Hologic Inc (HOLX) 2010 Q3 法說會逐字稿

Good afternoon and welcome to the Hologic Incorporated third quarter fiscal year 2010 earnings conference call. My name is Jessica and I am your operator for today's conference. Today's conference is being recorded. All lines have been placed on mute. I would now like to introduce Deborah Gordon, Vice President, Investor Relations to begin the call.

Thank you for joining us for Hologic's third quarter fiscal 2010 earnings conference call. I encourage everyone to visit Hologic's Investor Relations page of our website in order to view the PowerPoint presentation related to the comments that Glenn Muir, Hologic's Chief Financial Officer, will be making in his opening remarks. The replay of this conference call will be archived on our website to Friday August 20. A copy of the press release discussing our third quarter results as well as our fourth quarter and fiscal year 2010 guidance is available in the Investor Relations section of our website, under the heading, Financial Results.

Before we begin, I would like to remind you of our Safe Harbor statement. Certain statements made by Management of Hologic Inc. during the course of this conference call may constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements involve known and unknown risks, uncertainties, and other factors, which may cause actual results, performance or achievements of Hologic to be materially different from future results, performance or achievements expressed or implied by such forward-looking statements. Such factors include, among others, those detailed from time to time in the Company's filings with the Securities and Exchange Commission. We expressly disclaim any obligation or undertaking to publicly release any updates or revisions to any forward-looking statements, to reflect any change in our expectations, or any change in events, conditions, or circumstances, on which any such statement is based.

Also, during this call, we will be discussing certain financial measures, not prepared in accordance with Generally Accepted Accounting Principles or GAAP. A reconciliation of these non-GAAP financial measures to the related GAAP financial measures can be found in Hologic's third quarter 2010 earnings release, including the financial tables in the release.

Please note that today's conference call will consist of approximately 30 minutes of opening remarks from management, followed by a 30 minute question-and-answer session. We, therefore, please ask each participant to limit his or her questions to just one, with one follow-up, as necessary. We do appreciate you may have additional questions, so please feel free to get back into the queue, and if time permits, we'll be more than happy to take your additional questions at that time. With that, I would now like to turn the call over to Mr. Rob Cascella, President and Chief Executive Officer.

Thank you, Deb. Good afternoon and thank you for dialing into our conference call. Joining me on the call is Glenn Muir, our Executive Vice President and CFO, Steve Williamson, Head of our GYN Surgical business and David Harding, Head of International Business. We all will be available during the question-and-answer session. Our agenda for today's call is as follows, I will review our business performance and the recently completed third quarter, and Glenn will discuss in more detail our financial results, as well as provide our guidance for the fourth quarter and full year of fiscal 2010. We will then open up the call for Q&A, and as Deb stated, we will conclude this call in about an hour.

Well, I am very pleased to report that once again our quarterly revenues and adjusted earnings exceeded our guidance. As stated in our earnings release, Q3 2010 revenues were approximately $421 million, a 4.4% increase from Q3 of 2009, and slightly ahead of our guidance of $415 million to $420 million. Taking into consideration the impact of discontinued products and the effects of foreign exchange in the quarter of $5 million, revenues would have increased approximately 6% over Q3 from last year.

Our third quarter performance was driven chiefly by growth in our Breast Health and GYN Surgical businesses, offset by declines in Diagnostics and Skeletal Health. The improvement in Breast Health came from a combination of increases in revenues from service and our 2D and 3D Selenia Dimensions, while GYN Surgical growth was led by demand for both Adiana and NovaSure. Our revenue mix remains strongly weighted toward our Service and Consumable businesses, namely Diagnostics, Surgical and Breast Biopsy, which represented 74% of total revenues.

Third quarter non-GAAP earnings per diluted share were $0.30, ahead of our guidance of $0.29. This compares to our non-GAAP EPS of $0.29 for the same period last year. Our earnings are generally impacted by many changing variables. This quarter, for instance, earnings were affected favorably by increased revenues and tight control over operating expenses. Unfortunately, earnings were also negatively impacted by product mix shifts. In the quarter, we experienced higher Breast Health revenues which carry a lower gross margin than our average corporate rate, and also saw a reduction in our higher margin ThinPrep volume on a year-over-year basis.

I would now like to review our revenue performance in each of the four segments. In Breast Health, we recorded revenues of $189.3 million, an increase of 8% from $175 million for the same quarter, from a year ago. Sequentially, revenues were flat with Q2. The year-over-year increase was principally the result of strong growth in service revenues, as well as increased sales of our 2D and 3D Dimensions. Mammography unit volumes were up as compared to last year, as we are seeing a growing number of US customers purchasing the new 2D Selenia Dimension systems to upgrade their older systems and a growing number of international customers buying both 2D and 3D systems. Overall, ASPs were consistent with prior year due to larger percentage of higher priced Dimensions shipped in the quarter, which offset the shift in sales to lower priced DC-Chip Selenias. We expect product mix to change favorably with the emerging replacement market over the next nine to 12 months.

Demand for our Eviva breast biopsy product remains robust, and we believe we are continuing to take share in the stereotactic market. Similar to the prior two quarters; however, this business was once again impacted by reduction in the number of mammography screening exams which consequently reduced the number of breast biopsy procedures. From a longer term perspective we are cautiously optimistic the mammography and interventional breast product lines will trend upwards.

