study which will run into early 2010 before meaningful results are available.

Human clinical data is also very important, and Synovis is actively working to get retrospective clinical data published by our current implanters in relative surgical journals in addition to planning a perspective clinical study which will complement the in vivo data in that it is expected to allow us to relate the physiologic process of remodeling studied in vivo with the clinical outcomes and quality of life benefits experienced by the patients in the human study. We will begin setting up this study in the next month and expect to begin patient enrollment in the middle of the first calendar quarter of 2009.

In this third quarter, domestic sales revenue per person in our surgical groups surpassed an annualized rate of $1 million. As we have in the past, when we achieve this level of sales per person, we are making plans to expand the sales force. Although we are again looking at creating 12 additional territories, we will implement our plan in a step-wise fashion targeting the first three to four adds to be on board before the end of the first quarter of 2009. We will also expand to five regions at this time. We expect the remaining additions to come in the third and fourth quarters of the year. We are also looking to add to our micro sales team and those plans are in process.

Veritas sales revenue annualized to $5.1 million in this quarter, triple the revenue from one year ago. On a sequential basis, unit sales grew almost twice the rate of revenue. All sizes of Vertias patches saw increased sales ranging from 1% to 85% with our third largest size growing the most. Although we would typically see greater sales of our largest sizes which bring the most revenue, the growth of the other sizes assures us of the continued acceptance of Veritas. We understand that the surgeon is going to use only the size needed to complete the repair, and from the discussions we have had with our field sales people, enthusiasm remains high on their part and on the part of the implanters.

Veritas sales for the year are on plan and feedback from the field is that interest is strong and product performance is excellent. I remind you in this very challenging application, excellent means beats the competition. Some of the very best discussions we have had with our users of Veritas have begun by hearing how grateful they are to have a product which performs for their patients, especially their difficult patients as well as Veritas performs, and then hearing their ideas regarding on how we might become even better.

Looking now at another major market in which Synovis has a long and strong product entry, Peri-Strips, our staple-line reinforcement product line achieved an all-time record with revenues up 37% over the same period last year on strong sales both domestically and internationally. Our buttress products are used primarily in bariatric surgery for gastric bypass and sleep procedures, and in thoracic surgery for lung resection procedures. Bariatric surgery continues to grow as its benefits become more known to the general patient population. Recently, several articles have been published highlighting the reduction which is sometimes dramatic of the diseases associated with morbid obesity. Gastric bypass surgery is reported to result in a resolution of type 2 diabetes in 83% of patients, often within days of surgery. The procedure also results in a 70% reduction in colon cancer and an 85% reduction in breast cancer.

Although there is increased competition from gastric banding, a procedure in which staples and staple-line buttresses are not used, data from the American Society of Metabolic and Bariatric Surgery indicate that the number of gastric surgeries continues to increase. This includes the Gold standard Roux-en-Y procedure and another procedure which is rapidly gaining popularity. It is known as the sleeve gastrectomy, and it is less complicated than Roux-en-Y gastric bypass and lends itself well to a laparoscopic approach. This procedure involves converting the stomach from an oval to a tube shaped organ essentially from the input to the output by making a vertical staple-line from the duodenum to the esophagus, about 4 cm from the right side of the stomach and removing that portion of the stomach to the left of the staple-line. Since this procedure creates a much longer staple-line and thus a greater potential for leakage, surgeons, even those who may not use buttresses for the Roux-en-Y procedures, are more inclined to use buttresses for the sleeve gastrectomy.

We believe the strong growth in Peri-Strips sales this quarter may be related in part to the adoption of buttresses by former non-users because of this procedure. Even so, at this time, the number of non-buttressers still exceed the buttressers by about 4:1. So again in this market which is estimated to be greater than $140 million and growing at 5% to 8% per year, there is significant room for Synovis to grow now and in the years ahead.

Synovis also has a very attractive product in the microsurgical market. Our anastomotic coupler is used heavily by micro-surgeons reconstructing the breasts of cancer victims via a procedure which uses a dissected piece of tissue consisting of skin and subcutaneous fat from another part of the patient’s body. This tissue is called a flap and it is permeated with blood vessels called perforators. Immediate reconnection of blood supply to these vessels is needed to keep the flap tissue from dying and the coupler enables the surgeon to make the one or two connections needed for each flap in about 5 to 10 minutes instead of the 20 to 50 minutes required by hand suturing. It is critical to the success of the transplant to rapidly and reliably re-establish blood flow and there is currently no competing technology except the slower method of hand suturing. The time saving is also beneficial since it results in reduced operating time and anesthesia time. The quality of the connection which is called an anastomosis is every bit as good as or even slightly better than that achieved by hand suturing and it is more repeatable.

