金百利克拉克 (KMB) 2004 Q3 法說會逐字稿

Ladies and gentlemen, thank you for standing by.

Welcome to the I-Flow third quarter results conference call.

During the presentation, all participants will in a listen-only mode mode.

Afterwards, we'll conduct a question-and-answer session.

At that time if you have a question, please press the 1 followed by the 4 on your telephone.

As a reminder this conference is being recorded Thursday, November 4, 2004.

I would now like to turn the conference over to Don Earhart, Chief Executive Officer, I-Flow Corporation.

Please go ahead, sir.

Thank you, Jason.

Good morning, everyone.

Thank you for joining us for I-Flow's third quarter results conference call.

After our prepared remarks, Chief Financial Officer, Jim Talevich and I look forward to answering your questions.

We reported another great quarter this morning.

Our total revenue surged 58% to a record 18.7 million on the strength of 117% increase in regional anesthesia sales and a 59% increase in revenue in our oncology infusion services segment.

Excluding sales in last year's third quarter to a former regional anesthesia distributor, DJ Orthopedics, the increase in U.S.

ON-Q sales was 138%.

Revenue for the first nine months of 2004 increased 50% to $50 million.

Which was also a record.

Regional anesthesia sales were up more than 100% for the first nine months and oncology infusion services sales grew 45% for the same period.

Our regional anesthesia business retains our primary focus and I-Flow's crown jewel.

Our goal is to establish our ON-Q brand as the new best practice in post-surgical pain relief and ultimately to replace narcotics as the standard of care.

We are pursuing a four-pronged strategy to achieve this objective.

First, building our direct sales force.

Second, supporting independent third party clinical studies that demonstrate the benefits of ON-Q in an expanding number of surgical applications.

Third, offering innovative insurance billing programs to reduce the risk and expense for our customers so they can provide the ON-Q products to their patients.

Fourth, promoting ON-Q with carefully-targeted marketing campaigns.

I'm happy to say that we made progress in each of these elements of the plan during the third quarter.

Our distribution capabilities continue to expand as of the end of quarter 3, ON-Q was available in more than 900 hospitals throughout the United States.

At the end of October, I-Flow's hospital focus direct sales force numbered 115 quota carrying sales professionals calling on hospitals and surgeons compared to 60 at the end of last year and 87 at the end of the second quarter of 2004.

Just last quarter, we reported to you our decision to build another sales force targeted exclusively at AOCs and other outpatient settings.

Well, I am proud to report that this force is now fully staffed and numbers 20 sales professionals.

If you combine the two sales forces and add in the support players, which include sales associates, inside sales representatives, nurses, and sales management, the total sales organization supporting the ON-Q products now exceeds 220 professionals.

Clearly, our hard work to increase awareness and drive adoption of our proprietary ON-Q family of products for narcotic free release of post-surgical pain is delivering the growth we anticipated.

And based on the current level of market penetration, our opportunity is tremendous.

Each year, millions of surgical patients potentially could benefit from our ON-Q technology in the U.S. alone.

We estimate that the European market opportunity is just as large if not greater which is important in view of some recent news I'll review with you in a minute.

In fact, there were many significant developments during quarter 3, that we are excited about and I want to share with you.

But before I do, let me turn the call over to Jim Talevich, I-Flow's Chief Financial Officer, to review the numbers in detail.

Jim?

Thanks, Don.

Before we continue, please note that this conference call will include forward-looking statements.

These statements are based on current expectations, estimates of projections about our business based in part on assumptions made by management.

These statements are not guarantees of future performance and actual results may differ materially.

A more detailed discussion of the these risks and uncertainties is contained in this morning's press release and I-Flow Corporation's various filings with the SEC.

The statements made during this call are made only as of today's date and we undertake no obligation to update these statements.

Revenue for the third quarter ended September 30, 2004, rose 58% to a record $18,688,000 from $11,822,000 for the third quarter of 2003.

The largest component of the increase was in the regional anesthesia market which increased by $117,000 to $8,735,000 from $4,032,000 for last year's third quarter.

We were also very pleased with the growth in our oncology and fusion services business which grew by 59% compared to the prior year quarter.

Gross profit increased by 77% overall.

Including the effect of an increase in gross profit as a percentage of revenues by 8 percentage points to 71% of revenues.

Net income for this year's third quarter was a loss of $1,770,000 or 8 cents per share.

This compares to a net loss of $386,000 or 2 cents per diluted share for last year's third quarter which included net income of $121,000 from discontinued operations related to spinal specialties.

Selling general and administrative expenses increased by $7,834,000 for the quarter ended September 30, 2004 to $50,564,000 compared to $7,730,000 in the prior year third quarter.

This increase was primarily due to increased selling and marketing expenses related to the Company's ON-Q product line.

Moving to the balance sheet.

Total cash increased by $31,215,000 to $46,400,000 as of September 30, 2004 compared to $15,185,000 as of December 31, 2003.

The cash increase included net proceeds to the Company of $43 million from the Company's sale of approximately 3 million shares of stock in a public offering that closed on April 19, 2004.

