Hologic Inc (HOLX) 2002 Q2 法說會逐字稿

Ladies and gentlemen, thank you for standing-by. Welcome to the Cytyc second quarter 2002 earnings conference call. During the presentation, all participants will be in a listen-only mode, after which you will be invited to participate in a question and answer session. At that time, if you have a question, please press the one, followed by the four, on your telephone. As a reminder, this conference is being recorded Wednesday, July 24, 2002. I would like to turn the conference over to , . Please go ahead.

Thank you, operator. Good evening,everyone, and welcome to Cytyc Corporation's second quarter conference call. If anyone has not received a copy of the news release issued after today's close, please contact at 212-850-5600, and one will be FAX'ed to you immediately.

Forward-looking statements made during this call are made pursuant to the provisions of Section 21E of the Securities Exchange Act of 1934. Investors are cautioned that statements during this call which are not strictly historical statements, including, without limitation: statements regarding managements expectations regarding future business developments and results of operations; management's plans and objectives for future operations; product development; commercialization and performance; and management's assessment of market factors; as well as statements regarding company strategy, constitutes forward-looking statements.

These statements may be identified with such words as, "we expect," "we believe," "we anticipate," or similar indications of future expectations. These statements involve risks and uncertainties, which could cause actual results to differ, including, without limitation: the risks detailed in the company's press releases issued today; and in filings with the Securities and Exchange Commission, including in its 2001 Form 10-K under the heading, "certain factors which may affect future results." In addition, revenues and earnings in the medical device industry are subject to fluctuation, and the growth rates recently experienced by the company do not necessarily reflect future operating results.

The company cautions listeners not place undue reliance on any such forward-looking statements which speak only as of the date they were made. The company disclaims any obligation to publicly update or revise any such statements to reflect any change in company expectations or events, conditions or circumstances on which any statements may be based, or that may affect the likelihood that actual results will differ from those set forth in the forward-looking statements.

In addition, please note that this call is being recorded by CYTYC Corporation and is copyrighted material. It cannot be rerecorded or rebroadcast without the company's express permission, and your participation implies consent to our taping.

With that, I'd like to turn the call over to Patrick Sullivan, Chairman and Chief Executive Officer of CYTYC Corporation.

Good evening, ladies and gentlemen. This is Patrick Sullivan. I'd like to welcome you to our teleconference to report on the performance of the company for the second quarter June 30th, 2002.

Joining me on the call this evening are Dan Levangie, our President and Chief Operating Officer, and Bob Bowen, CYTYC's Chief Financial Officer.

As noted in our press release, revenues for the second quarter of 2002 are 43.2 million, with pro forma earnings per share of two cents. That is excluding the one-time 6.1 million charge associated with the transaction.

As Bob will outline in his remarks, we believe we have a good understanding of our field inventory issue, and our executing of our plan to reduce those levels. Our guidance for the balance of this year and next remain as discussed in the conference at the end of June.

The fundamentals of our business remain strong. Our ThinPrep Pap test continues to increase in penetration of the overall market, and we believe is now the standard of care for several cancerous screening in the United States.

From the second quarter we announced that the F.D.A. had approved testing for chlamydia and gonorrhea directly from the ThinPrep Pap Test Collection Vile using Roche's COBAS AMPLICOR Automated System.

We remain the only company on the market today with a PMA approval for additional testing for the cervical sample for both HPB testing and chlamydia and gonorrhea.

We are focusing on several growth areas. The ThinPrep Imaging System is currently under review at the F.D.A., and we expect to have that product approved at the end of this year or early next. We're focusing on increasing sales in Europe, and are encouraged by the development of the market in Germany. Our FirstCyte(TM) ductal lavage product is showing some early signs of favorable reimbursement, with recent decisions to cover FirstCyte(TM) ductal lavage, bringing the total number of covered to over 23 million.

Dan will highlight some of the developments in the ductal lavage opportunity. Our balance sheet remains strong with over 200 million dollars in cash at the end of the second quarter. As announced in January, Cytic's board of directors has authorized a 50 million dollar share-repurchase program over the next five years. Due to the activists who are associated with the Digene transaction, and a normal black out, we have not heretofore been active with the program. We expect to initiate an active share repurchase program in the very near future. I would like to now turn the call over to Bob, who will update you on the financial highlights. Bob?

Thank you Pat, and good evening ladies and gentlemen. My remarks today will compare the financial results of the second quarter of 2002 with the results of the immediately preceding first quarter of 2002. Additionally, I will be giving guidance for the third quarter of 2002, the full year 2002, and the full year 2003. Our guidance on today's conference call will be completely consistent with guidance provided during our June 25th conference call. In compliance with the FTC's regulation FD, this guidance is being disseminated simultaneously to all parties. Further, as noted at the outset of this conference call, listeners are cautioned that the Company's guidance is forward-looking in nature, and subject to risks and uncertainties which could cause actual results to differ, including, without limitation, the risks detailed in the press release we issued earlier today, and in our SEC filings, including our 2001 10-K.

