瑞思邁 (RMD) 2008 Q2 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the second quarter 2008 ResMed Inc. earnings conference call. My name is Akia, and I will be your operator for today. At this time, all participants are in a listen-only mode. We will conduct a question-and-answer session toward the end of the conference. (OPERATOR INSTRUCTIONS)

Before we begin, the company has asked me to address certain matters. First, ResMed does not authorize the recording of any portion of this conference call for any purpose. Second, during the conference call, ResMed may make forward-looking statements such as projections of future revenue or earnings, new product development or new markets for the company's products. These statements are made under the Safe Harbor provision of the Private Securities Litigation Reform Act of 1995. Risk and uncertainties exist that could cause actual results to materially differ from forward-looking statements. These factors are discussed in ResMed's SEC filings such as forms 10-Q and 10-K which you may access through the company's web site at www.resmed.com. With that said, I would like to turn the call over to Kieran C. Gallahue ResMed's President and CEO. Mr. Gallahue, please go ahead, sir.

Thank you, Akia. As noted, this is Kieran Gallahue. I will be facilitating these calls on a go-forward basis.

Before I begin, I would like to acknowledge our founder and executive chairman Peter Farrell who has led the organization from its inception and who has presided over these conference calls where he's announced record results for 50 consecutive quarters. That's an amazing result by any measure. And just to put that in perspective, in 1995, we had annual revenues of less than $25 million and today we're reporting revenues in excess of $200 million for a single quarter.

I would also like to remind investors that Peter isn't going anywhere. He remains a very critical part of our strategy development process and of course, he is a well known luminary in the industry. I personally feel very fortunate to have worked with him the past five years and I very much look forward to working side by side with him as we move forward. All right. Let's get on to the call.

So, we're going to structure these calls a bit differently as we move forward. After this initial introduction, I'm going to hand the ball off to Brett Sandercock, our Chief Financial Officer and he is going to review results. At that point, I'll take the ball back and make a few comments, putting the quarter in perspective and updating you on key developments and then I'll open up the call for your questions. So, with that, let me hand it off to Brett. Brett?

Great, thanks, Kieran.

So, I'll just run through the December quarter results briefly and start from the top. So, revenue for the December quarter was $202.7 million, an increase of 14% over the prior year quarter. Favorable currency movements added approximately $10 million to our Q2 revenues. Our income from operations was $36.8 million for the quarter and net income for the quarter was $26.9 million. Our pro forma EPS was $0.41 for the quarter. Now, this measure excludes restructuring costs, stock based comp expense and amortization of acquired intangibles. Our a GAAP basis, our EPS was $0.34.

In terms of overall currency impact on our result this quarter, the weakening U.S. dollar had a negative impact on our EPS of approximately $0.01. Gross margin for the quarter was 60%. This was broadly consistent with the September quarter.

SG&A for the quarter came in at $67.6 million, an increase of 18% over the prior year quarter. If you look at that in constant currency terms, SG&A increased by 10% over the prior year quarter. SG&A as a percentage of revenue was 33% this quarter compared to the year ago figure of 32%. R&D expense for the quarter was $14.9 million, an increase of 24% over the prior year quarter. Again, in constant currency terms, R&D expense was a more modest increase of 9% over the prior year quarter. R&D as a percentage of revenue was 7%, which is consistent with the year ago figure.

Looking a little forward, with ongoing commitment to innovation, solid product pipeline and clinical trial commitments, we expect R&D expense as a percentage of revenue to continue in the 7% to 8% range through the balance of FY '08. Amortization of acquired intangibles for the quarter was $1.9 million. Stock-based compensation expense for the quarter was $5.3 million.

For the balance of FY '08, we expect that quarterly stock-based comp expense to tick up to around $5.7 million per quarter. Now, that reflects an uptick as a result of the annual stock option grant in November last year.

Turning to revenues in more detail, overall Americas styles were $100.2 million, an increase of 7% over the prior year quarter while sales outside of the Americas totaled $102.5 million, an increase of 21% over the prior year quarter.