Property plant and equipment increased by $3,506,000 to $10,250,000 as of September 30, 2004 compared to $6,744,000 as of December 31, 2003, primarily due to purchases of additional electronic infusion pumps by the Company's InfuSystem subsidiary to support its growing rental business.

Total assets increased on a year-to-date basis by $42,468,000 to $94,364,000 as of September 30, 2004 from $51,896,000 as of December 31, 2003.

The Company had no long-term debt outstanding as of September 30, 2004 having repaid all bank debt during the previous fiscal year ended December 31, 2003.

Don?

Thanks, Jim.

There are several developments I want to highlight on today's call.

I alluded to the first one in my introductory comments.

During the quarter, we received CE Mark approval for our ON-Q brand for additional indications for use within the European union.

These additional indications are identical to the FDA clearance that ON-Q received in May 2004 for the United States.

They allow I-Flow to market ON-Q as superior to narcotics alone for reducing pain after surgery.

So, as of now, all ON-Q branded products sold within the United States, Canada and the European unions, 25 member states, are cleared to carry this enhanced labeling.

CE Mark approval fundamentally changes the playing field for ON-Q and significantly expands our overall market opportunity.

In the past, we had elected not to pursue wholeheartedly the European opportunity since our early forays into this market taught us that it would be very difficult without a highly motivated sales presence and possibly enhanced labeling.

With the enhanced labeling now in hand, we are reconsidering our options regarding European distribution.

We believe that this CE Mark approval will dramatically improve our ability to attract highly motivated sales partners for ON-Q in Europe.

And facilitate the development of a distribution network for this large market.

I expect to have more to report on the subject in our next call.

The second major development I want to focus on involves our ongoing support for third party clinical studies.

We recently announced the publication of a study of abdominal surgery that found that continuous post-surgical wound infiltration with a local anesthetic delivered by ON-Q increased tissue oxygenation at the surgical site.

Which may enhance wound healing and prevent post-operative wound infections.

Another study following gynecologic oncology surgery also supported the use of ON-Q to provide pain relief after surgery without increasing the risk of wound infections.

Let me repeat.

These studies showed that the use of ON-Q helps increase oxygenation that promotes wound healing and does not increase the risk of wound infections.

These are compelling results that lend further support to the benefits of ON-Q which we think will encourage additional physicians to adopt our product.

Other recently-published studies demonstrated the effectiveness of ON-Q in treating pain while minimizing the use of narcotics in additional surgical procedures, including outpatient bariatric surgery, that's weight loss surgery.

Outpatient total hip replacement surgery.

And radical prostatectomy surgery performed with a robotic minimally invasive technique.

In trial after trial and in indication after indication, the clinical results have been remarkably consistent.

ON-Q helps surgical patients recover faster with less pain and less narcotic use.

The third development I want to highlight concerns distribution.

Earlier this week, we announced an agreement to make ON-Q available to healthcare organizations that purchase supplies through Novation, the supply company of VHA incorporated and University HealthSystem consortium that serves more than 2300 healthcare organizations nationwide, including 1400 acute care facilities.

We also recently announced the award of a contract with Med Assets, a fast-growing group purchasing organization and supply chain management company under which Med Assets will offer ON-Q to its network of healthcare providers including hospitals and ambulatory surgery centers.

We now have established relationships with four of the major group purchasing organizations in the United States.

Novation, Med Assets, Consorta, and Premier.

This is an important accomplishment for I-Flow since these contracts are not easy to get.

When I-Flow started this journey in January 2002, to build a sales force and go direct with the ON-Q, we had 0 contracts.

Winning these contracts really demonstrates how far I-Flow has come in increasing acceptance of our ON-Q products and how far our customers have come in recognizing ON-Q's value in enhancing patient care.

That said, it is important to note that contracts alone do not guarantee sales.

They are, at best, door openers and I-Flow sales people still have to work every day to convince surgeons to adopt.

With the contracts, the product has a green light for usage by the practicing surgeons, pricing is set and the product is in the computer making it easy for the OR facility to purchase.

Most surgeons and operating room administrators can now order the product without getting special approvals.

We know from experience that not having a contract is a huge barrier that must be overcome in order to generate sales in the member facilities.

The fourth important development I want to mention involves promoting ON-Q via targeted marketing campaigns.

We recently retained a world-class healthcare advertising agency to help us strengthen our brand messages in both the professional and consumer markets.

Our first initiative with this agency was to conduct primary market research to test messaging with surgeons across the United States.

While the results of this work are still being collected and analyzed, I think it's fair to say that we will have a new and exciting advertising campaign directed at surgeons to introduce at our national sales meeting in January 2005.

So, all in all, I am very pleased with our progress.

ON-Q is a revolutionary product but the phenomenal success of our proprietary brand is not happening by accident.

It's happening because we have the right strategy and the right team to implement it effectively.

I want to thank everyone on the I-Flow team for the hard work that is making our success possible.

And I want to thank you, our shareholders, for your support and understanding as we implement our plans.

Jason, we are now ready for questions.

Thank you.