The market for this product is about $20 million in the United States and it is growing with the popularity of the perforator flap procedure not only here at home but also in several countries in Europe and the Asia Pacific area. Also worth noting, Synovis is in the final stages of development and testing of the next generation of coupler technology which combines the blood flow measurement capabilities of Doppler ultrasound with the coupler using a tiny microprobe mounted to the coupler itself. This system will allow the vessels to be coupled together and also provide immediate audible confirmation that blood flow has been established to the transplanted tissue. This improvement has the potential to double the market size to $40 million in the United States and possibly result in identification of additional markets for this technology in the near future.

These products and markets provide the basis for the sustainable growth we need to achieve our revenue targets over the next five years.

In addition, we are working on other applications for Veritas including its use for the repair of arteriovenous fistulas. An AV fistula is a direct connection between a large artery and a vein usually in the arm to prepare the vein to accommodate the return of large blood flow volumes from the dialyzer needed by a renal dialysis patient. The data needed to support the use of Veritas for this application already exists. However, the process of gaining access to the data has taken longer than anticipated due to the heavy clinical and travel schedule of the surgeon involved and availability of certain hospital administrative personnel. Nevertheless, we’re expecting to begin analyzing the data in the next few months for inclusion in the submission to the FDA.

An article from the journal of the American Society of Nephrology projected that greater than 520,000 end-stage renal patients would be dialysis by 2010 in the United States and that number would be growing at the rate of 7.1% per year. The National Kidney Foundation’s Kidney Disease Outcomes Quality Initiative has set a goal to have 60% of dialysis patients using AV fistulas by 2009 and the Fistula First Initiative has reported the number of dialysis patients with AV fistulas has risen from 32.4% in December of 2002 to 50.3% in June of 2008. Conservatively, if the proportion of dialysis patients using fistulas remains at 50%, the number of patients using fistulas is projected to be 260,000 by 2010 with 18,500 more patients added each year. If 30% of these fistulas fail each year as projected, that would be equated to a $25 million annual market for fistula repairs in United States and an equal number outside of the country.

Moving now onto the Cardiac arena, our work with the myocardial patch continues and we have received most of the results from our 6-month study in which Veritas was used as a substrate to replace myocardial tissue surgically removed from the left ventricle. You will recall that earlier studies in which Veritas was implanted for 8 weeks showed the regeneration of myocardia muscle to about half the original ventricular wall thickness. The longer-term study in which Veritas was implanted for 26 weeks showed the longer implant time corresponded to additional growth which resulted in reaching an average of 70% of original wall thickness. The positive work measurement also increased significantly on average.

We’re in the early stages of studying Veritas for this application and are planning protocols for the next experimental tests. We remain excited about the idea of being able to replace non-functioning scar tissue in the heart with Veritas with the intention of regenerating functional heart muscle.

During the third quarter, Dr. Nick Oray, our Vice President of Research and Development announced his intention to retire at the end of this fiscal year. Nick has made many contributions to Synovis over his last 10 plus years and although we are happy for him we will also miss him. I would like to take advantage or this opportunity to publicly thank Nick for his many contributions to the company and his unflagging enthusiasm for Veritas and to wish him a long and rewarding retirement. Nick has agreed to be a consultant to the company, and this will allow a smooth transition to his successor. We have begun the search for a suitable candidate for this important position and will begin the interviewing process early next week.

In addition to gains in sales revenue and product development, Synovis is benefiting from the application of lean manufacturing principles in our manufacturing, warehousing, and shipping areas. These programs are being implemented in stages and have already made significant contributions to operating efficiency which contributes to lower cost of goods and improved customer service. Creative solutions are being offered by production operators as well as manufacturing and quality engineers, supervisors, and managers. We are striving constantly to improve our value offering and competitive position throughout the organization.

We have been active in the corporate development front also. We have visited and been visited by several company which could be potential acquisition candidates. We have a disciplined process in place, and we’re optimistic that we’ll identify a win-win combination using this method. That said, we are experienced enough to know that we cannot predict when a transaction might take place or what it might be. We do see acquisition as an integral part of our growth strategy, and thus we’ll continue to give it the effort that it is due.