Now, our traditional break out of the revenues by product segment. In the Americas, slow generators were 2% lower than the prior year quarter while masks and others increased by 12% reflecting strong sales in our new product introductions.

For revenues outside the Americas, flow generators increased by 16% over the prior year quarter reflecting momentum in our SA-2 style set while masks and others increased by 31%, again driven by strong new product styles. On a group basis, slow generator sales increased by 9% while masks and other increased by 19%. Turning now to cash flow, our cash flow from operations was $18.9 million for the quarter. However, excluding the impact of recall costs, cash flow for the quarter would have been $31.2 million. Capital expenditures for the quarter was $21.9 million. This includes $14.2 million in building construction costs, predominantly associated with our San Diego headquarters. Depreciation and amortization for the quarter totaled $13.8 million.

In terms of balance sheet, our balance sheet remains strong. Total assets at December 31 were $1.3 billion and net equity was $1 billion. Cash and cash equivalents, net of our external debt were $156 million at the end of December. I would now like to hand the call back to Kieran for comments.

All right, thanks, Brett. All right, I will make a few comments and what I'm going to try to do is anticipate a number of the questions that are frequently asked and try to answer those in advance. Then I'll open the call up to more general Q&A.

So as you can see, we've now had our 51st quarter of record results and those results are in spite of the fact that we had anticipated both Q1 and Q2 of this year to be challenging due to difficult base year comps, a GAAP period in our product introduction cycle and the response to earlier price challenges. I should also note that Q2 should be the last quarter where we expect our motor business to negatively impact our Americas' growth rate. Q2 represented a few milestones and I would be remiss if we passed by the call and I didn't note them. This was the first quarter in the company's history that we surpassed $200 million in revenue for a single quarter and I'm very pleased to report that both the Americas and ex-Americas markets both contributed over $100 million each. That's a very nice balance of geographic revenues.

All right. Let's transition to talking about the future. Let me say just as a header note, I feel extremely optimistic about this industry as we move forward and I feel just as optimistic about the role that ResMed can play within this industry. And let me tell you why I feel that way. I'm going to cover three basic topics although there are certainly many more that we can go through. I'll talk about our planned product introduction schedule, a heart failure clinical study we're initiating and finally, the preliminary decision by CMS to allow home sleep testing. First, our planned new product introduction schedule.

In this quarter, we're launching, and in fact in the past few days we've launched, two important new products in the Americas. First is a VPAP Auto which is a bi-level device. The second is the Mirage micro nasal mask.

All right, first on to the VPAP Auto. So, what's different about it? Well, first, it is our first bi-level product to be introduced into the more compact S8 body. It is far smaller than our previous generations of bi-levels.

Second, it will use the same accessory sets such as our S8 humidifier as we use with the more general S8 product line. This helps provide scale economies for ResMed while eliminating non-value added changes for our customers reducing their inventory challenges.

Third, it is powered by a unique patented double-ended motor, the same motor that powers our SA-2 CPAPs that we're currently selling outside the Americas. This motor is a core component in our next round of product interactions because it vastly increases the efficiency of the motor allowing us to increase performance while simultaneously reducing noise generated by the device. Because noise is an important factor in user comfort and compliance, we feel this is going to be a very highly valued feature of our customers. In fact, since it is in the SA-2 device that has been launched ex-U.S., we've already been receiving very positive feedback about that.

The fourth value proposition for the VPAP Auto is the integration of our unique Easy-Breathe waveform. You're going to be hearing a lot more about the Easy-Breathe waveform in the coming months. The Easy-Breathe waveform is an extremely comfortable flow pattern that once again improves user comfort and as we know, that's a major factor in driving compliance.

So, we're very optimistic about the launch of the VPAP Auto. Given the timing of the release, we should see some of the impact in Q3 although it is going to be a partial impact in this quarter and a more full impact in Q4.