Turning now to diagnostics, we recorded revenues of $137.4 million, a decrease of 1.5% from the $139 million in Q3 of 2009 and down 1.5% sequentially due mainly to a reduction in ThinPrep volume. We believe the softness in wellness visits to OB/GYNs in the US is primarily due to the effects of high unemployment, coupled with economic uncertainty. It is important to note that based on our sales intelligence and discussions with national labs, we continue to believe we are maintaining our market share, so the declines in volume are not the results of competitive pressures. Also important to note is that although imaging revenues were slightly down due to a reduction in patient visits, imager adoption continues to increase.

Furthermore, we are very pleased that Cervista HPV sales increased both sequentially and year-over-year as we continue to open new accounts and gain traction in existing ones. Despite the softness in patient visits and ThinPrep test volumes, Cervista sales continue to grow, and we remain very optimistic about its potential to help drive our top line over the next year.

In GYN Surgical, revenues totaled $71.6 million, an increase of approximately 9% compared to $65.8 million in Q3 of 2009, and a gain of approximately 7%, sequentially. The improvement versus last year is primarily the result of continued adoption of our Adiana system in the US, and worldwide growth in NovaSure. With respect to Adiana, launch activities expanded in the quarter, and we now have our full sales team focused on training doctors and selling the product into our target accounts. We believe we continue to take share from a competing technology and have now reached low double-digit market share.

In Skeletal Health, revenues totaled $22.4 million, a decline of 2% compared to $22.9 million in Q3 of 2009, and a 4% increase sequentially. We continue to remain optimistic the results of recent favorable changes to reimbursement will have a positive impact on demand for our bone densitometry systems over the next several quarters.

I would now like to talk about a few topics of interest, the first being our acquisition of Sentinelle Medical. In early July, we announced the signing of a definitive agreement to acquire Sentinelle Medical, a Toronto-based Company established in 2004 and engaged in the development and marketing of MRI breast coils, patient positioning and transport systems, and MR-CAD workstation solutions. The closing of the transaction is expected to occur later this week. Sentinelle has developed a strong brand by delivering superior image quality through the use of proprietary coils. They have also developed an innovative MR-CAD and work flow solution that potentially surpasses many of the existing products on the market.

The Sentinelle team will remain in Toronto, and will be run as a division within our Breast Health group. We fully intend to maintain and grow our strong OEM relationships, while also selectively selling certain, more complementary products, direct. We believe Sentinelle represents best of breed technology, consistent with the approach Hologic has taken. This acquisition is yet another example of expanding our offerings in the Breast Health market and provide significant product and technology synergies with both our breast imaging and interventional businesses.

Hologic and Sentinelle also share common operating philosophies. A commitment to excellence, a determination to provide only Best-in-Class products, and a passion for women's health. The people at Sentinelle are some of its greatest assets, which we intend to cultivate.

Now to move on to Tomosynthesis. As most of you are aware, on July 27th, we announced that the Company's Tomosynthesis system is scheduled to be reviewed by the Radiological Devices panel of the FDA on September 24th of this year as part of the Company's PMA application. The PMA application being reviewed was originally filed in 2008, and subsequently updated with additional data and seeks approval of the use of the system for both screening and Diagnostics.

Scheduling of this panel review is the result of our ongoing discussions with the FDA. We believe this is the positive turning of events and a valuable next step in our approval process. This does not mean we will discontinue the clinical trial currently underway, and as discussed previously, we anticipate multiple FDA submissions over the next six to nine months. We are extremely pleased to have a set panel date to review our exciting next-generation technology, and remain committed to striving to work some level of approval in 2011.

Now, for a brief update on the economy. We continue to closely monitor the effects of that unemployment is having on the healthcare consumer. As we have mentioned in today's discussion, we have felt the impact of wellness exams being deferred in favor of addressing the mandatory healthcare needs of the family. This is translating into lighter procedure volumes for ThinPrep and breast biopsy products. We continue to believe that the fundamentals of these businesses are sound, and this recent softness is short-term in nature.

On the European front, we are seeing an impact from the economic conditions they are experiencing, both in terms of unit volumes and foreign currency. Although we are not in a position to project the outcome of austerity measures that may be implemented, or any potential impact such measures may have on our business, we did experience lower procedure volumes and equipment purchases in the quarter, resulting from the current economic climate. We will update you in the future as we gain more clarity on the economic conditions abroad, the impacts of reform, including changes in reimbursement rates and our efforts to preserve and enhance our profitability in the face of these changes.

With that, allow me to summarize. I am encouraged by Hologic's performance in the third quarter, particularly as our capital equipment business continues to show signs of stabilization, and our most recently approved products, Cervista and Adiana, are gaining traction and contributing to the growth of our business. Nonetheless, we continue to continue to face some challenges related to high rates of unemployment in the US and the European economy in general. I remain confident, however, in Hologic's longer-term growth prospects, particularly as our new products mature and increasingly contribute to our revenue and earnings, and as we continue to build our international infrastructure in order to grow our business outside the US.

I will now turn the call over to Glenn to provide the third quarter financial details and guidance for the fourth quarter and full year of fiscal 2010.