That concludes our update for this third quarter of 2008, and we’ll be happy to take your questions now.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Greg Brash - Sidoti & Company.

Greg Brash – Sidoti & Company

You put up a very strong operating margin this quarter. Thinking looking at ahead here, obviously you’ll probably see some more gross margin improvement, but it looks like you’re going to hire 12 or so new sales reps and invest a little bit R&D. Is that sort of operating margin sustainable?

Richard Kramp

I think that we’ll be looking for topline growth, Greg, and the operating margin, that might be a bit high going forward. We are going to make some investments in clinical studies and in additional salespeople, so I think we’re certainly going to keep an eye on the bottom line, but growth from those levels would be probably not our main focus.

Greg Brash – Sidoti & Company

The hernia studies, how many studies were you running? You mentioned you were spending $300,000 on the one in vivo study. How many studies are you doing total? How many patients do you plan to follow, and is it $300,000 for one study and you’re also having other studies that may push the total cost up to $1 million? Is that a good way to think about it?

Richard Kramp

Greg, this $300,000 has already been spent and expensed, and that was an in vivo study, a long-term study, and these were not in humans. What you need to do when you’re studying Veritas, or one of the things that we wanted to do, I should say, is be able to look at it at various stages of remodeling, and you don’t do that on humans. You don’t reopen them, and so that study is underway. We’ve done most of the implants. That’s why the money has been spent up front. What we do now is monitor those and follow them for a period of about a year or a little over a year, and we have not only Veritas, but a competitive product in there, so we’re watching our remodeling of Veritas. We’re watching remodeling of others that claim to remodellable, some of which we don’t think will, and then those that claim to be permanent, and we’ll see what impact is there on that. Now that study is separate from the human study, so there’s a second study which I mentioned. That’s the human study. That will begin enrolling patients about the middle of the first quarter of calendar 2009, and that study again will be a random perspective study. We’ll have some competitor product involved there also, and it’ll be about 100 patients, I believe, with our product, and 100 with competitor product. The purpose of doing that somewhat delayed but in parallel is as we see results in the nonhumans, we can relate to the human study and see how remodellability affects patient benefit and quality of life.

Greg Brash – Sidoti & Company

Okay, and on the gross margin side, obviously you’re meeting your goals here, possibly even exceeding them. Where do we sort of max out long term on the gross margin? I know you’re getting the gains from the PSD Veritas and the Veritas. Do we max out in the mid 70s, is that a good way to think about it?

Brett Reynolds

You know, Greg, as we look forward, it is very dependent upon sales mix, but to think maybe 72 to the mid 70s over the next 3 years, but right now, it’s a mix game.

Greg Brash – Sidoti & Company

You mentioned just universe dollar sales on the Veritas, and dollar sales were wider than unit sales. Was that just because you were selling smaller size grafts or did you lower prices there?

Richard Kramp

It was a size mix. We did not lower the price.

Greg Brash – Sidoti & Company

Obviously, you guys are doing very well in the bariatric space, and procedure volumes are growing. How much of the contribution is from international with you having launched the PSD Veritas overseas?

Brett Reynolds

Greg, we have not broken out by product line international versus domestically. Overall, our business is about 15% international, but we have not broken out by product line.

Greg Brash – Sidoti & Company

I guess another way to put it is are you seeing better growth internationally and maybe even through all product lines than you’re seeing in the US?

Richard Kramp

It’s about equal for the year international versus domestic. Within this quarter, Peri-Strips grew 37%, and I think I mentioned internationally we grew 77%. It’s a much smaller base that we have right now internationally, but the growth rate was higher, and it’s really the acceptance of PSD Veritas in Europe.

Operator

Your next question comes from Ernest Andberg - Feltl & Company.

Ernest Andberg – Feltl & Company

I know that you have talked about in excess of 30% for the year overall revenue growth. Given the trends in your business, is there any reason why shouldn’t expect a sequential growth in fourth quarter revenues versus the third quarter again this quarter?