Second product we've introduced within the past few days is the Mirage Micro Mask. This is our first product introduction into the standard nasal mask category in four years. So just as the Quattro set a new standard for full face mask performance, we believe the Mirage Micro will set a new standard for comfort, ease of fitting and performance within the standard nasal mask category. As we look to Q4, we should have a full quarter of impact both from the Mirage Micro and the VPAP Auto and then we are going to introduce another series of products during the fourth quarter. Let me go through those for just a minute.

On the CPAP side, we'll be introducing several of the SA-2 product series into the market. In the Americas that we've already launched during Q2 in Europe or outside the Americas. Once again, the products will be powered by our unique double-ended motor technology that has allowed us to improve performance and at the same time, lowering noise levels. Just like the VPAP Auto, we'll retain the current S8 design and accessories in order to minimize transition challenges for our customers while maintaining our own supply chain scale efficiencies.

Finally, we expect to be introducing a new mask product into the nasal pillows category also during Q4. We'll provide more detail on that product as the product launches. So, as you can see, we've got a fantastic new product flow over the next five months or so. And it is a -- it is a product line that is built up with innovative technologies but is also consistent with our strategy of maintaining efficiencies with the customer in our own supply chain.

All right. Next I would like to address the industry drivers. First, let's talk about congestive heart failure. In January of this year, we have begun the recruitment of our first patients into the predominantly European-based clinical study in heart failure. We've long noted the critical role the treatment of [inaudible] can have on very serious and very costly co-morbidities such as congestive heart failure, such as diabetes, hypertension and others. This study represents a very tangible stake in the ground of our commitment to providing and generating value from these co-morbidities.

This study, which is intended to be conducted over a five or so year time frame is targeted to the use of adaptive-servo ventilation and very specifically to the use of ResMed's ACS2 products in severe heart failure patients. The primary end points measured are the end points which are meaningful to the heart failure and to the payor communities; mortality and hospitalizations.

The study will engage two primary critical medical specialties, cardiologists and respirologists or pulmonologists.

Heart failure costs government billions of dollars per annum to treat and we're optimistic that the use of ResMed's adaptive-Servo ventilation, and very specifically, the ACS2 products will provide not only clinical benefits but also positive economic benefits. While we don't intend to report specifically on the study as it progresses, we will provide updates as material information and results become available.

Finally, let me briefly comment on the preliminary national coverage decision that CMS issued in December. First of all, let me highlight that this decision is preliminary and a final decision is due out mid March of this year. Now, our reading of the preliminary decision is that CMS has recognized that SDB is an enormous public health issue and they're seeking to increase the access to diagnosis and treatment of the 90% of the patients who have not yet been diagnosed or treated. We also see the decision as an indication that home testing will be complimentary to the current diagnostic pathway and we're hopeful and confident that our valued partners in the sleep community will continue to play a pivotal role in treating patients and we plan to support our partners as they evolve and thrive in this new environment.

From the perspective of impact on the SDB device community, this represents an additional driver for growth over the long haul and one more reason for us to believe that the industry continues to have bright prospects. We remain in an industry that is 90% [impenetrated] and that cheating sustainable industry growth in the 15% to 20% range is supported by these types of drivers.

Now, importantly, there is some water to flow under the bridge before the decision is finalized and before we feel its full impact in the industry. In general, the medical community takes a bit of time to absorb change. It wouldn't be surprising to us if it is 18 to 24 months had passed before this thing sorts itself out. Nonetheless, it remains a very positive change for the industry and one that we look forward to supporting.

In summary, we're very optimistic about the future of the industry and the role that ResMed can play in our industry's growth and we're looking forward to the positive forward momentum that we'll see not only from our new product introductions that we'll be seeing over the next five months but also these positive developments in the industry as a whole.

All right, with that, why don't I take a break and turn it over to Q&A. Akia?

Thank you. (OPERATOR INSTRUCTIONS) Thank you. Please stand by for your first question. Your first question comes from the line of Joshua Zable of Natixis. Please proceed.