Thank you, Rob. As Rob stated, consolidated revenues came in just slightly above our expectations, primarily as a result of the strong performance in our Breast Health segment, led by Service, which was up $13 million year-over-year. We also saw nice growth in GYN Surgical from an increase in NovaSure procedures, coupled with growing Adiana sales. Our mix of domestic and international sales was 80% and 20%. Foreign currency translation had a modest negative impact of $1.5 million, which was less than 0.5% year-over-year on our reported revenues. Primarily within the Breast Health and Diagnostic segments.

Turning to the rest of the P&L, our gross margins, on a non-GAAP basis, were 60.2%, down 130 basis points from the second quarter, and down 240 basis points from last year. The gross margins were just below our guidance range of 61% to 62%, due chiefly to, first, we saw unfavorable yields in scrap and on our Adiana manufacturing line resulting in unacceptable margin levels that are improving with time and volume. Second, the write-off of unabsorbed overhead on our NovaSure line, resulting from an adjustment in production levels related to the switch to the new-generation Protostar version. And third, lower ThinPrep volumes, which is a higher than average gross margin product for us.

Non-GAAP gross margins exclude $43.5 million of amortization of intangibles in the third quarter. On a GAAP basis, gross margins were 50%. Going forward, we are expecting gross margins on Adiana and the new NovaSure Protostar to improve with increased volume.

Our operating expenses continue to be well controlled. Operating expenses on a non-GAAP basis of $116.7 million, primarily excluding amortization of intangibles of $13.6 million, came in $8.7 million below our second quarter and down 2% compared to last year. This was below our guidance range of $128 million to $130 million. This decrease from Q2 of 2010 primarily resulted from a reduction in our legal fees. We do continue to invest in R&D related to clinical studies and next generation products, and reported an R&D ratio of 5.8% as a percent of revenues in both Q3 of 2010 and Q3 of last year.

In the first quarter of fiscal 2010, we adopted a new standard that changed the accounting for convertible debt instruments with cash settlement features. The additional charge, resulting from the adoption of this accounting guidance, was $18.5 million this quarter, and $17.1 million in the third quarter of last year. This non-cash interest expense charge has been excluded from our non-GAAP results of operations for all periods presented. Absent the acquisition related and other charges, pretax earnings this quarter were $122.1 million. Using our annual effective tax rate of 36% for the quarter, non-GAAP net income was $78.2 million, versus non-GAAP net income of $75.5 million last year, an increase of 3.5%.

Our total dollar backlog for all of our products was $286 million at the end of June, down from $297 million at the end of March. The majority of this $11 million decrease was in Breast Health, where the reduction in backlog was related to a weakness in international orders. The summer is always a seasonally slower quarter for our CapEx business, which makes up the majority of our backlog. Even still, we are encouraged at this point in the quarter and are expecting Q4 bookings to be similar with Q3.

Turning to the balance sheet, during the third quarter we fully repaid our $540 million term loan, with a final payment of $47 million in April. Our plans for use of cash are focused on investing in our current technologies and operations, our current acquisition of Sentinelle, and potential future deals as well as preparing for the possible redemption of the convertible notes beginning in December of 2013. Regarding free cash flow, we generated approximately $125 million in the third quarter of 2010, comprised of approximately $137 million of cash flow from operations, less capital expenditures of $12 million.

Now, moving on to guidance. All of our guidance does exclude the acquisition of Sentinelle, which we are expecting to close later this week. For the fourth quarter of fiscal 2010, ending on September 25, we are expecting revenues in the range of $415 million to $420 million, comparable to Q3. We expect gross margins of approximately 60% to 61%, on a non-GAAP basis.

We are expecting operating expenses, primarily excluding amortization of intangibles to increase slightly on a sequential basis from Q3 to $118 million to $120 million, or approximately 28 to 29% of revenue. We expect interest expense to be approximately $29 million in Q4, including $18.7 million of non-cash interest expense as a result of our adopting the new accounting guidance related to our convert. Our effective tax rate is expected to be 36% and we expect non-GAAP earnings per share of $0.30 per diluted share.

Now, for fiscal 2010, which ends on September 25, we are increasing our total revenue guidance. We are you now guiding to full year total revenues in the range of $1.665 billion, and $1.67 billion, up from prior guidance of $1.64 billion to $1.665 billion. This is due primarily to our revenue outperformance in Q3. This reflects the current level of capital equipment stabilization and our outlook for flat to slightly increased GYN Surgical revenues, and flat to slightly decreased Diagnostics revenues for the remainder of the year. We are guiding to non-GAAP adjusted EPS of approximately $1.17 per share, compared to our prior guidance range of $1.16 to $1.20 per share. This guidance reflects gross margins of 60% to 61% for the year.

We are expecting operating expenses to be in the range of $491 million to $494 million, up approximately 2% to 3% from fiscal 2009, and excluding amortization of intangibles. We're expecting interest expense to be approximately $126 million, including $73 million of non-cash interest expense from the new accounting guidance related to the convert. And we are expecting an effective tax rate of 36%. Turning to cash flow guidance, in fiscal 2010, we expect to generate approximately $450 million of free cash flow, excluding the $70 million payment from KV we received in January, and excluding the $85 million payment we expect to make this quarter to acquire Sentinelle Medical. We are expecting capital expenditures of close to $50 million, and depreciation of approximately $70 million for the year.