Richard Kramp

Ernie, as I said earlier, we don't have guidance. Now with only one quarter left in the year, it’s difficult to change what we said in Q2 without providing quarterly guidance. Certainly with 35% growth each of the first three quarters, one probably can draw a conclusion that it would be above 30%, but I will say that if we look at last year, fiscal ’07 Q3 to Q4, we did grow, but the business grew about 4%, and we’re still new with our direct sales force. Is there seasonality in the business? We don’t know yet because we are too new, but sequential growth, I don’t think there’s anything we would see right now that would say no to that.

Ernest Andberg – Feltl & Company

Fair enough. On the increase in the sales people out there, Rich, did you say you thought you would try to have three to four of those guys hired in Q1 or in the first half and then balance of, you said, 12 hired in the second half?

Richard Kramp

No, it was a total of 12 Ernie, and the message I was trying to get across was we have really lived literally laying out. We now have 36 territories. We are laying out 48 now, but we’re only going to fill about 3 to 4 of them in the first quarter, 3 to 4 of the additional 12. The others will continue to be handled in the way they are being handled now, but we didn’t want to be kind of carving up throughout the year, so we’re doing all of our layouts now, and then we’re going to fill the newer territories at the rate of 3 to 4 in the first quarter and then probably nothing in the second quarter, and the last 8 would in the third and fourth quarter.

Ernest Andberg – Feltl & Company

How does that affect your spending on SG&A on average, Rich? It goes up, I know, but how much should we think about the change?

Brett Reynolds

In the past when we’ve added sales people, fully loaded with travel, with the regional structure, customer service, this and that, I think a good spot is maybe 275 per person on an annual basis.

Richard Kramp

I would look, Ernie, as those first 3 or 4 being on board early in the quarter, maybe even toward the end of this quarter, but certainly early in the first quarter.

Ernest Andberg – Feltl & Company

Is there any opportunity to find guys who are experienced as opposed to needing to go up the learning curve, learning the territory and the product?

Richard Kramp

We really have always hired experienced sales people, Ernie. I don’t know if you recall, but when we first got our original 24, we had an average, if you took the average of all the people, of 10 years of operating room selling experience. I think the youngest or the least we had was 3 and they ran up to about 19 or 20 years. We’re continuing to do that. We are paying a good salary, or I should say a good base with a lot of commission potential, so we’re looking for experienced people. First we targeted for staple line. Second 12, we leaned a little bit more in the hernia area. I think we will continue to lean a little bit more on the hernia area for this round, and are there experienced people out there? We are suspecting there probably are.

Ernest Andberg – Feltl & Company

Have you seen any changes in the competitive environment with the acquisition of the big dog in the hernia repair market?

Richard Kramp

So far, we have not. We are watching for that. No more news than we had the last time. We do hear there’s a lot of chatter amongst the sales forces because of the differences in their pay and everything, and that goes both for the Lifestyle by KCI as well as Tissue Science Labs by Providian. In either case, we haven’t seen much reaction in the field just yet.

Ernest Andberg – Feltl & Company

If I interpret your comments correctly, Rich, in the Peri-Strips area, the new surgery may be driving better than expected results in the Peri-Strips area than I had thought, and the other area is the new breast reconstructive surgery with the coupler. That’s why both of those areas probably came in better than I expected.

Richard Kramp

Yes, I think you heard it right. The sleeve gastrectomy is interesting from two standpoints. It does use more buttresses because it’s just a longer staple line. Instead of kind of going somewhat horizontally across the stomach, it’s going vertically, and the stomach is more tall than it is wide, I guess. The other thing is that because of the potential for leakage there on that long staple line, they are more likely to use a staple buttress, so I think you’re right there, and also the perforator flap procedure, which used to be done mostly at teaching institutions because it was thought to be fairly difficult, but it’s coming down to what, I won’t say it’s routine, but it’s certainly coming down to where it’s getting comfortable to go out into the community hospitals now, and its popularity is growing because it really produces a much more aesthetically pleasing then natural solution for the women who have had cancer.

Ernest Andberg – Feltl & Company

How many people do you have selling in that area now? is it 7 or 6?

Richard Kramp

It’s actually seven, one of whom kind of does double duty. He does a little bit of just training, but he also sells.

Ernest Andberg – Feltl & Company

So, the average sales in that whole like, it looks like it might be higher than your tissue area. Are you considering adding people in the microsurgery area?

Richard Kramp

Yes. I don’t know if you heard me say that. It was towards the end, but we are looking for an ad there. I didn’t call out any number yet because those plans are still in progress.