Ladies and gentlemen, if you would like to register for a question, press the 1 followed by the 4 on your telephone.

You'll hear a three tone prompt to acknowledge your request.

If your question has been answered and you would like to withdraw your registration, please press the 1 followed by the 3.

If you're using a speakerphone, please lift your handset before entering your request.

One moment please for the first question.

Our first question comes from the line of Alex Arrow from Lazard.

Please go ahead, sir.

Thanks.

Good morning Don and congratulations on that great revenue number.

Thanks, Alex.

If we could start by asking just about the hospital distribution.

Can you give us any color on how many if any of the hospitals are up to steady state where you think they would like to be.

You mentioned at one point a million dollars per hospital is a goal.

If you could say how many hospitals you're in and how many of them have come up to be significant accounts.

Well, I think we mentioned we're in over 900 now.

And most of those hospitals are ordering at least once every three months.

So, we are making excellent progress in not only increasing the number of hospitals that we're in but the product is sticking.

Okay.

Anything you can tell us on revenue for hospital?

Any impressive stats about how many have crossed the .5 million per hospital or 1 million per hospital on a run rate?

No, we don't have any statistics like that to give out at this time.

Okay.

If you look at the revenue per rep, it looks like in the regional anesthesia division, you're about 300,000 annualized per quarter carrying rep which is pretty similar from last year.

So, is there a -- a big distribution over the -- the more senior reps are doing far better than the mean or is it pretty much where you add a new rep and you know exactly how much new revenue that rep is going to -- has generated.

Can you give us some color on the revenue per rep trends?

Well, if you take a look at the fact that at the end of July, if you count the two sales forces together, we had about 107 quota carrying reps at the end of July, at the end of October, we had 135.

So we've added another 28.

Every time we add new reps, we bring the average down.

So, it's really the wrong time to try and use those kinds of statistics when those statistics will make sense will be next year about halfway through the year when everybody has been on board at least six months.

So, the statistics you're talking about, Alex, it's hard to respond to because we've got so many new people that have been coming on board and we have an additional number that will come on board between now and the end of the year.

How is the -- how has the turnover been?

Can you say anything about how much if any turnover you've gone through over the course of the last one quarter or two quarters or one year?

Well, if you take the total turnover for this year, we estimate it to be less than 10%.

Somewhere between 5 and 10.

But again, some of that turnover is because we want it to be and some of it is because others have decided that this is not the right assignment for them and they've moved on.

But when you're hiring as many people as we are, you're going to have some turnover but we think that something between 5 and probably 8% is pretty good.

Okay.

Great.

My last question, I'll go back in queue.

On your SG&A, that was a bit higher than we had thought.

Is there a marketing special events that we should be thinking of as part of that SG&A number other than just the new rep expense?

No.

I think that -- you've got the new rep expense but don't forget now, we're in the middle of Sarbanes.

And that's not an inexpensive activity.

Can you give us any detail on roughly the magnitude of your Sarbanes expense impact?

Well, since it's still ongoing, I think that's something we can provide at the end of the year, Alex.

There is a lot of invoices out there we haven't even seen yet.

So, the activity is pretty heavy.

Okay.

Great.

Thanks.

I'll get back in queue.

Okay.

Our next question comes from the line of Bill Plovanic from First Albany Capital.

Please go ahead.

Thank you.

Good morning.

Congratulations.

Hi, Bill.

Thank you.

Jim, actually, can you -- on Alex's train of thought there, can you just split out what the sales and marketing and G&A was in the quarter?

Maybe that will help us out on figuring out where the costs were.

Sure, Bill.

Selling to marketing was $11,729.

G&A was $3,835,000.

Were there any one-time events?

I mean you hired this marketing firm.

I mean was that a big chunk of money up-front?

Is that -- it just seems like the percentage is going up and while you're adding more reps, you're not, on a percentage basis, it is not as fast as it was before.

That's -- we're all trying to figure out when do you hit the cross point.

When do we actually start to see leverage onto the operating line?

Well, Bill, a lot of folks are blowing out their numbers.

We obviously pay commissions on those.

In addition, the new reps that do come on board they obviously have expenses, very disproportionate to what those individual reps and new territories are creating.

Great.

That's helpful.

And then I was wondering as we look at the distribution and thank you for the color you've been giving us recently.

Just what is your goals for year end this year and then into next year for the quota carrying reps in both the hospital and the ambulatory surgery center market?

Our plans right now, Bill, are to have about 130 hospital reps and 20 ASC reps by the end of the year.

So, that goal has not changed from the past six months.

Okay.

So, we're right now at 115 hospital reps and 20 ASC reps so we're getting close.

Any thoughts on '05, Don?

Right now, our plan is to settle it down, Bill.

And leave it at that.

And we would only hire on an opportunistic basis.

So we might pick up one or two reps here or there depending on who shows up at the door.

But if we have an opportunity to bring on an all-star, we'll do that.

And that's in the ASC market as well?

Yes.

That would be in either.

Okay.

Can you give us some color on the success of the ASC sales force through -- up to date?

Yeah.

We don't divulge numbers at this time.