Hey, guys thanks for taking my call here. Peter, want to take this opportunity to thank you for all of your help over the years. And Kieran, you've obviously been awhile but a formal welcome to the party here.

Just obviously kind of the main -- probably the big question that sticks out is flow generators in the Americas. Can you just comment, I mean everything else looks great. Maybe that's a function of the motor business. Just, if you can give us a little commentary on that.

Yes. I'll let Keith handle part of this. Let me just open it up. We're basically in a GAAP period here. We've had some very difficult base year comparables that we're dealing with and it sort of peaks out in Q2. We've got the new product introductions that will be in the flow generator side that will be coming forth not only the VPAP Auto here in Q3, but also what we are going to see in Q4. And quite frankly, there's also a bit of price impact that was in those numbers as well. So, a little bit lower than we're used to, that's for sure. But again, we've got confidence as we move forward that we'll be pulling out of that. Keith, anything you can add to that?

Kieran, I think that that's a pretty adequate job of going through the explanation. About the only thing I would add is that we've also had some growth in our sales force over the course of the last year or so. And as a result of that growth, we've had some promotions within the sales force. We've expanded some territories and added some new territories.

One of the things that we found is that it takes our reps about six months to really begin to ramp up to a level of productivity once they come on board. And fortunately, we're at the point where those reps, those new reps that we've added, are now clearing that six-month productivity and moving towards nine months. So, with the refreshing of the product line which gives us an opportunity to really get the sales force excited about what they're selling and the combination of the reps becoming more mature in what they're doing, I think that that's something to look forward to.

Great. Then just a follow-up. Can you guys just talk about the sort of overall health of the market here. I know you sort of alluded to it. But just obviously with, you and Respironics out there and I guess as it relates to maybe home diagnostics. Are we expecting sort of a -- some change here with people kind of getting ready, maybe holding back as things get -- and then obviously expect to pick up when it sort of goes full swing.

Yes. So, you know, I think periods of change, there's always short term opportunity for people to sort of look and question what their role is. But all of the general signals in the market are positive ones at this point. I think that the home -- the preliminary decision on home testing certainly is one that bodes extremely well for the long-term access of patients for the diagnostic process and removes some of the bricks and mortars limitations that may have been a governor on growth as we've seen in the past.

So, near term, there certainly is going to be some jockeying for position out there. As various members of the medical community determine what the role is that they're going to play in this new world going forward. But I suspect that will yield some more positive contributions versus negatives. So, I think the changes are good.

Great. Thanks a lot. Great job, guys.

Thanks.

Your next question comes from the line of Jason Mills of Canaccord Adams.

Hey Kierani, how are you? Congrats. Wanted to follow up, Kieran, if I can on the last question or the last answer about some of the constituents within the supply chain here jockeying for positions and trying to figure out how they could fit in. Could you elaborate on that a bit further, specifically it seems that we're seeing growth in the number of beds which is an underlying variable that's important for growth in the underlying market. However, maybe not as robust as we've seen in years past. And perhaps that's because folks in this supply chain are trying to figure out what it's going -- what the markets -- or what the environment's going to look like after the final decision.

Could you help us understand what you see in terms of growth in the number of sleep labs currently and how you think that will change as folks -- as folks sort of figure out where they fit in?

So, part of this is information that we have direct -- sort of detail or data on part of it is going to be more just looking at the market and providing --

Sure.

But we are seeing continued growth on the sleep lab PSG capacity side. But lets face it, if we're looking for the real growth in the capacity, that's going to be this home testing as it comes through because then it moves well beyond the bricks and mortars. We're all going to have to look at different indicators of growth as we move forward. As far as I'm concerned, that's a very positive thing, right, because it demonstrates that there's going to be more ways of growing capacity.

It is good to see that the sleep labs continue to expand some of their capacity because we feel that they are going to play a very important role within this -- in the diagnostic process. There is going to be a certain amount of patients that will be able to be fully tested and diagnosed through the home testing and there will be a certain amount of those patients which are going to need more comprehensive care such as those, let's say, in complex sleep apnea that are going to need the help and support of that in lab diagnostic process. We're pleased to see that they'll continue to do that.