In summary, we are pleased with our third quarter revenue performance in the face of weak office visits, caused by economic factors impacting unemployment, as well as the ongoing difficult global economic environment, including uncertainty over changes in healthcare regulations. Despite these headwinds, we were able to increase our revenues, and we believe our market share for many of our products. We expect to see our gross margins and earnings improve over the near to long term, as many of our new products grow in volume. Given the continued external pressures to control healthcare costs, we are attempting to remain conservative in our outlook. Now with that, let me turn the call back to Rob.

Thanks, Glenn. To wrap up, we remain on track to meet our full year guidance, and are optimistic as we begin to look out to the next fiscal year and beyond. We believe we have a strong product portfolio that can fuel growth over the long term. Our focus in the meantime is to continue to build our foundation for future growth, both domestically and abroad, invest selectively in new opportunities through product development and acquisition, and finally, manage our businesses with an extraordinary commitment to our customers. Finally, I'd like to thank you all for your participation on the call. This now concludes our remarks, and we'd be happy to answer any questions that you might have. With that, operator, please open the lines for questions.

Thank you. (Operator Instructions). And our first question comes from Thomas Kouchoukos from Stifel Nicholas.

Hi, good afternoon, guys. Congratulations on the nice quarter.

Thanks.

Just wanted to start on the ThinPrep business. I don't think it should be a surprise to anyone that patient volumes were down but you also commented on the extended intervals as having some impact during the quarter. Just looking forward, assuming that we do see patient volumes tick back up over time, how do you see the interval issue affecting your business going forward?

Certainly it is the lesser of the two areas of concern, but nonetheless, we would anticipate, based on changes in guidelines, a higher degree of co-testing for HPV, that the PAP intervals will expand. As I say, I think it will be the lesser of the effect than what we're seeing today but nonetheless we would expect it to continue.

Okay. And then as a quick follow-up, just looking at Adiana, I know there's been some concerns in the recent past about Adiana not being able to share the 58565 code with Essure in the marketplace. I don't know that anything definitive has been published at this point but was wondering if you could comment on that and maybe your outlook for that reimbursement code.

Sure, and in February, the AMA had a meeting to discuss the code, and the ability for Adiana to share the 58565 code. The results of that meeting were private, but the decision of that panel was subsequently appealed to a meeting that was held in June. Again, the June results are private, but what I can tell you is that we'll continue to tell our customers to use 58565 until something becomes available where we can share the final results.

Okay. Thanks. I appreciate that.

We'll now go to Bill Quirk from Piper Jaffray.

Yes, thanks, good afternoon. A couple of questions. First is Glenn, just thinking about the bottom line guidance here, we beat by a $0.01, trimming the full year number by a $0.01. I assume a lot of this has to do with mix but can you give us any additional color around that.

I'm sorry, Bill, on next --

I'm sorry. Looking at the fourth quarter guidance, rather than the full year guidance, just beat by a $0.01 in the third quarter, but we're basically taking the fourth quarter down by a penny. I guess I'm trying to figure out here, you mentioned mix earlier, obviously higher mammo, lower Diagnostics, is that essentially why we have the guidance change?

I think mix is a big part of it. I think it doesn't help that our -- if we look at our revenue for a moment and our earnings and our gross margins are going to be very dependent on our revenue growth going forward. And to a certain extent, we are guiding to a flat Q4 from Q3. But within the revenue stream itself, you are correct, that some of our higher gross margin products, such as ThinPrep, are down a little bit. We are seeing this weak visits on the patient side and they are being replaced in other areas of the business, such as on the Breast Health side, where even though service is growing and even though we are holding up nicely on the product side, it does come at a little bit of a cost on the gross margin side. So that mix differential did have impact on our guidance as we look to Q4, that's correct.

Just as a follow-up, Rob, appreciate the color on the physician office trends, and essentially your view on that. Can you talk a little bit, longer-term, here, do you expect to see a little bit of a deductible phenomenon here in the calendar fourth quarter, or is this something that we have to wait until 2011 before we start seeing people going back to the doctor? Thanks.

Thanks. I don't -- we are not expecting a trend change in our fiscal fourth quarter. However, we do think as we roll into our new fiscal year, that we'll see some of the benefits of a re-upping on insurance and resetting of deductibles. The unfortunate part is that we believe that until there is a material improvement in unemployment, that there's always going to be some downward pressures on wellness visits. So that is a gating item that we think improves over time, but we certainly don't see that in the near quarter.

Understood. Thank you.

We'll now go to Sameer Harish from Needham & Company.

Hi, guys. Thanks for taking the questions.

Sure.

Hello, can you hear me?

Yes, sure.

Sorry about that. Just maybe talk about a bit about the upcoming Tomosynthesis panel that you have in September, just how you're viewing the potential outcomes of the panel meeting, both in terms of time lines for approval and expense expectations coming out of it?

Obviously, whenever dealing with a situation like this, and particularly with the agency, it's difficult to predict the outcome. We are encouraged about the indications that we've seen and heard thus far. We are not changing our date of saying it's sometime within 2011 that we'll have approval. But again, we believe this is a very, very encouraging sign for us to now have a panel date and be able to present in greater granularity some of the benefits of the technology. Sorry to be vague about it. It's very difficult to predict the outcome of such things, other than we believe it is a positive move on both parts.