And the numbers that we've actually booked for ASC sales is still relatively small.

It's very small in comparison to the entire $8.7 million.

We're being very cautious, we figure it's taking us between -- a little over six months to collect on a lot of these and the reason being is that we have to appeal most of them because it's the first time the insurance companies have ever seen the request.

But we are continuing to make progress and the amount of paper we're generating is going up exponentially.

Which means we're getting billings.

So the sales force is starting to get traction.

You have a lot of billings you're sending out, and that's just a function of collection.

And again, you only count those revenues upon receipt of the cash, correct?

We can't do it that way but we have an estimate and the estimate is about a 1/3 of what we bill, we book.

And that number again in this quarter was insignificant.

Are you still running about that $150 ASP on that -- in the ambulatory surgery center market?

It's about 120.

We've heard some rumblings about California worker comp cutbacks.

Has that impacted you at all?

No.

Workman's comp is one of our best billings.

Okay.

And then you know, running through the numbers, I'm just trying to get a handle on some things.

It looks like the DJO number, your partner last year, was probably about $250,000.

Is that pretty fair?

I'll go ahead and check that for you.

In the prior year quarter, Bill?

Yeah.

378.

Okay.

And then your international revenues in the quarter?

Well, you talking about for regional anesthesia?

No, worldwide.

If you want to split out regional anesthesia, that would be great.

2.6 in total.

About 3 or 400,000 for regional anesthesia internationally.

And then, you know, you had -- last question, I'll jump back in because I actually have more after this.

But what were your thoughts on the build-out -- you know, you talked about Europe.

Is that going to be a partner or is that going to be a direct sales build-out of -- by you guys?

It will not be a direct sales force.

Because there's no way we could afford or even try and control that but we still have so much opportunity in the United States but what it does do, Bill, it helps us attract distributors now because we will have claims on the product that will make it significantly easier for them to position it with hospitals in Europe.

Without these enhanced claims, it's very difficult to get a product -- a new product into a hospital in Europe.

We're hoping these will help us do that through distributors.

In the -- is this going to be the typical socking distributor or would this be one broad stroke signing of a deal with somebody?

It will probably be a series of distributors by country.

One exception may be the continuous Nerve Block product.

We are looking at the opportunity of bringing on a large distributor in Europe just for the continuous nerve block product because their call point is anesthesiologists.

Great.

Thank you very much.

I'll jump back into queue.

Okay.

Our next question comes from the line of Jason Kroll from Roth Capital Partners.

Please go ahead, sir.

Hi, guys, good quarter.

Thanks, Jason.

Question, Don, on the surgical procedures in Q3.

Have you seen or can you prioritize just some of the key ones again, do you see any change there?

Was there one in particular too that clearly stood out and has that changed from prior quarters?

No.

I think it's still a lot of heart surgery, thoracic surgery, bariatrics, is becoming important.

Oncology surgeries, by the way are becoming very important.

Oncology is a very important part of our business when you include InfuSystems.

One of the interesting things, Jason, is that we actually lost some opportunity in September because of the problems in Florida and some of the southern states with the hurricanes.

We had hospitals shut down for a week and two weeks and cancel surgeries.

So, our numbers would have been even better if we had not had the hurricanes hit us in the Louisiana area and in the Florida area.

And the Georgia area in September.

Mm-hmm.

Okay.

I know you're finding that with oncology, that's interesting, are you able to leverage the system to attack that market?

No, we're not.

They're totally different.

Okay.

Then just also on InfuSystem, obviously that was extremely strong in the quarter.

Can you comment on -- I guess the continued drive of that business.

Is it the shift in continuous infusion versus a bolt injection of a cocktail of drugs with chemotherapy still ongoing?

Yeah.

It's the shift in protocols to some extent.

But the other thing that's really driving it is the new protocols as I mentioned before, are getting us new customers who have never used infusion pumps before.

They've always put those patients in the hospital for the infusion or handing -- or handed them off to a home care company.

Since they've got to do the protocols anyway, for some of the colorectal cancer protocols, they're now starting to use them for everything.

So, not only are we getting new customers because of the new protocols but a lot of those same customers are beginning to do old protocols because the pumps are now in the office.

You know, it's just an exciting business right now.

Is it sustainable, Don?

That type of a growth?

I keep saying it's not.

And every quarter I get surprised.

So, Jason, your guess is as good as mine.

There's no reason to believe it's not sustainable through the end of the year.

That's for sure.

Okay.

And then back to the ON-Q line.

You know, you talked in the past about an 80% plus growth net business.

It's now well in excess of that.

Can you talk about any outlook and your expectations?

Have they changed at all in terms of ON-Q growth going forward?

You know, potentially more than 80%?

Well, I think you found that we were dead wrong on the 80%.

So, I'm not going to go back to the 80%.

I think there's no reason to believe that we won't continue to do what we are doing and that is to be somewhere north at least for the next quarters or so of over 100%.

Okay.

Very good.

Then final question, just on the overall profitability of the business, obviously with that type of ON-Q growth, it seems to me that next year, you will start to leverage the P&L and there will be a more profitable outlook.