So, in general, again, I guess I can only say that there are various players who have spoke up that are waiting for the final decision but are looking to get actively engaged. There are members of the sleep community who feel they can play an important role as part of the Hub and Spoke model of engaging other specialists and primary care physicians. You've heard public statements from home medical equipment providers who feel that they can provide a role in helping to accelerate the diagnosis rate by getting engaged in home testing. I suspect that there will be other players that will get involved in that as well.

So, from our view is we try to boil that down and say what does that mean from an industry perspective, and I've got to tell you, everything that we see in that is extremely positive. It means that there is going to be more awareness building. That there will be more interested parties in various stages of the market that will be looking to try to take those 90% of the patients who remain undiagnosed and try to find a complimentary pathway to help them reach therapy.

Great, that's very helpful. Just two quick follow-ups here. I don't know if they're quick, but I'll try to make them quick. So, I understand how that would impact positively, perhaps longer term. Near term, perhaps somewhat of an impact but we won't see the final decision until March.

So from what you've laid out, we have this environment for you. We have new products and easier year-over-year comparisons and perhaps still some jockeying for position as a modest offset. So, with that said, as we look into the near term for the second half of your fiscal year, could you help us a little bit with respect to your expectations for the growth especially in your U.S. business but also the ability to maintain the growth you put up this quarter in the international business given what's laying in front of you for the next couple of quarters.

Sure. So, obviously anything to do with the home testing -- actually, one point of clarification before I start. When I say the jockey for position, to me that's all positive side. I don't know that that's an offset at this point.

Okay.

So, you know. But if we go to the next stage. Obviously on the international side, they're not going to be influenced or impacted by the home testing. Really what's driving that is, a positive introduction of the SA-2. It has been a very well received product into that market as well as some of the new mask products. As well as, quite frankly, execution. We've been improving in many areas of the world, we've been improving our execution. I feel very good about that piece.

Obviously the piece that's influenced by currency is in the lap of the gods. But as far as the execution, the basic fundamentals of the business, I feel very good about the way the team is performing and the basic stable of products that we have. On the Americas side, as we move forward, what we've been stating here for quite a number of quarters is that we felt that Q1 and Q2 were going to be difficult for -- because of the product gaps and some of the base year comps and sort of absorbing some of the pricing channels. As we move through Q3 and Q4, we're beginning to get into that product flow in Q3 and a bit more product flow in Q4 and we -- we expect that we'll begin climbing back during that period, back to market rates of growth. So, we continue to feel comfortable with that assessment.

Last question, I'll get back in queue, regarding gross margins. I mean, just ask sort of in plain speak here, have we seen the trough in gross margins. I think 60% was a line that most of us wanted to see sort of stabilize that. And can we see expansion from here giving clearly a lot of what you've talked about with respect to the new products suggest efficiencies are being worked into the manufacturing facilities and, I guess it speaks to, how can that sort of be a greater influence to your gross margins relative to the price pressure you've seen and with respect to the latter, do we expect to see that abate a bit as Respironics becomes part of the larger organization that probably is more interested in sales -- or interested in running a profitable business.

Yes, well, I think you've got a short term element to that question. You have a longer term element to that question. Would I be looking for margin expansion in the next few quarters, no. I think that would be difficult to look for. One of the very comforting things in this market is that many of the pricing pressures that we talked about six months ago, nine months ago, it seems that there's been a floor established in the market. We're not seeing price levels drop below where we had seen some of the deals six and nine months ago. On the flip side of that, you do have obviously more customers as we've said it is going to happen here. More customers who are getting those price levels.

So what you're going to see externally during the time period is a bit continued pressure on ASPs here over the next few quarters but again, the good news is we're not seeing -- it is just simply an expansion to more customers and that's a very classic way of what happens in price in this market. So, a lot of the gross margin improvements that -- and some of the fundamental drivers that you would see, really come with significant changes in the product evolution and that we would see in sort of next generations of product and some of the changes that we are working on behind the scenes and the supply chain.