Total revenue for the quarter of 2002 was 43.2 million dollars, a decrease of 24.9 million dollars from the prior quarter. Essentially all of the decrease was attributable to lower shipments of the ThinPrep Pap Test, in line with our plan to reduce inventory levels at labs. Revenue from sales of ThinPrep processors in the U.S. for the second quarter was approximately 2.1 million dollars, and we placed 77 new instruments in the current quarter. We believe revenue from T-2000 and T-3000 instrument sales will be in the range of 1 ½ to 2 million dollars in both the third and fourth quarters of 2002.

Revenue from sales of our non-GYN products in the U.S. for the second quarter was approximately 2.1 million dollars, and was 5 percent higher than the previous quarter's level. We believe revenue from non-GYN products will be approximately 2 million dollars in each of the third and fourth quarters of 2002. Revenue from international sales of all products during the second quarter accounted for 10 percent of total revenue, compared to 7 percent of total revenue in the first quarter. We believe sales of our products outside the U.S. will continue in the range of 7 to 10 percent of total revenue in the third and fourth quarter of 2002.

Revenue from sales of ThinPrep Pap Tests to U.S. customers during the second quarter was approximately 33 million dollars, a decrease of approximately 25 million dollars from the first quarter. Based on information we have collected from customers and our field sales force, we believe lab inventory levels have been reduced approximately 18 million dollars during the second quarter, to approximately 32 million dollars at the end of the second quarter.

As indicated in our June 25th conference call, lab inventory levels would be in the 15 to 18 million-dollar range if all labs carried on average, and estimated inventory of approximately 20 working days. Also based on information we have collected from customers and our field sales force, we believe usage on a unit basis, of the ThinPrep Pap Test grew approximately 9 percent in the second quarter, compared to the first quarter. We believe that usage during the second quarter approximated 54 percent of the overall market, compared to approximately 50 percent during the first quarter. Our second quarter average sales price increased approximately 4% from the first quarter largely due to the absence of any second quarter sales promotion program and favorable customer mix with the large lab category. The largest U.S. labs represented approximately 60% of sold in the second quarter compared to 50% in the first quarter. We are very pleased with the progress we made during the second quarter. Usage levels continue to grow, lab inventory levels have been significantly reduced in line with plan and price concept firmed. All of the revenue from accessories, service, and co-marketing activities total approximately 1.3 million dollars in the second quarter. We believe the third quarter total revenue will be in the range of 54 to 58 million dollars.

For the full year 2002 and 2003, our guidance is consistent with our June 25th conference call. We believe total year revenue will be in the range of 230 to 245 million dollars and 2003 total revenue will be in the range of 315 to 350 million. Our second quarter gross margin rate of 73.8% was below first quarter levels largely due to lower sales of pap test disposables, our highest margin rates, somewhat higher unit production costs as a result of lower production volumes, lower instrument margins and a higher proportion of sales coming from outside the United States. We believe gross margin rates during the third and fourth quarter of 2002 will be approximately 80%. Second quarter 2002 total operating expenses of 34.9 million include 6.1 million of external expenses, largely legal and other external advisories services related to the transaction.

Excluding these non-recurring costs, total operating expenses were 28.8 million dollars or approximately $800,000.00 higher than the first quarter. We believe that total operating expenses will be in the range of 26 to 27 million dollars in the third and fourth quarter. Excluding the 6.1 million dollars of related expenses, we believe that total operating expenses for the full year 2002 will be approximately 110 million dollars plus or minus a million. The company recorded a second quarter loss of 1.6 million dollars for a loss of $1.00 per basic share and $1.01 for basic share and .1¢ for diluted share. Excluding the non-recurring expenses associated with transaction, the company recorded a second quarter gain of 2.2 million dollars or a gain of .2¢ per basis share and .2¢ for diluted share.

We currently estimate that our fully diluted earnings for the third quarter of 2002 will be in the range of .9 to .10¢ per share. As previously communicated during our June 25th conference call, for the year 2002 we believe our fully diluted pro forma earnings excluding the non-recurring transaction related expenses, will be in the range of .40 to .45¢ per share and for the full year 2003, we believe our fully diluted earnings will be in the range of .66 to .76¢ per share. Turning to the Balance Sheet, second quarter 2002 Accounts Receivable of 34.6 million increased 24.8 million dollars from the prior quarter end reflecting lower sales levels and improve receivables day sales outstanding.