And just in terms -- to follow up on organizational changes with 3D Mammography, what would you have to do within the organization to do an initial launch of that product? And what sort of investment would you have to make?

And keep in mind that we have launched 3D Mammography or tomosynthesis abroad. So we are selling product routinely in Europe and in other parts of the world. The requirement for Tomosynthesis is that it differently than digital Mammography, it does not only cause us to provide clinical training, but it also requires us to provide training for the radiologist in terms of how to read Tomo, not just how to operate the system. So we have built an infrastructure and a training protocol for our European sales to effect just that, and we anticipate that would be done on a US basis as well whereby we would conduct fairly comprehensive reader type training programs and that really being the only thing different in terms of a launch of the product. Its service requirements are very similar. I think from a sales perspective, obviously there's much more sales training that will go into it, but the true incremental cost will be physician training.

Thank you.

We'll now go to David Lewis from Morgan Stanley.

Good afternoon. One question for Rob, one question for Glenn. Glenn, I want to start with you. This is a kind of interesting quarter. SG&A on both a relative and an absolute basis was the lowest we've seen in I think two and-a-half years and what we've seen in that time frame is GMs come down incrementally and operating margin still maintained at the same level through lower SG&A. Wonder if you comment at $92 million SG&A, at these levels, is this trend we've been seeing the last 2.5 years sustainable?

There was a conscious effort going into 2009 when we were concerned about the economics out there in the world that we consciously brought down our expenses by over $50 million that year, and I think in 2010, we've tried to hold expenses, and as a quarter looks a little bit weaker than another, there are levers that we can pull on the SG&A side. So I would say that a big chunk of that is the controls that we put in place. But David, I don't think it's sustainable to the extent that we can continue to drive it down.

I think at this point we have driven it down to a fairly low level for the type of operation that we have and I would expect going forward as our guidance underscores in Q4, and when we look out into 2011, we would expect it to come up as well. I mean, R&D is that one area where we're trending right now just under 6%, that we wouldn't expect that to go down in the short term. I mean, we do have a lot of initiatives internally that we are looking at and a lot of programs under way that we think can move the market in the future. So we're going to continue at that 6% level, even on a higher revenue base. But on the G&A and on the sales and marketing side, that's where we have more flexibility.

Okay. Very helpful, Glenn. Thank you. Rob, two questions. You made a statement about Tomo, that you expect an approval one way or the other in 2011. When you say an approval one way or the other, I'm sorry, I'm paraphrasing, do you mean Screening or Diagnostic, is that what you meant to say? And my second question, could you share with us at all, because it will be a matter of public record in six weeks, what additional data was provided to the Agency that we'll see in the panel. Thank you.

Sure. And look, we intend as we had said earlier in my portion of the script that initial PMA called for both Screening and Diagnostic and that is our intent. That is the approach that we're taking with the FDA. Whether or not we prevail is another matter, and whether there is a more limited indication is certainly something that will have to come out of not just the panel, but obviously in the FDA's final review. The additional data that was referred to, David, had to do with a follow-up through our original submission, all done within the original PMA. So when we submitted clinical data, the FDA came back and asked for some additional information, and we had submitted that a year ago. It really was a matter of I think the FDA now having the mindset that they would review that data more carefully, that has now prompted us to go to panel with that information. So there really was no information from any of these additional clinical trials that we've done. It is simply data that was presented probably well over a year ago.

Great. Thank you very much. Very clear.

Our next question comes from Jayson Bedford from Raymond James.

Hi. Good afternoon. Thanks for taking the questions.

Sure.

Just a couple quickies. Can you help us reconcile the US Mammography market in terms of you guys are growing units on a year-over-year basis, yet the MQSA data is going the opposite direction. So is there any color you can give? It certainly seems like you've taken some share but I guess maybe best guess in terms of replacing digital for digital?

I think you're right on the first point of taking share. Our focus has been in this somewhat more mature market, the emphasis has really been on going after as much of the available market as possible. High end, mid-tier and low end products. So we have segmented the market with a pretty broad range of product offerings. With respect to what happens going forward relative to the replacement market, we had said, and continue to say, that replacement market has yet to really evolve and that it's probably now nine to 12 months away. In terms of it being a more normalized replacement market.

And what I mean by that is that in complete market maturity, that's probably more like a 10 or 12% number of the installed base turning over on an annual basis. We're nowhere near that today and feel that over the next nine to 12 months, we will be approaching probably a 5% to 7% of the installed base turnover, but it won't be for another couple of years until we're back to a level of market maturity that would suggest that the only units being sold are those that are replacement in nature. And by the time that happens, we feel pretty comfortable that there will be yet another new technology which will be Tomosynthesis and it will start that whole technological succession over again.

Okay. And Rob, I may be misunderstanding this, but is it fair to say less than 10% of your new digital units being sold in the US are replacing existing digital?

Yes, I think that's very accurate. It is clearly less than 10% today.

Okay. And just as a follow-up, maybe for Glenn, on the gross margin side, Glenn, you listed three factors impacting that. Just trying to figure out kind of what is the biggest impact from those three, meaning you mentioned scrap on Adiana, write-off of the NovaSure overhead, and lower ThinPrep volumes. What's had the biggest impact?