So, near term, would I be looking for expansion? No. Are we fundamentally doing the right things to continue to reduce our cost of goods over the longer haul? Absolutely.

Your next question comes from the line of Michael Matson of Wachovia. Please proceed.

Sure. I guess just wanted to ask you again a little bit about your confidence level in a rebound. I mean the comps obviously do get easier but the growth in the U.S. does seem to have slowed pretty substantially and the numbers that are out there show the consensus estimates show a fair bit of acceleration during the next couple of quarters. Are you comfortable with those?

Well, I don't comment on any specific sort of numbers that are out there. Let me talk a little bit more in general, Michael. The -- so, again, these first couple of quarters, we did have very difficult base year comps. We were in a gap in the product flow, et cetera. As we move into the Q3 and Q4, again, we're climbing back towards market levels of growth. So, do I feel comfortable with that? Yes, I do feel comfortable that we can climb back toward those levels. I'm not here saying we're going to get back to where we were a year and a half ago at 45% and 50% growth levels, I don't think that would be reasonable to assume. But I do think that we'll have some very good, positive momentum to get back to market levels of growth.

Okay. And then I was wondering if your growth -- are you going to do anything to try to reign in the SG&A and R&D levels given -- or the growth in those expenditures given the slowing revenue growth that we've seen? Because they were growing a little faster, I think, than your overall revenue growth in the quarter. I realize some of that might have been due to currency.

Big part of it was due to currency. I think Brett had given the breakout on, for instance, for R&D in the growth and constant currency, and it was substantially lower. At this point, we feel very comfortable, particularly in the R&D line, with the amount of investment that we're providing into the business. And when you're in a market that's 90% untapped, our view is that this is not the time to take your foot off the accelerator. So, we're doing the smart things, I think, in the sense that as the currency has gone a bit against us, we have slowed constant currency growth of those. But we're not going to starve the business. We simply -- this is simply the wrong phase of this industry's growth.

Particularly when you look at all of the good things that are happening whether it is the home testing decision that we're looking forward to in March or whether you talk about the data that's coming out in the co-morbidity, be it the congestive heart failure. And this study I think is going to be very important over the long haul, both to payors as well as to the clinical community. And areas such as diabetes and occupational health. There are so many aspects of this market that are untapped that our job is to keep this market growing and to participate more than our fair share in that growth. And so I think now is the wrong time for us to look at any substantial leverage off that.

All right. And then I guess just two product-related questions on some of your recently-introduced products. I guess not that recent, but the Adapt SV and then the Tango, kind of at the low and high end of the markets, just any updates you can give us there on the progress with those products?

Yes, both are playing their role. The Adapt SV remains -- and remember, the Adapt SV is also known as the ACS2 in Europe. So it remains a core element of our strategic growth as we move forward. And it is the basis of this congestive heart failure study. So, we continue to gain traction in the understanding awareness of complex sleep apnea and we continue to focus on the significant role that it can play in congestive heart failure outside the U.S.

As far as the Tango, remember there is really two different parts to the strategy behind Tango. On one side, it was basically to pick up some gravy, right? We haven't traditionally participated in that very low end part of the market. And the idea was, when you're on a sales call and they're buying those low end, let's participate. We're doing okay in that area. That's not really our core skills set. We tend to sell higher technology. We tend to sell algorithms that make a difference and focus on other aspects of the sales process. So, I'll say that we're doing all right. We're certainly not hitting out of the park with that part of it.

The other part of the Tango, of course, was more of a strategic blocking strategy over time. And not for any particular competitor or any particular risk on the Horizon but, we've got a nice market here and one of the things that we look to do is to create barriers to entry over time and if you look at the most rational place that a competitor might try to enter the market, it is where the intellectual property barriers and the technical barriers, the lowest of which is the low-end CPAP. It has done a effective job, I think, in that side of the market, which is to create a bit of block.