Day sales outstanding were 70 days at the end of the second quarter compared to 79 days at the end of the first quarter. Inventory at the end of the second quarter 2002 of 11.9 million dollars was 2 million dollars higher than the prior quarter. Inventory levels were somewhat higher than the norm, as we made an explicit decision to smooth our production over the last three quarters of 2002. inventory turnover at the end of the second quarter was 4.3 turns, approximately the same as at the end of the prior quarter. During the second quarter, we generated cash of 19.7 million dollars from operations, used 2 million dollars for investing activities and generated 3.9 million from financing activities. Over all, our cash balance increased by 21.6 million dollars to 200.1 million. Right now I'd like to turn the call over to Dan.

Thanks Bob. During the second quarter our OB-GYN sales team focused on increasing conversion levels and their busiest physician offices by educating these physicians about the recent guidelines published by the American Society of and Cervical Pathology. These guidelines underscore the advantages of the ThinPrep Pap Test as a testing platform for HPV in the management Pap test results. We are seeing very strong reception to this marketing message, and our field is reporting more and more physicians fully converting to the ThinPrep Pap Test. In order to implement this method of follow-up for women with results. During the quarter our lab sales team focused on lab standardization. As we've recorded before, lab standardization means that a lab has decided that based upon clinical data, and their own in-house experience, that full 100% conversion to the ThinPrep Pap Test is in the best interest of their laboratory, their physician clients and the patients being tested. As a result the lab will proactively announce their decision to standardize all of their cervical testing on one method. The ThinPrep Pap Test method. As of today, we have 149 laboratories that have announced their intention to their clients and have converted their testing the ThinPrep. During the quarter 58 additional laboratories standardized on the ThinPrep Pap Test.

As Bob mentioned, another indicator of increasing conversion, our ThinPrep Instrument placements. During the quarter we placed an additional 77 instruments in the United States, with more than 70% of those installed in labs of existing customers in need of additional processing capacity. This brings the installed base of ThinPrep instruments to more than 1700 in the United States. Our lab sales team will continue to focus on this objective, standardization, which we believe will continue to drive conversion. Beyond the core ThinPrep Pap Test business, our other current major product opportunity is . At this time we have 227 centers trained to perform and 149 laboratories trained to interpret those specimens. Our sales team continues to be highly focused on expanding the base of trained physicians and to working with these centers to help them fit into their regular schedule. In the second quarter more than half of our sales of catheters came from existing physician customers. A clear indication of continued use following initial training. As we have said, reimbursement is very important to our successful rollout of First Sight.

As of today, we have written coverage policies from 12 insurance companies representing approximately 24 million covered lives. Most recently GHI of New York City announced coverage of First Sight for their high-risk patients. GHI's coverage now means that 9 million covered lives, approximately 2/3 of the covered lives in Metropolitan New York have access to reimbursement for First Sight. In addition to these formal coverage decisions, is being covered on a case-by-case basis by many other plans. In total, 135 plans have approved prior authorization requests for First Sight since the beginning of this year. Among these are some large companies like Cigna that approved 50 percent of the prior authorization claims and requests it received during the past quarter.

At this point, we believe that reimbursement has remained steady in the range of 500 to 600 dollars per Duct Lavage. As we discussed in June, we recently put in place 3 initiatives to support increased adoption of FirstCyte Ductal Lavage. First, we have begun using our Cytyc OB-GYN sales team to generate referrals from primary care OB-GYN's to train breast centers in areas where reimbursement is most favorable. In addition, the sales team is identifying carefully selected large OB-GYN practices to train as Ductal Lavage practitioners. We believe these efforts will allow us to capture a larger percentage of the high-risk women eligible for Ductal Lavage and will enable us to maximize solid reimbursement coverage in certain areas of the country, such as New York City and the Mid-Atlantic region.

For example, in New York City, we have coverage for two-thirds of the covered lives in metropolitan New York. The sales team is trained and already in the process of educating primary care OB-GYN's about breast cancer risk assessment and Ductal Lavage. Thus far, the reception from OB-GYN's has been extremely positive, with significant interest expressed both in referring patients and in becoming trained in their own practice. This increased patient flow will increase the number of procedures performed, the number of prior authorizations requested and, we believe, will solidify and expand reimbursement.

Our second initiative is based upon results of a paper presented at the American Society of Clinical Oncology by William in May, in which he described his experience in performing Ductal Lavage on breast of patients undergoing a surgical procedure in the operating room. On a series of 77 patients that observed, that more than 20 percent had in their FirstCyte specimen, consistent with our data published in December, and was able to use that information to change his management in many of these patients. We believe that there is important clinical value to be derived from this operating procedure, and we believe increased use of FirstCyte in the OR will spill over into increased office use by physicians that have been trained.