Are your expectations still the same in terms of profitability, at some point in '05?

Yes, we're still talking about profitability fourth quarter of '05 and if we continue with this kind of performance, you know, I think that pretty well secures that.

I'm not going to go so far as to say it might make it earlier but it definitely secures that.

Thank you very much.

Great quarter.

Thank you.

Our next question comes from the line of Spencer Nam from S. G. Cowen.

Please proceed with your question.

Thanks for taking my questions.

I just have a couple of questions.

The first -- the third quarter sales with ON-Q at 8.7, I was wondering if that number was distributed to 126 sales reps that you had at the end of the quarter or if you had some reps who were ramping up at that point so did not really calculate into that distribution?

Well, I think, Spencer, if you take a look at the fact that at the end of July, we had 107 sales reps and at the end of September, we had 126.

So, that's 19 new ones.

Those 19 new ones who were on board less than three months probably didn't contribute a whole lot.

Gotcha.

And that number doesn't include anyone who let's say signed up into the fourth quarter but counted in the third quarter because they had accepted the offer and things like that.

It is purely the number from third quarter, is that right?

Well, if I told you that we had any sales, from reps in the fourth quarter, that we counted in the third quarter, I would probably go to jail.

So, the answer to your question is no, we did not have any sales from reps in the fourth quarter that we counted in the numbers today.

Yeah.

Just to make sure from my end.

That's great.

Let's see.

So, in terms of the sales force ramp up, we -- 150 is the target.

Are you still planning to finish out the recruiting by end of this month or is that -- how would you describe that right now?

We have only 15 more to go.

If you take a look at the numbers I just gave you.

So, we have 15 more to go.

All of those are on the hospital side.

Now, as you well know, the last 15 will be -- arguably be the toughest because we're getting towards the end of the year.

It's hard to get people to leave the companies they're at when they're getting this close to year end and of course, they're looking at bonuses.

But we continue to hire and hopefully we'll have all if not most of those on board by the end of November.

Couple of quick questions then I'll get back on the queue.

The oncology rental business which showed a very significant increase in the revenue line, given that you are using a third party reimbursement process, how has that worked out in this environment?

It seems like it's working really well.

Just wanted to -- given that it is always a challenge to bill insurance companies, what are some of the things that are going on that suddenly are making this a much more efficient it looks like and also very successful?

You're talking about the oncology business?

Yes.

Well, that business has been in place for 18 years.

So, we have contracts that go back as far as 18 years and we continue to add contracts for the oncology business.

And as that business gets bigger, of course, we get tremendous operating efficiencies.

So, between the new protocols, the new customers, the new business, et cetera, that's what's making it grow.

It's all a factor of --

You're not running into any sort of a reimbursement issues with that business segment at this point?

It's pretty smooth operationwise?

Since we've been dealing with the same insurance companies for 18 years, they all know us very well so the answer to your question is no.

We don't have any insurance billing problems.

Great.

Final question I have is just the -- any sort of -- I know you don't provide guidance -- specific outlooks but in terms of looking to next year, what would you consider to be the most -- the key areas of spending outside of the -- maintaining the sales force.

What are some of the things that you're thinking about going forward?

I can't think of anything unusual other than to continue to support SOX 404.

Those efforts.

And of course we will roll out a marketing program.

As I mentioned earlier in my comments, we will roll out a program in January directed at surgeons with new messaging to hopefully help us increase awareness.

And usage through that.

So, we think we're ready now with 900 plus hospitals on board.

We're reaching the point where it now makes sense for us to do something with the surgeon.

Not the consumer.

But the surgeon right now.

We'll see how that rolls out and then at some point in the future, it would be something for the consumer.

The marketing will be our big push next year.

Just to finish my question on that, then, what kind of spending level are we -- can we expect on all of your marketing programs?

Is it going to be relatively small compared to some of the spendings on the sales force ramp up or is it going to be fairly significant given that you are planning a huge push.

How should we think about that?

Well, initially, it will be relatively conservative.

Because again, the push will be to surgeons.

We're not talking about a Super Bowl ad or anything big like that.

We're talking about probably print and advertisements in their professional magazines.

So, it's not going to be that big a number.

Now, if that starts to catch on, and generate sales faster than we had planned, then we could add to that spend and at some point in time, we would end up doing something with consumers.

But don't forget our plan next year is to be profitable in the second half.

Definitely by the fourth quarter.

So, all of that will weigh into our decisions on how we spend our money.

Great.

Thanks very much.

We're going to be very prudent yet aggressive.

Thank you.

Our next question comes from the line of Katherine Soloman from Barrington Partners.

Proceed with your questions.

Good morning, everyone.

Hi, Katherine.

I have a couple of questions.

First some housekeeping questions.

Could you give the accounts receivable balance and the CapEx for the quarter?

Yeah.

We knew you were going to ask that so we got that ready.

Jim?

The net --

Sorry, I'm not very original.

Okay, the net accounts receivable number was -- at the end of the quarter was $13,783,000.

Okay.

And the capital expenditure number for the quarter -- I don't have it at my fingertips.