All right. That's all I've got. Thanks.

All right, great.

Your next question comes from the line of Tim Lee of Karis and Company. Please proceed.

Hi, good afternoon. Kieran, can you just give us your thoughts on how you think the market dynamics may change here with Respironics about to be in the hands of the Phillips. So do you think we're heading into an era of greater pricing stability, and Keith would be great as well, given his experience with Phillips as a part of Heartstream.

Yes, that would be great. So, in -- obviously the water has got to flow under the bridge here. So, we're sitting here trying to predict the future. But I can tell you that my view on the acquisition is I'm very positive on it. I think it is great. And I think in a lot of ways, it is great validation of the growth prospects in this industry. I think it is recognition of this industry being highly underpenetrated. And I think having a large well-known brand entering the marketplace should help us in creating awareness within the industry and creating awareness within the various medical silos. So I'm very positive and very optimistic about the future and Phillips' entry into the marketplace.

As far as pricing, we'll have to see how that flows. I am encouraged to note the reputation of their company is usually to sell on value and on a market expansion. And value being -- bringing new and innovative ideas to the market place. That's the kind of market that we think is appropriate again for such an underpenetrated market. So, my view is it is a positive development and I'm looking forward to working with them in market expansion and obviously competing with them in the appropriate manner. Keith, do you have anything to add to that?

Kieran, I would just say that I agree with you 100% on the perspective that Philips sell on the basis of value. They also have a history of growing markets which is one of the things that a lot of us are very excited about. We -- ResMed has spent a lot of time growing individual market segments. Respironics has spent a lot of time as a close follower. We view Philips as a company that will invest in the market growth and put as much time into the development driving more people into the diagnostic channel and the therapeutic channel as we are. So, we're very excited about this.

Just one last bit, if I may. Can you give us your current thoughts on how you think competitive bidding is going to play out in the market place?

Well again, water has got to flow under the bridge there. We'll wait to see what the -- how the results pan out there. And what bids are accepted and what not. We hear mixed things from the market place. As with anything before the final pronouncements, you get plenty of rumors running around. The good thing here is that CMS has -- was running a bit higher on the pricing than you'll see at most managed care and other payers. So there's room to move on that to start with. And, from our perspective, it is 10% of our global sales, 20% of our U.S. sales and so we think we're still well-positioned to compete there. But it is not a direct impact on us. It is an indirect impact.

Thank you.

Your next question comes from the line of Ben Andrew of William Blair. Please proceed.

Good afternoon, Kieran.

Good afternoon.

Just a few things wanted to follow up on. First, if you look at the U.S. generator growth versus the international and you normalize for currency, what's your sense about how important a driver the new generators have been on the constant currency generator growth overseas and should we see that really kicking in quickly here in the third fiscal quarter with the new product?

Yes, great question. So the -- a large part of the SA2 impact has not really even been felt in the ex-U.S. market. It was launched during the quarter so you have the product introduction time and depending on what market you're in, you either see a delayed impact or you see it more similar to what we'll see in the Americas. France would be an example of where you would see it more quickly. Germany would be an example of where there is a multi month delayed impact on that stuff.

So, what I can speak to is all of the leading indicators and the signals and the feedback we've had for the market then. And I've got to tell you, people are responding very well. And the thing that they seem to be keying on is the difference in this motor technology. Getting the concept that this is like changing the engine in your car. And it is very different. I mean it is much more efficient.

The motor spins at a slower rate and yet it gives higher performance and that all leads to a major issue in this marketplace which is how do you reduce noise? So it provides wins in each of those segments. So, all of the indicators that we've had out of the ex-U.S. marketplace today have been extremely positive. And I think it will have a very positive impact on our ability to sell in the Americas. To be able to not inconvenience our customers by making them change their accessories and what not and yet giving them a whole new engine in the car. So, it is -- I think the singles are good.