Overall, we believe there are approximately 300 thousand patients who undergo a surgical procedure on one breast in the OR who are ideal candidates for FirstCyte on the contralateral breast. Our sales team is focused on implementing this procedure in the OR now, and we have already begun to receive orders from existing customers for catheters to be used in the operating room.

Our third initiative pertains to the news that most of you have read in dozens of articles appearing during the last several weeks. On July 9th, Federal health officials announced that the Women's Health Initiative Study on hormone-replacement therapy was being stopped 3 years early due to the increased risk of breast cancer, heart attack, stroke and blood clots. Over 16 thousand post-menopausal women had been randomized to combine hormone-replacement therapy or placebo. Researchers found that in 5 years, the risk of invasive breast cancer was 26 percent higher in women on combined hormone-replacement therapy than it was for women on placebo. Approximately 6 million women in the United States are on combined HRT.

For women who already have risk for breast cancer, decision making about whether to discontinue use will be difficult, given the symptom relief that HRT offers them. As many of you have probably read, most experts are advising women to think carefully about the pros and cons, in part by understanding their personal risk for breast cancer and other diseases. Certainly, Ductal Lavage can play an important role in helping women better understand their risk for breast cancer. In fact, many of our customers have told us that they intend to recommend Ductal Lavage to all high-risk patients who have been on hormone replace therapy and our ability to participate in providing some value there. But we're early stage with this product.

OK. Fair enough. One last question -- I'll give (inaudible.) Can you tell us how you're going to trim the fat going forward in terms of your and your , because you talked about adding quite a few reps in Europe, but yet we're going to see decline here in the second half of the year. Can you tell us what you're - what kind of initiative you're doing to get the expense down?

Well, I didn't mean to imply that those additional sales people were not already in our numbers. But the projected expenses that we've given -- guidance to include all of those additional people.

Yeah, I know, understood. But yet, your expenses are gonna be lower in the second half than they were in the first, yet you're gonna have more people. So, I was just wondering, you know, what kind of ...

We basically have different levels of program spending in the second half than in the first, Nathan.

OK. All right. Thanks a lot.

Ladies and gentlemen, as a reminder, to register for a question, press the one four on your telephone. Our next question comes from of Chilton Investments. Please proceed with your question.

Hi. I apologize if this is repetitive. I was on the call late. With respect to the ductal lavage, are there sort of standard protocols in place as to how the physician reacts to the test results?

Yes, there are. There was a paper that appeared in the journal "Cancer," in the fourth quarter of last year which really was a treatment algorithm based upon ductal lavage results that was published by a consensus -- was a consensus paper as a result of a risk assessment working group discussion that took place, and analysis that took place. That paper was published in "Cancer," and it very clearly indicates treatment algorithm and treatment guidelines for physicians who are performing ductal lavage.

And, you may have addressed the gross margin already, but the deteriorization -- was that just absorbing higher fixed costs, I assume?

It was a piece of that. It was unfavorable instrument margins largely related to an adjustment to warranty reserve one time. And it was unfavorable mix related to the proportion of business that was done outside the U.S. versus the U.S. market, which has higher margin rates.

Because your margins have pretty much been rock solid the last several quarters, and this was a fairly dramatic decline.

Well, we have -- we had a significant reduction in the number of the amount of our sales related to the ThinPrep Pap Test Disposables - $25 million from the first quarter. That's our highest-margin product, so the fact that that was a smaller piece of the overall portfolio put downward pressure on the margins.

And we expect those to return ...

Yeah, we expect them to return to the norm in the next quarter.

Can you elaborate just real quickly on the margins and the warranty reserve?

We made an adjustment to our warranty reserve in the second quarter -- a one-time adjustment to true up the warranty. Just based on -- we have a normal practice of reviewing all of our reserve accounts and based on your discussions with Quest and LabCorp, can you give us an estimate of when you think they will be down to the accepted levels they want to be at, and then secondly, the rest of the market, where--how long you think that will take, based on the latest information?

Yeah, Quest and LabCorp actually are--have been down to their--what I'll call their normalized inventory levels, probably--actually, I think LabCorp really never really had much of an excess to begin with, and Quest had by sometime during May was--already worked off any excess they had, so they've been ordering from us on a normalized basis for the last 30, 60 days or so. And the balance of the inventory at the smaller labs, we think will get worked down over the course of the next three to six months.

And, last question on this one, and then I'll get back in queue. In the earlier conference call that we had, there was an assumption that these smaller labs would try to approach that same 20 days that the bigger labs had set. Has there been any confirmation coming from the labs, that they in fact are and want to do that, and can do that?