Jayson, I really listed them in order. Number one was the biggest impact is the start-up cost related to Adiana and this is all about yield and it's about scrap. It was a tough product for us to transfer from California down to Costa Rica. We're making tremendous process. We've now gotten the manufacturing volume up where we can meet the sales demand but nowhere near the margins that we feel are acceptable over time. So that's number one.

And that is followed by the Protostar by NovaSure. As we built up production prior to the launch of pro toe star, of the old version, in order to have enough on hand, it did create an imbalance between quarters as far as our production volumes, and it did create some unabsorbed overhead in earlier quarters that got expensed out in Q3. And the start-up on Protostar. That is secondary to Adiana. I would say those two points are -- they're pretty much one-time. They're early on in the process. We feel very confident it's only going to get better on those two items going forward.

The third, on ThinPrep is a little bit harder to tell. That was directly related to volumes of ThinPrep, especially here in the United States. International seems to be holding, but it was affected here in the United States and that's one of our higher gross margin products, so that did have a strong impact on the gross margin.

Thank you.

And we'll now go to Tycho Peterson from JPMorgan.

Hey, thanks for taking the call. Just a question I guess on mix. Can you talk specifically on Mammography, what maybe percentage of the units you're replacing now are upgradeable, versus the Encore, that are in the value system?

When you say upgradeable, you mean the Dimensions unit.

Yes, Tomo-capable.

It's probably somewhere in the area of 18 to 20%.

Okay. And then I guess to your comment before on we're not really seeing a replacement cycle yet, can you just talk about the competitive dynamic as it stands today. Obviously you now have more of a time line potentially around the 3D product. Just talk about your discussions with some of the GE customers. You have always talked about the opportunity to swap out some of those early adopters, how are you looking at that?

We are heavily focused on looking at older units from any of the other manufacturers, including our own. And we believe that we have a strong reason for them now to convert and to trade up to a product that is truly software upgradeable to Tomosynthesis. It is a matter of we are really working the existing installed base of products, Tycho, and every one of them is obviously a sales opportunity and yet also a sales challenge and you could rest assured that our competitors are not lying silently in the dark and allowing us access without some level of response about their future product line or their future road map for their product line, I should say. So it is clearly a focus, but every one is not a win but we clearly are making in-roads into installed bases of competitive products for the reasons I just gave in terms of the nearness of the dimensions product.

And then with regards to the follow-on studies for Tomo, have those been halted or how do we think about the additional data generation or just do you use that for marketing purposes? What's the thought process there?

We're continuing on with the clinical trial. We're continuing to aggregate cases. That data are going to be used for a variety of different reasons. It will be ongoing clinical studies. It could be used for the FDA if need be. And in addition to that, we intend to use that data for reimbursement purposes. So it will be a strong support of the clinical benefits of the product, primarily from a private pay perspective, to show better cancer detection rates, lower recall rates, and so on and so forth. In addition to that, we are conducting a variety of international studies all over Europe to gain clinical adoption and credibility for the product in different parts of Europe.

And then just last clarification one for Glenn. Your comments on the margins before, for Adiana, is it fair to assume that this has been a little bit more of a hurdle than you anticipated and how do we think about for that product in particular getting back to -- I think you called it unacceptable margins. How do we think about you getting back to acceptable margins there?

The acceptable margins would be closer to the type of NovaSure margins that we get which is in the 70% range, and that's what we're aiming to get to but that's probably a year away. It will take us a little bit of time to get up to that level. Part of it will be volume and part of it are the engineering changes that we're making on the product itself.

Okay. That's helpful. Thank you.

And as a reminder, we do ask that you limit yourself to one question and one follow-up question. Our next question will come from Amit Bhalla from Citi.

Good afternoon, everybody. So I actually do have a follow-up on the gross margin. Glenn, you mentioned that the factors that you laid out, those three, were the biggest chunks of them were one-time in nature but you are taking down a full year gross margin by a point. So I'm wondering do you just walk through how and to what level the gross margin's going to improve over the next three or four quarters, and what the longer term targets are for gross margin.

Yes. Well, if we think about Q4, I just want to be careful that we don't expect any quick fix here that would impact Q4. So we are more comfortable in the 60 to 61% range. But any time you talk about gross margins, and I try to identify some of the major pieces, but underlying those pieces, there's other factors in our business as well, and you almost have to look segment by segment.

So we looked at the two biggest pieces, and the biggest negative impact in gross margins came first of all from the GYN Surgical, and that group I would have to say, some of that we can work ourselves out of through manufacturing improvement and through volume, as Adiana continues to build. In the other area of Diagnostics, primarily on ThinPrep, we'll need the ThinPrep volumes to go back up to get any kind of real improvement. But at the same time, we do see Cervista growing on the molecular side. That's helpful over time as well, and we're estimating right now with Cervista, that our market share is at the high single digit kind of level, so we continue to make progress in the marketplace with Cervista.

But then the third change I'm trying to get to is really in the Breast Health group and even though in we look at the PowerPoint and the numbers that we put forth in that segment, that it doesn't look like the gross margin didn't change very much and it didn't. There's some underlying dynamics in that the biggest growth driver we have today in Breast Health happens to be from Service. So if I look out into the next year, we are continuing to expect Service to grow. We can see that volume because we know the product has been put in the field. On the other hand, there's more uncertainty around the product.