Brett Reynolds

Again, the direct sales force for micro is domestic only, so you have to take our portion for international, and if you look at it, it’s about the same revenue per person.

Ernest Andberg – Feltl & Company

Thank you. I can’t do that because you told us you won’t give us that breakdown.

Operator

Your next question comes from Robert Cvengros - Next Generation Research.

Robert Cvengros – Next Generation Research

I’m looking at some of the numbers here for annualized sales in the ventral hernia sales, and that’s a key metric, of course. In Q4 ’07, annualized sales were $2 million; Q1 this year, $3 million; Q2, $4.5 million, and Q3, $5.1 million. For the previous quarters it appeared that, like what you said, annualized sales growth was roughly 49-50%, but there seems to be a dip in this quarter sequentially of roughly 10-15%. Am I reading that appropriately?

Richard Kramp

Bob, on the revenue side, it’s true, but that’s why I kind of pointed out on the units. We don’t know particularly in terms of unit mix, where there just more procedures in which they could use smaller size on or not. It’s hard to tell that for sure, but that’s what it appears to be because our units, like I said, the third from the largest size, we had about an 85 or 84% growth rate, so we see a lot of those being sold, but the larger sizes are the high revenue sizes of course, and so when you ship a little bit down, you see a more dramatic shift in revenue as we reported about a 2:1 difference in growth rate. Do we think that’s a trend? We can’t tell at all. We don’t really know what it is, and we can speculate that doctors are getting more used to the performance of Veritas, maybe selecting more conservatively smaller sizes because they tried to save or maybe just the number of procedures or the types of procedures they are doing, this time they only needed the third largest size instead of the first or second largest size, but the rate of uptake, and that’s an important metric for us, the units seem to be solid, but the revenue was lighter, but that’s the only reason that we can see.

Robert Cvengros – Next Generation Research

When you say that they are meeting internal plan, I would imaging it’s meeting internal plan on the uptake of units or more or less the breakout of dollars?

Richard Kramp

Actually they’re meeting on both.

Robert Cvengros – Next Generation Research

Going forward, just for modeling purposes into Q4, would this be from a sequential standpoint similar to Q3 or would it be more similar to what we had seen in the past with 49%?

Richard Kramp

Bob, I’d like to be able to help you there, but again it’s a unit mix and it really is driven by what patient presents to the doc and what do they do to it. We know that we’re getting a little bit more usage in a hernia type called hiatal hernia which uses a slightly smaller size, but still the size that’s sold the most would seem to be a little bit bigger than that indication, so it might be just smaller complex hernias that we’re seeing, but we don’t have a trend going anywhere. We have one data point where we see this slightly smaller size mix being used for this one quarter. It could go back the other way in the fourth quarter. It could continue. We don’t even know the answer to that.

Robert Cvengros – Next Generation Research

It’s a key metric, and thank you very much for the clarity on that. In reference to seasonality once again, that’s an issue that basically is still new to guys, right?

Brett Reynolds

Right.

Robert Cvengros – Next Generation Research

And as far as counter detailing, I know you guys have a very good relationship with your sales force as far as communication goes, is your sales force anything about counter detailing or issues to that effect?

Richard Kramp

Our competitors certainly know we’re there, and they’re not giving up the territory easily. They certainly come in and they try to reinforce that their product is good or try to detract from ours. We let our data stand for itself. It is very important for us to get peer reviewed clinical journals out there. Counter detailing is effective if you can create doubt, but it’s harder to create doubt when you have published journals. We do have a lot of data, and our sales people are very much aware of that, and they go in and convince the doctor. Plus, it’s not a runaway job. They have to go account by account and make sure they make their case, but the performance of the product is of course the last word, and that overcomes any kind of doubt that can be seeded by a salesperson. Yes, they’re aware we’re there. Yes, are they trying to stir up the pot a little bit? Sure. They are not giving up. This is a great market, and they’re not going to give it up easily. We did not go into this thing thinking anybody was going to hand it over to us. That’s why we have very experienced sales managers as well as salespeople.

Robert Cvengros – Next Generation Research

I don’t know what granularity you can provide any further on basically the internal plan and growth and things such as that, but I will ask a question, which is from a new user standpoint for Veritas in the ventral hernia space versus organic growth, is that meeting plan?

Richard Kramp

I can’t tell you on that.

Operator

Your next question comes from Stan Manne - Manne Family Investments.