There really hasn't been. We--that's the assumption that we've communicated based on a 20-day working inventory level. The smaller labs actually have not necessarily communicated that specific target to us. They all have different ordering patterns, many of them have a preference for ordering once a quarter, and we see being one shipment a quarter, and we're working with them to schedule those shipments as evenly--those quarterly shipments as evenly throughout the quarter as possible, so that we don't get bunched up from a logistics standpoint, and an internal administrative standpoint. But that's the benchmark that we're working toward, we'll see whether or not they get that low or not.

And then, Bob, one other question on the mix of labs. You said that it went from 50 percent in Q1 to 60 percent large labs in Q2?

That's correct.

And that helped ASP?

No, that would be--that would normally hurt ASP. That would cause ASP to go down. But ASP actually went up by 4 percentage points because of the absence of the sales promotion program at the end of the second quarter, as well as the mix of orders received within the non-large-lab category was actually favorable. So we had some favorable customer mix in the all-other-lab category, that caused the ASP to go up.

Okay, thanks for the clarification.

with Pacific Growth Equities, please proceed with your question.

Good afternoon. Bob, could you clarify, I think you mentioned that ThinPrep tests, that the usage was up--there was a number of 9 percent sequentially. Can you clarify what that means exactly?

The number of tests used in the second quarter was 9 percent higher than the number of tests performed with the ThinPrep Pap Test in the first quarter.

Okay.

So the growth in unit--the unit growth was 9 percent. You're probably more familiar with hearing that as on a percentage of market share basis.

Does that basically correl--

It correlates going from 50 percent to 54 percent.

Great. That's helpful. And when you're saying the 60 percent of the tests through the largest labs, is that in the past used to quantify that, I think it was either the big 6 or big 6 labs and what, what are you.

Yes.

Could you characterize.

It's the same labs, there has been some consolidation, so it used to be big 8 and now I think it is now the big 5 or 6.

OK, great. And then, it's been some time since, I don't remember if you have commented on this recently, but what is the latest number that you would consider to be the appropriate denominator for, you know, for market share purposes. Are we talking 50 or 55 million tests a year?

50 million tests is our assumption.

Okay, great. And then, question for Dan. You mentioned that you successfully were able to get some labs to standardize, agree to standardizing. What is typically involved in garnering that type of agreement from them? Is there any sort of incentives you are offering to try and get them to do that?

No, as Bob mentioned, we had no incentive programs available during the quarter of the sales and it is basically a discussion with the laboratory to talk about the advantages to them to convert with higher reimbursement for thin prep than the conventional pap smear, the streamlining of the lab operation by eliminating the pap smear and only taking in the thin preps and the ability to provide HPD testing from a single sample. So, the nature of that discussion as opposed to any economic concessions that we make on the thin prep testing price.

Okay. And then, with regard to the growth opportunity internationally, especially in Europe and I think you specifically pointed out Germany as a compelling opportunity. Can you address any of your plants perhaps to expand your infrastructure internationally or perhaps provide us with some details as to what you have in place currently and how you might grow that to increase your focus on the international opportunity?

Sure. I think we got direct operations in seven countries in Western Europe. Both operations have been in place throughout the year and we are adding people, sale people primarily in Germany, some in France, some in the U.K., and some in Scandinavia to capitalize on those opportunities. I think at the end of the second quarter we had approximately 60 people in Europe, going to about 90 by the end of the year would be my estimate. The majority of those folks are sales and marketing people.

Okay, great. And then, lastly, is there anything else you could say about anticipated timeline to where you might make a decision as to how to approach the STD testing opportunity and I know you mentioned gross but any updated thoughts as to your plans.

Well, as you know we just recently received the FDA approval for area testing. We have ongoing discussions currently underway with regarding that relationship and we would hope to have a positive outcome to report to you in terms of an agreement between the two companies.

Right, thank you.

Yep.

David of Thomas Weisel Partners LLC. Please proceed with your question.

Good afternoon. First this fits. Prior to this call you had mentioned that historic 60 to 65% of your sales coming in the last month of the quarter. Could you any shift you have see in that ?

The numbers in the second quarter was down from that level. It was more in the 45% to 50% of the sales, I believe, of the quarter occurred in the last month of the quarter.

and how do we think that is going to trend, let's say, by the end of 2002. Is there a target for the company at the end of 2002, or mid 2003, where they would like that number to be?

well we ought to be in the 30-40 range is where we targeted.

and when do we think we can get to that - if we can get to there by the end of the year?

yes.

okay. I think this follow-up question was asked previously. Just in terms of the ongoing relationship, has there been any movement to further expand these relationships to or and then more specifically, given recent nod approval letter with has that shifted the dynamics at all in that relationship?