So there is a change, even in the Breast Health, that the gross margin may come down a little bit because of service, and a reduction on the product side. But at the end of the day, the service has a net margin that's more profitable to us than the product does, just because it doesn't have R&D, it doesn't have sales and marketing, it has very little G&A. It's a very profitable part of the business. We just won't see it in gross margin but it's going to drop to the bottom on a net margin basis.

So Glenn, additional follow-up question is on Cervista. Can you talk about some of the trends in adoption of Cervista and that comment you just made about high single digit levels for share, I thought you were talking last quarter about double-digit. Did something change?

No, nothing changed. I'm pretty sure we said high single digit.

Yes, I think we've been kind of around that area of high single digits. I think we'll cross over the low double digits over the next quarter to two. But that's been fairly consistent. With respect to Cervista, though, you had a specific question? I'm sorry.

Can you talk about some of the adoption, give us some more color on sites that are still validating the technology and what trends you're seeing in adoption.

We remain pretty encouraged by Cervista and what I mean by that is we continue to win additional labs on a monthly and quarterly basis. We are now finding that obviously 16 to 18 is rolling out to the national labs. We're in ongoing discussion with the national labs from an initial adoption point of view of our high risk test. All but four of the national labs were having very good success with our first phase of automation. So I think the results are very positive. Obviously the hurdle for us, as it has been, is we want to continue to be in the market with our current levels of automation and we want to get our HDA product across the finish line as we had talked about in 2011.

Okay. Great. Thanks.

We'll now go to Josh Jennings from Jefferies & Company.

Hi, thanks guys. Good evening. Just on the GYN Surgical guidance, flat to slightly up, if you look at where NovaSure was last year and Adiana, is this suggesting that you're going to have sort of a year-over-year down-tick in the NovaSure product line?

No, we actually for our GYN Surgical, we had a record quarter this quarter. We continue to see growth obviously from Adiana and taking share from Adiana but on the NovaSure perspective, we see growth both domestically and internationally with the product, and we're encouraged with where the product is in the marketplace. In terms of what's going on in the economy.

In terms of the guidance for Q4, you're still expecting NovaSure product year-over-year to grow?

Yes.

Okay. Great. And just in terms of your international strategy there, can you just talk about sort of what inning you're in internationally with NovaSure, sort of some of the strategic initiatives to grow that business line and maybe give us an idea of what percentage of revenue from the NovaSure product does come from international markets. Thanks a lot.

This is David Harding. Thanks for the question. As far as our strategic initiatives, they are several-fold. We invest most of our efforts strategically in Europe. That is the largest marketplace for NovaSure.

The real growth areas are coming out of our Benelux region, certainly the UK has been exceptionally strong and we are investing more and more in the Southern European countries as well as Germany. So from a strategic focus perspective, adding some headcount, adding more salespeople there to take advantage not only of NovaSure but also of Adiana, potential has been an area for us. Australia is also a very rapidly growing area. We're going to add some additional resources there.

In terms of the mix of revenues, I don't think we're prepared to kind of disclose the various mixes between international and domestic at that level of granularity. But suffice it to say that we are in fact growing NovaSure in kind of the 20 to 30% range on a year-over-year basis in terms of international revenues. So we're very, very excited about that product and about Adiana as well.

All right. Great. Thanks a lot.

Our next question comes from Amit Hazan from Gleacher.

Thanks, hey, good afternoon, guys. I thought maybe first question would be about the backlog. It looks like it's a second quarter in a row where backlog has declined. Thought I'd try to reconcile some of the things you said on the call. Your units on Breast Health were up, but you attribute the backlog decline to Breast Health. So I'm wondering if you could just talk about what's been going on there for the last two quarters, if units have been increasing, if we really have that significant of a drop in ASPs to take your total backlog down?

Hi, it's Glenn. Yes, the backlog has come down the last two quarters, and it is a function not related to ASPs, but as far as order volume, and especially this quarter we've seen it on the international side and that -- I did make the comment that what we're seeing in the market going into the summer months is a pretty stable order rate for us, comparable to Q3. So we feel good about the current order rate but we do appreciate that for the last two quarters, it wasn't at the same level as our shipment rate. So that's why you saw the backlog come down.

But as it relates to ASP and Rob touched a bit upon this, we are getting a positive ASP from the sale of our dimension product line and if we look at just the 2D version for a moment, because we are selling the 2D heavily, we are at that 20% level as far as our total units and I'm not trying to give out unit numbers, but just to illustrate that 2D is becoming more important and it's a product that not just new customers look for but replacement customers look for as well and that product is helping on our ASP side of the equation, more so than some of the D feature Selenias that we talked about in the past.

Okay. Great. That's helpful. Second question is on the Diagnostic side, on PAP testing in particular. I'm just trying to figure out if -- since your revenues were down sequentially as well, whether testing volume in terms of the economic weakness, had changed at all from Q1 to Q2, because what we heard from most companies is that it was still weak but about the same, and if it hadn't, then to what extent or how do we know how much of this is really related to kind of the second point that you had mentioned, which is a transition to HPV testing and if you can comment on whether your PAP testing revenue can grow sustainably, as you think about it, over the next year or two.