Oh, maybe I do.

Hang on a second.

Yeah, I don't have that.

I'll have to get back-- Here we go.

Sorry.

I'll have to thrash around for a second here.

It's about 2 million.

2 million.

My next question is to the point about it taking between 4 and 6 months for sales reps to get up to speed.

When I look at product revenues and ON-Q revenues, as a function of the sales reps that you had four months ago and six months ago, that looks like it's declining year-over-year.

I was just wondering if you could speak to how you expect that changing going forward.

If it takes a little bit longer than 6 months to really get up to speed or what's happening there.

I don't know where you're getting your numbers but the way the thing works is that we have the entire United States spread out amongst X number of sales reps as we bring on new reps, we split their territories.

Okay.

So, what happens is that the average per rep goes down as we add new ones.

Because they actually give up part of the territory they're not doing a good job getting to and that becomes the seed territory for the new rep and that's how we do that.

So, you really can't look at those kind of numbers until we settle it down.

And that will be at the end of the year when all of the territories will be in place and we won't be splitting and taking parts of territories away from reps and giving them to new.

Okay.

All I was doing was taking this quarter's product revenue or ON-Q revenue and dividing it by the number of sales reps you had two quarters ago.

See, the hard part of that is I only give you numbers on a quarterly basis so you don't know whether they came on board the first day of the quarter or the last day of the quarter.

Okay.

Okay.

There is a three-month swing in there.

Mm-hmm.

Okay.

Another factor, you know, when they come on board, some of them don't get into training for 30 days.

So, on the first 30 days, you know, I'm not saying they're not productive but they might flounder a little bit because they don't get formal training for maybe 30 days but nobody waits any longer than 30 days.

And there is a disruption factor every time I split a territory.

Okay.

That means a rep has got to introduce those customers to a new rep.

But as we get this thing settled down, you'll have a much better feel for what the real statistics are.

And that would be when?

Roughly?

At the end of the year.

At the end of '04?

We're trying to hire 15 more people and then we said that's when we're going to basically freeze it.

That should be by the end of the year.

Okay.

Thank you.

You're welcome.

Our next question comes from the line of Steve Krueger from Forsythe Investing.

Please proceed with your question.

Good morning, Don.

Congratulations on some great results.

Thanks, Steve.

I would like to visit the dollar revenue -- annual revenue per sales rep question in another way.

Can you give us some idea from a goal standpoint, based on what you know about the nature of the product sale and post-sales support and so forth, what do you figure a rep -- once he's fully up to speed, fully trained, has a mature sales territory, will be able to generate on an annual basis in revenues for ON-Q?

Well, today, when you still have a lot of missionary selling going on, even though that's becoming less and less as we get more clinical studies and we get more users, a good rep should be able to do something north of $700,000 and there's no reason to believe that as we continue to build awareness, they can't do something north of $1 million.

Okay.

Your most experienced, most successful reps today, do you have any that are approaching those levels?

We have quite a few that are over those levels.

Over the 700.

Terrific.

Oh, yeah.

Next question then Don, in the past, you've talked about a market potential in the U.S. alone for ON-Q of over $2 billion.

Let's just take half of that and say a billion.

Now, with a million dollars per sales rep on an annual basis, to get to a billion in revenues, you'd need a sales force of 1,000 reps.

So, I'm wondering why it is at this point that you're planning on kind of slowing the hiring of sales reps way down when you get to 150 because from what you've said, I think if you really are serious about that 1 billion or $2 billion market, you would keep hiring as far into the future as we can see here.

Well, I think that if we start to approach those kinds of numbers, Steve, you'll be more than happy to let me start hiring more people.

I would indeed, yes.

We don't quite think of those yet today.

I'm just trying to understand how serious you are about $1 billion Company here.

If somebody lets us get to that point, we would love it.

All right.

Should I assume then that you could very well open the door to hiring more sales reps.

In the not-too-distant future?

Next year or the year after?

As you learn more and more about I-Flow, you'll learn that we're very opportunistic.

So, if all of a sudden we start to blow the numbers out next year, let me assure you that we will add whatever people we need as long as we can hit that goal of becoming profitable and continue to grow this business significantly.

But right now, we think that we're at the right point to start settling it down.

And see what happens.

All right.

So, I guess maybe the thrust of settling it down for now is to let all of the sales reps get up to a higher level of annual revenues to generate some profitability and then take it from there.

You're absolutely right.

You've been reading our strategic plan.

All right.

Very good.

Thanks very much.

Thanks, Steve.

Our next question comes from the line of Michael David Alden from Espidosie.

Please proceed with your question.

Good morning, guys.

Thanks for taking my questions.

First question, did you guys buy back any stock during the quarter?

No, we did not.

No, okay.

Question on the consorted deal and some of the other hospital contracts is you know, generally, is that something where you would expect to get a lower selling price on the devices and you know, you have to take a little bit of a hit in the margin to kind of get that hunting license.

Well, I think any time you sign a national contract, Michael, you're going to end up giving some pricing but that's offset by the ease of being able to get in the facility.