I don't know that that event has changed the dynamics. We have - since the receipt of our FDA approval for testing, have had conversations with and would hope to have an agreement in place that would be positive for both companies, but it's - I am not able to tell you any of the details behind those discussions, or give you a timeline, but we are working our way through it.

okay, and then didn't you spend a fair amount of time talking about the you are seeing with the and the sales force there. What about some of the pushback that the sales forces reporting from the channel. If you add in those two or three of those concerns that those guys are saying, what would those be, tied to product.

I don't think those have changed since we've introduced the product. The priority concern is 'am I going to get paid for this' so reimbursement is number one. Number two is the time and liability as a surgeon to fit this procedure into an already busy schedule and a lot of that decision is also a function of reimbursement. So I think reimbursement is the primary issue that we run into in the field, and the second would be the time and allocating the appropriate amount of time to the procedure in the office.

okay Dan, is it still safe to assume that 80-85% of the focus for product now is tied to the northeast region of the country? Has shift already into other regions of the country that are material?

well, I think our original rollout was not as heavily weighted in the northeast as that. But most recently we have trained 10% of our OB-GYN sales force. A group in the metropolitan New York area and another group in the mid Atlantic area, those are places where we have trained surgeons, center doing and we have got pretty good reimbursement, so I think today the emphasis is very heavily weighted toward the northeast and the mid Atlantic. If you add all of the resources together, both the direct sales force for and the OB-GYN sales force, we are pretty heavy now in the mid Atlantic and the northeast.

okay, thank you very much.

our next question comes from at UBS . Please proceed with your question.

good after noon. A couple questions. First question was the sales and marketing expense looks like it was up sequentially and I know it trended up in the past as well, but it looked like it was up a little bit more than it has trended up historically. Wondering if there was anything you've done there in terms of motional activities, that were different than you've done in past quarters?

Binner, we hold our national sales meeting in the second quarter of each year, or at least we did in the second quarter of this year and we did in the second quarter of last year. And so that is a one time expense that occurs in that second quarter that usually causes it to trend up a little bit. I think if you look back over the last four quarters of last year, you will see that it generally trends down in the remaining quarters of the year.

Right, OK. And I noticed that there was an up-tick in the second quarter of last year, as well, it just wasn't quite as steep. In other words, nothing else really in there other than the one time, or the annual expense, that you see in the second quarter for the sales meeting?

We may have had, you know, gotten our Ductal Lavage organization more up and running by the second quarter. It was just really kicked off in the first, so I think we were getting people in place, etcetera, etcetera.

OK. Fair enough. And then, on the gross margin, I know that, obviously, there was a product and geographic shift there that impacted the gross margin in the quarter, but I think you also mentioned a lower gross margin in general on the . Is that something that's going to continue going forward and, if so, what's driving that?

I would not expect that to continue going forward. We did have a one-time of our warranty reserve that depressed margin rates in the second quarter and that's a one-time event.

OK. And then, lastly, one more question and I'll get back in the queue. What was the Digene royalties in the quarter?

We didn't specifically indicate the Digene royalties. We said, in total, that Digene Ductal Lavage service and accessories were a million three for the quarter.

OK. Thank you.

Our next question comes from Nathan of Banc America. Please proceed with your question.

Hi, guys,

Hi, Nathan.

A couple of quick questions, here. First of all, on, you talked about the paper that the doctor presented at where the person or the doctor used the results from Ductal Lavage to change the way he was treating the patient. He talked about how, or what changes were made in the way the doctor treated the patient because I know that's been an issue when we've talked to the people in the field is what to do with the information.

Yeah, Nathan. In that paper, the most significant change is the fact that women who have this result of Ductal Lavage in the OR are more likely to go on Tamoxifen in this Dr. experience. Women who have atypia normally are offered Tamoxifen to prevent the development of breast cancer and many reject that because of the side effect profile of that medication, but with these results in hand, having had a surgical procedure and a Ductal Lavage that was abnormal, he was much more successful in having this group take Tamoxifen. That's the primary change that he indicated in his paper.

OK. That's good. Also, can you talk a little bit about, I know you've talked about 1.3 million in sales from royalties product and etcetera, and can you frame the magnitude of product a little bit more. I mean, was it, you know, less than a million but more than half a million or were you still talking in the low hundreds of thousands. It's small potatoes, but it's kind of important for the ramp and the, how the market acceptance of the product.