Yes, I mean, I think from our perspective, we viewed the US market even prior to any of the economic issues that we're faced with today of being one of market maturity. So imager adoption with some upside as well as any kind of competitive wins that we might have in terms of greater gains in market share. I think what we're seeing today is that although the market has been down relative to OB/GYN visits, we were fairly resilient to that in our first quarter and started to see the effects of it in Q2 and then more in Q3. But when you look at our volume decreases in the quarter or our erosion in volume, it's far less than what we've heard from the national labs, what we've read in the press, in terms of reductions in office visits. But we believe that we're holding both market share and holding gains relative to pricing or otherwise appropriately, but nonetheless, the overall market is down because of patient visits and we are certainly seeing effects of that and saw the effects of that in our Q3.

All right. Thanks very much.

(Operator Instructions). We'll now go to Jonathan Block from SunTrust Robinson and Humphrey.

Maybe the first one, I hate to burn a question here, but Cervista revenue, the absolute amount. It seems like you've been willing to give that in the past quarter.

We actually have not given the product line revenues. We've been focusing on segment, the numbers up to this point. We prefer not doing that for all the reasons we said in the past.

I think Cervista was up 24% year-over-year last quarter. Do you have a percentage increase year-over-year?

On a quarter-over-quarter basis, we are growing at a rate of 20% to somewhere north of 20% on a quarter-over-quarter basis.

Sequentially?

Sequentially.

Okay. Great. Thanks for that. And then Steve, maybe this one's for you, just sort of parsing through on the Surgical side. Adiana revenues maybe around $3 million in the quarter. Is that right? And then when we sort of peel back to what that means for NovaSure domestically, after taking into consideration the recent comments on international NovaSure, you get to a number around 2 or 3%. I know it's not easy out there, but how should we think about that growth rate? Is that purely a function of the slower environment, or how much is patient volumes weighing on that? That's a big deceleration from the past. Thanks.

I think to start with the Adiana question, I think your number is a little conservative. We had a very strong Adiana quarter, which I understand probably puts a little more pressure on the second half of your question. We've done quite a bit internationally with NovaSure. As David was talking, we've got consistent growth rates out there that we're very happy with, and we'll continue to invest in that business and expect to grow that into different markets. As far as domestic NovaSure goes, we do continue to see growth and our checks on the channels continue to show that we're increasing market share to flat on market share.

But I think what the economy means to this market is that you're going to see a temporary negative effect on the growth of the overall market. It's not going to continue growing as fast as it was, but when you look at the patients that are in this marketplace, there are women that have -- they're underserved, first of all. So there's a large group of women out there that are not getting the procedure that they should and it's -- over time it's getting to those women and that's really been our strategy and I think that's been why we've been able to continue to grow in the tough economic times with the product.

Great. Thanks, guys.

And we have time for one more question. And our question comes from Vivian Cervantes from Maxim Group.

Hi. Thank you very much for squeezing my question in. Wanted to drill down a little bit on the GYN Surgical. I understand your comments about moving manufacturing for Adiana out, and maybe improving gross margins by pushing through some engineering changes. Will that in any way affect your ability to do a bigger push for Adiana with all these manufacturing changes that are still ongoing?

I think if you look at where we are right now from a yield perspective with the product, we really slowed down the launch of the product and didn't go full market release to all our sales reps until April and that was because we really wanted to make sure we could get out there and make sure all the customers were serviced. We really concentrated on getting inventory up as high as we could to support the full-market release of the product. Now we've got the engineers that we're working on getting production up focused on making it better and making the yields and the margins better and at the same time working on next generation products as well. So as we continue to make improvements to the product and decrease our scrap rates, we don't see that it would negatively affect our ability to roll out next generation products.

When you say next generation, a new iteration of Adiana in the market at some point soon? Do you have a time frame for that?

We're working on several different iterations of the product. This is a product that will continue to evolve over time as we work with different physicians. It's an interesting product in that it's got ease of use benefits right now and there's patient use benefits as well. But we're going to continue to work on it to make sure that we can continue to improve our strength of clinical data and continue to make it something that the marketplace will adopt as the premiere transcervical sterilization product.

As you have broadened your launch of the product through your entire sales force, are you looking to do something I guess more broader in the sense of a direct to consumer campaign or anything of that nature any time soon?

That's a good question, Vivian. It's one that we get quite a bit. Our competitor has done some direct to consumer advertising and I think it's done a lot for the segment, if you will. It's got women aware that there are alternatives to laproscopic tubal ligation, and I think that's a benefit to all of us. Right now, we're really focused in a couple of areas.

First of all, we're going out and we're getting competitive share. We've got some good relationships out there with doctors that have used our products for quite a while. They're interested in the advantages that the product brings to the market. And secondly, we've been in some accounts that weren't necessarily enamored by the competitive offering and have looked at transcervical sterilization as something that they want to bring on, and something that they are interested in. It's just that they weren't interested in the initial product that was in the market. So what we'll do is we'll continue to focus on training doctors. We've got several thousand doctors in the training queue and it looks very good for the future and very promising for us.

Great. Thank you.

And that does conclude our question-and-answer session and our conference for today. Thank you for your participation, and have a wonderful day.