So, you know, I say to you what's better?

To give away a couple of dollars so that they'll let us in the door or not give them anything and keep us shut out.

So, that's what you -- that's what you have to weigh all the time.

And what you give up by the way, is not that much.

Okay.

Especially on those sides where you don't have any competition.

Remember one of the things about I-Flow is is we have a family of products that, as you move to longer days or more days of infusion, we have little or no competition.

Those products maintain margins well above 90%.

It's only on the products where somebody else can compete against us like the two-day devices that we would have to give up any margin on.

Okay, great.

In terms of international in Europe, how do you guys distribute the ON-Q now.

Because you do have some sales there, right?

Yes.

We have some sales internationally.

In fact, Jim, I think you just gave a number.

What was that number?

International totals about 3 or $400,000 Mike.

Who's distributing that product today?

We have some local distributors by country.

One of those distributors includes Braun.

Then we have some other distributors.

Again, we don't give all of those numbers out.

So, it's a small business right now.

But now with the enhancements, the new labeling enhancements, we'll -- we expect to get some more distributors.

So, is the thought that now you'll be able to attract more established or larger distributors?

Than what you're doing now?

Is it you push more through the existing distributors?

I think it's a combination of the two.

With the enhanced indications, we will get a higher quality of distributor.

Okay, great.

Because it will make it easier for them to sell.

Right.

If labeling says you're better than narcotics, then how does the surgeon or the hospital in Europe push back?

Right.

Makes it a little more difficult.

Same advantage we have in the United States.

Okay, great.

Last question.

Just as your sales force becomes a little bit more mature and the reps start to have some more time with the Company, can you just refresh us and you know, where I'm going is from a leverage standpoint.

How do the commission structures change once the reps are expected to have higher quotas and can you just walk us through kind of how we should be thinking about that?

How those commissions will grow with sales?

We tell everybody that we expect a sales rep to be profitable by the sixth month or sooner.

And whatever you generate in revenues this year, next year becomes part of what we call your base.

We pay a lower commission on base than we do on new business.

So, every year that a sales rep is with us, in order for them to continue to make lots of money, they must continue to generate new business.

And their business from last year is considered to be old business.

So, we calibrate each year for quotas.

We'll do that in January.

So, if you were a rep with us this year, whatever you sold, a certain portion of that would be considered your base business.

Even though that was new business for you this year.

So, it will be paid at a much lower commission.

We hire hunters and we pay them as hunters.

Okay.

Thanks a lot, guys.

You're welcome.

Our next question is a follow-up from Alex Arrow from Lazard.

Please proceed with your question.

Just two follow-ups.

First a question about the anesthesiologists.

The field work that we've done, we've picked up -- there is a point of resistance, it could come sometimes when the surgeon really likes the ON-Q and the anesthesiologist may feel that the use of the ON-Q post-op takes away part of what they do for a living and therefore, they make up excuses or they come up with reasons such as we don't know if we're going to start the -- we don't know if you're going to need to call us to start an epidural or I don't know how much I.V. morphine to use.

I have to use some I.V. morphine anyway so therefore why not just use I.V. morphine instead of messing with this new thing.

So I'm wondering if you could give us some feedback since the results are so good and since we know surgeons like it so much.

Is there any resistance that you're hearing from the anesthesiologists call point and do you have a -- a specific strategy that's been working when you get that type of resistance?

Well, because we have so many surgeons out there today, that are still not using the product and so many hospitals that haven't seen us yet, Alex, it has not become a problem.

There is very little if any pushback as you can tell from the numbers.

Don't forget, now, especially in the orthopedic area, if you have an anesthesiologist who does push back, we just sell them the Continuous Nerve Block.

Which is a great product for them, the C-bloc.

So, the answer to your question is no, we don't see much.

As you can see in the numbers, it's not something that's affecting our business.

Okay.

Thanks.

My other follow-up would be then on the marketing plan.

You've given us some details about the marketing plan, you've mentioned it for the last 2 quarters.

And I know it will involve the new claims and you've said the print journalists, the targeted at surgeons.

Anything you can tell us about what the marketing plan will do with these new claims as far as -- I mean you can -- obviously make the claims known to surgeons but anything else you can tell us about what the plan is of this marketing plan?

Well, the first step has already taken place.

We've done all of our market research in which we've tested several different messages.

Messages being you know, what would attract or get the surgeons' interest if those messagings were put into an ad.

That's all been done.

We've picked the messaging as I speak.

That's all done.

Now we're in the last stage of formulating that and putting it into a campaign.

Which will roll out to the sales force in January.

That's really all I can say.

Because I don't want to tip off at this time what we think the messaging is going to be because we kind of like to save that for the January roll-out.

Okay.

Can you say which surgical specialties or would it be general orthopedic, cardiac, plastic, all of them?

Initially, it will be messaging for everybody.

But the messaging can be then honed down and can be designed for specific journals depending on the type of surgery.

Okay.

But starting in January, you anticipate going into all different journals for all the different specialties?

There will be some target journals we'll hit in January then we'll add some more in February.