I think we'd prefer not to help you zero in on the real number, Nathan, just to, I think the way to think about this is we have these initiatives in place, the 3 initiatives that I've talked about, and I think that we're seeing very positive signs in training additional physicians, seeing reimbursement come around, seeing use of the product in the operating room. I think the big upside, a wildcard for us, frankly, is the news related to hormone replacement therapy and our ability to participate in providing some value there. But we're early stage with this product.

OK. Fair enough. One last question -- I'll give (inaudible.) Can you tell us how you're going to trim the fat going forward in terms of your and your , because you talked about adding quite a few reps in Europe, but yet we're going to see decline here in the second half of the year. Can you tell us what you're - what kind of initiative you're doing to get the expense down?

Well, I didn't mean to imply that those additional sales people were not already in our numbers. But the projected expenses that we've given -- guidance to include all of those additional people.

Yeah, I know, understood. But yet, your expenses are gonna be lower in the second half than they were in the first, yet you're gonna have more people. So, I was just wondering, you know, what kind of ...

We basically have different levels of program spending in the second half than in the first, Nathan.

OK. All right. Thanks a lot.

Ladies and gentlemen, as a reminder, to register for a question, press the one four on your telephone. Our next question comes from of Chilton Investments. Please proceed with your question.

Hi. I apologize if this is repetitive. I was on the call late. With respect to the ductal lavage, are there sort of standard protocols in place as to how the physician reacts to the test results?

Yes, there are. There was a paper that appeared in the journal "Cancer," in the fourth quarter of last year which really was a treatment algorithm based upon ductal lavage results that was published by a consensus -- was a consensus paper as a result of a risk assessment working group discussion that took place, and analysis that took place. That paper was published in "Cancer," and it very clearly indicates treatment algorithm and treatment guidelines for physicians who are performing ductal lavage.

And, you may have addressed the gross margin already, but the deteriorization -- was that just absorbing higher fixed costs, I assume?

It was a piece of that. It was unfavorable instrument margins largely related to an adjustment to warranty reserve one time. And it was unfavorable mix related to the proportion of business that was done outside the U.S. versus the U.S. market, which has higher margin rates.

Because your margins have pretty much been rock solid the last several quarters, and this was a fairly dramatic decline.

Well, we have -- we had a significant reduction in the number of the amount of our sales related to the ThinPrep Pap Test Disposables - $25 million from the first quarter. That's our highest-margin product, so the fact that that was a smaller piece of the overall portfolio put downward pressure on the margins.

And we expect those to return ...

Yeah, we expect them to return to the norm in the next quarter.

Can you elaborate just real quickly on the margins and the warranty reserve?

We made an adjustment to our warranty reserve in the second quarter -- a one-time adjustment to true up the warranty. Just based on -- we have a normal practice of reviewing all of our reserve accounts, and adjusting those accounts based on new information that comes to light. We have calculations that underlie each of the amounts, and we adjusted our warranty reserve based on the most recent 12-month warranty expense results.

Hello?

Your next question comes from of USB Warburg. Please proceed with your follow-up question.

Just a quick follow-up. On the balance sheet, in the other current assets line, I just wanted to know if you could refresh my memory, what is exactly in that line item. I know it trended up quite a bit in that first quarter, from the fourth quarter, and it's down this quarter, but still higher than historical levels.

Okay, those were costs largely related to the Digene transaction in the other assets?

Okay.

, please proceed with your question.

The market share numbers you talk about, that 54 percent number, what--is that a U.S. market share number?

Yes it is, yes.

Just U.S.

Okay. And I don't know if you have this handy, but if you do, if I could just have those numbers, say from the first quarter of last year, or going backwards or any way you want to give it, because I had some other numbers from press releases that don't foot out to the number you're giving now.

Yes, if you look at the first quarter of 2001, Q1 was 41 percent, Q2 was 46 percent, Q3 was 51 percent, Q4 is 57 percent, and Q1 of '02 was 64 percent, and then we readjusted based upon usage as opposed to shipments, so that would be--have been readjusted down to 50 to 55 percent was our estimate. And now it's back up to 54 percent. All the previous numbers were based on shipments to laboratories, not usage--

Okay.

... by physicians, and we made that switch at the end of the first quarter.

Okay, so that 64 percent goes down to 50.

Yes.

Correct.

And then, are you able to go back and redo the other numbers for usage, or is it just--?

I don't--I don't--

--so much water under the bridge at this point?

It's water under the bridge.

I don't think we'd be able to do that.

Okay, I can understand that. And then, over what time span do you think the build-up occurred? I mean, just doing some guesswork, looking at accounts receivable, it looked like maybe it started in the second or third quarter of last year. Is that a reasonable guess?