And as we go, of course, we're testing the messaging and making sure we pick the right messaging and we'll make whatever changes are necessary but the plan is to roll out an advertising campaign in January.

Okay.

Great.

Thank you, Don.

You're welcome.

Our next question comes from the line of Bill Plovanic from First Albany Capital.

Please proceed with your question.

Great, thanks.

Couple of questions.

First on the ON-Q.

Do we have -- could you tell us what the ASP was in the quarter?

Is that going up or down?

It is still staying right around 170.

That's not changed Bill.

It's still pretty much what it's been for three years.

Okay.

And then is there any plans or have you already started working on a bolus function for your device?

It's already introduced.

How long ago was that introduced?

Six months.

Yeah, we had a bolus device out there six months ago for the C-bloc.

And we're in the process of adding that to the wound side product as well.

But we have a bolus device that's been in the Continuous Nerve Block market for six months.

But the ON-Q for the ON-Q, not the C-bloc, the regular one, you're just rolling out the bolus right now.

And the other thing is Bill you should know is, is we also have a variable rate device as well.

So, now you can actually change the rate on the pump if you want to without electronics.

Is that in the C-bloc?

What market is that geared towards?

The C-bloc.

We're also looking at that for wounds right now.

We've been asked to provide that on the wound side side as well.

So, on the C-bloc side, we've had a bolus device and a continuous rate device.

In other words, you can change the rate for a while.

We're taking those same products and we're adding that to the wound side side.

We've also been asked for two other products on the wound side side and that is a ten inch Soaker Catheter which we're in the final stages on that product as well.

And we've also been asked for a one inch Soaker Catheter for smaller surgeries like hands, bunions, and even shoulders to some extent, they would like a shorter Soaker Catheter.

All of those things will probably be rolled out before the end of the year.

It sounds like you're shifting from the build-out of the sales force to kind of new products to help continue to attack the market.

We're doing both, Bill.

Excellent.

We're not leaving anything out there for somebody else to capture.

Fantastic.

And then why was the cash down sequentially from the second to third quarter?

I think it was down a little over $6 million.

Your cash and equivalents?

Yeah, Bill.

I mentioned earlier about $2 million of that's capital expenditures.

Some of it is just timing of -- we actually ended up with some one-time cash that came in in June, I believe if I recall correctly.

So -- but it's more or less a continuous burn rate that we've been experiencing roughly maybe 3 million a quarter what I would say is the residual burn rate for right now.

Where we're in this rapid growth phase but I would expect that to level out.

Next year.

At term.

Okay.

And as we look at the fourth quarter for the sales and marketing line, I think in the past, you've had some true ups if you had to pay up on the bonuses as sales reps exceeded quotas, even the top end of quotas.

Could we likely see that bump up in the fourth quarter for that reason?

We hope so.

Yeah, we hope we can deliver a quarter, Bill, that will cause us to have to pay some more bonuses, yeah.

No, but I mean because we're at year end.

As you roll out the final bonus for the year.

The bonuses are quarterly.

The only thing we have as a final bonus is the vesting of the restricted shares and we hope as many as possible.

Hit that number, that's the yearly number but quarterly numbers are separate.

So, the restricted shares is kind of the true up in the fourth quarter that we could see.

Yes.

And is there any -- can you give us any color on the size of that?

Like would it be $1 million, $2 million just so we're prepared as we see the numbers roll through?

Again, we would have to project then how many are going to hit it.

And we're not ready to do that right now, Bill.

Okay.

Last year about a third of the sales force hit their quota.

Uh-huh.

Which you have to do to get the restricted shares.

Okay.

So probably somewhere in the neighborhood of a third of the number of people that were on board through the first half of the year.

That would be a pretty good guess.

And that number could be anywhere from 40 to $50,000 per person if they hit it.

Great.

That does it.

Thank you very much.

Then lastly, for Jim, just -- I don't know if you have those numbers in front of you right now.

Housekeeping.

Inventories at the end of the quarter then operating income in both the manufacturing and marketing ARM and the rental ARM?

Inventory at the end of the quarter, Bill, was $7,946,000.

Operating income , I do have that.

Let me dig for a second here.

You're looking for the quarter.

It looks like 447 for rentals and minus 1297 for manufacturing and marketing.

Okay.

Let me check something.

You said 447.

I'm sorry.

I read the wrong year there to you.

I apologize.

Rentals is 1.6 up and manufacturing marketing is 4.4 down.

4.4 down.

Yep.

Okay, great.

Thanks a lot.

Ladies and gentlemen, as a reminder to register for a question, please press the one followed by the four on your telephone.

Mr. Earhart, at this time there are no further questions.

I will now turn the call back to you.

Please continue with your presentation or closing remarks.

Our third quarter results show that we have the right strategy to take maximum advantage of what we believe is an enormous growth opportunity for our proprietary ON-Q brand of products.

Our people continue to respond to the challenges of delivering rapid growth quarter after quarter.

We are excited about the outlook for continued growth in the top line and ultimately in the bottom line as well.

We look forward to reporting continued progress on our fourth quarter conference call in a few months.

Thank you very much.

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.