We have always had a quarter-end skew to our business for the last four or five years, so there's always been inventory at labs for--at the end of the quarter, for the last four or five years, it was part of the way in which the commercialization plan was unfolded. It was in our interest. It was also in the lab's interest to have inventory available for each and every test that was being performed, as physician demand grew, they had little visibility relative to the pace of growth that would occur in the coming quarter, and so you--I think you could always say that there was inventory in the system at the end of any quarter for the last five years.

Okay. Thanks. One quick, final question. Are the European operations profitable?

The European operations are pretty close to break-even.

About break-even. Okay, thank you very much.

, Pacific Growth Equities, please proceed with your follow-up question.

you expect for being in the training of OBGYN's actually perform the procedure. Do you expect to encounter any resistance in that area from the traditional breast centers and breast specialists in that particular community and is there any difficulties in sort of bridging the gap between those two separate doctors?

I missed the first part of the question, Al. I am sorry.

It didn't come through Al.

Okay, I think you mention as one of the growth drivers you are putting in place are the growth you are putting in place for This idea of being able to train OBGYN's to perform this test as well as that. Is that correct?

Yes.

Okay, I am just wondering what issues if any you are going to run up against as they relate to how these patients are normally treated and how these types of procedures might normally flow through to the breast cancer specialist and the breast centers. Are there any issues with sort of navigating that the gap between the two different communities that you are dealing will be OBGYN's and then the beast cancer specialists?

Well, I think it is interesting, Al, that all the work that we have done indicates that we a pattern to the OBGYN but if the highest volume of referrals go to the breast surgeon through the OBGYN. And that will occur even if that OBGYN is performing in the office. Those patients will still end up at the breast surgeon's office or surgery and so I think that while there may be some perception out there as we get more and more OBGYN's trained, that there is a conflict. In fact, the patient flow will remain. So, I think to that extent we will, in fact, potentially encourage more referrals to the breast surgeon.

Okay, and then, you know, if we look ahead perhaps, you know three or four years; how significant a portion of these tests would you expect to be done by the OBGYN?

I think it is too early for me to give any prediction. We are two weeks into the OBGYN activity and it is just too soon right now.

Okay, let's say based on the type of reimbursement you are getting to-date. What would that suggest that which doctor would be more likely to perform this ?

Again, it is much too early for me to make that prediction.

Okay.

Operator, any more questions?

Adam Weiss of Investments. Please proceed with your follow-up question.

Yeah, I got cut-off before. I was going to ask the margins on your European business are lower than the U.S. because you have to use distributors. Is that right, or?

Well the price points are lower in Europe then they are in the U.S.

Why is that?

market conditions primarily driven off of reimbursement.

And just general market conditions on a worldwide basis?

Most of the countries in Europe are single player system. The government and as a result the lab pricing is lower than here.

And, I think you made a comment about sales promotions, impacting your average selling price. I am just curious, given your huge market share and so forth, how prevalent are promotions?

That related to the second quarter. I am sorry to the ...

We had a sales promotion the first quarter that we did not repeat in the second quarter which part of the reason why our price points were higher in the second quarter than the first. We have used a variety of marketing programs over the last five years in order to encourage laboratories to work with us to increase conversion rates.

OK. And the last question I have is about the sales and marketing. I am sorry if this repetitive but the increase year over year is that mostly for the new products?

Sales and marketing expense increase year over year?

It was up 30 percent year over year.

We purchased a company by the name of Product Health in November of last year and we are in the process of commercializing that product product and we built out our sales and marketing organization and to support that commercialization effort. That is the most significant reason for the increase in year over year sales and marketing expenses.

And the increase in G&A? Almost 60 percent year over year?

Just normal build out of the organization to support a significantly higher bigger business.

And it is also the transaction that is including in this.

unid(?): Well, yes. I am not sure what numbers you are looking at. There is $6.1 million worth of G&A numbers in this quarter's results that are one time in nature that were related to the Dygene transaction.

I am looking at the $5.6 million G&A line compared to $3.5 million a year ago.

OK. It is simply building out the company's infrastructure as it grows.

OK. Thank you.

Ladies and Gentlemen I would now like to turn the conference back to Patrick Sullivan, Chairman and CEO of Cytyc for any closing remarks.

Thank you operator. We have made adjustments to the business in the second quarter to address the field inventory issue and we are executing on the plan, starting to see the results of our efforts. We are also focusing our key growth initiatives being the increased conversion of the Thin Prep Pap Test, the international opportunity, the Thin Prep imagining system and in particular, the . With $200 million on the balance sheet, we believe we have the financial resources and cash flow to take advantage of these significant opportunities. Thank you for your participation.

Ladies and gentlemen that does conclude the conference call for today. We thank you for your participation and ask that you please disconnect your line at this time.