So if you look at the U.S. generator growth then, what is really going on here? We're down 7%. What's mix? I mean what is price and then what's units? Are units down -- are units flat and prices down 10, 15? What's going on?

Well, I think when you say we're down, we're down about 2% in the flow generator, right?

Excuse me. I was thinking of the -- so, minus 2. But, what's going on there?

Right. So, it is a little bit of both. Clearly, you had some price in that. But for the most part, I thought to say the slow generator on a volume basis is flat. It may not have gone backwards but it is flat. And part of that is the various elements that I noted earlier. Part of it is it's a difficult base year, part of it is a product gap. Where we're sort in anticipation of the -- of these changes to the S8 where we can introduce some new feature sets and introduce some new value props and some of it is some of the other points that Keith has noted.

Okay. Okay.

Keith, do you have anything to add to that?

I would just say when you look at the SA1, it is a product platform that's 10 or 11 quarters old. And our competitor has had a re -- a new product introduction during that period of time. The momentum swung in their direction. The SA2 with the new motor and the noise factor and the easy breathe capability is something that our organization is looking for very strongly to breathe significant life into what we're doing. It is, for all intents and purposes, we will view it as a new product introduction and we're very excited about it. The pendulum will swing back.

Okay then just kind of finishing up on the generator side --

But Ben, let me interrupt you for a second. Because I don't think Kieran caught this in his response back to you. You asked specifically about Q3. That product will be introduced into the U.S. at the beginning of Q4.

All right. We've got that. We've got the S8 platform for the VPAP in there so that may help a little bit, I guess.

Yes.

Exactly. Partial quarter impact.

So, if you think about though the impact of the Adapt SV, this is a very high dollar price system, what sort of impact is that having? Is that a $5 million product a quarter this point and is that keeping the core generator business from being down five or ten on a units basis or is it all generally flattish?

We haven't broken out that piece in the past and so I don't feel comfortable at this point going below that on sort of the mix analysis. But in general, I think it is fair to say that when you look at the materiality of impact, flow generators flat to down a little bit. And I think that's -it's a fair assessment and a conclusion to walk away with then.

Just one quick question for Brett if he's still around. The tax rate in the quarter, can you kind of walk me through what's going on there and what we should expect for the balance of the year please?

Yes. Hi, Ben. The tax rate for this quarter was 30.9%, the effective tax rate which is pretty similar to Q1. And I expect the balance of FY '08 to be around that level as well.

Okay. So no changes there. Then finally on Cap Ex, you can obviously see the impact of the facility build-out in San Diego. What's your thought on that and how long that's going to run at kind of a higher level and is there any additional Cap Ex for facilities expected beyond that new facility?

No. So, we're pretty much through. We had some extension to the manufacturing facility down here in Sydney which was completed in December. So, that's pretty much through there. So, now we've got the County [inaudible] Facility that's being constructed. It is due to finish around March 2009 and I would roughly dial in about $50 million a quarter on Cap Ex for that facility.

Your next question comes from the line of Paul Choi of Merrill Lynch. Please proceed.

Thank you. Brett, maybe some housekeeping questions with respect to currency. Can you please give us what your FX assumptions are for the -- in terms of the total impact for the rest of this year.

If I could tell you what the currencies were going to do, I could probably do that. But I think -- you just don't know where we're going to do with currencies, particularly at the moment where it is pretty volatile. But clearly, we have some hedging in place which mitigates to some extent. But I think when I'm looking at -- I don't think we're going to get appreciable movements [inaudible] and the Euro or the Aussie and when you look at a whole various analyst predictions, some are up and some are down. So, I think we'll just continue to manage it as we've done. And in terms of impact though, if you're looking at -- it was $0.01 this quarter, what it might be in the next few quarters, I suppose as the currencies wash through, you're probably looking at that sort of impact over the next few quarters, barring any major movements in the currencies.

Okay. Very good. So, then in terms of as we think of margin impact over the quarter here, we should think of the gross margin perhaps being relatively flat with the room for potential little bit of improvement from (inaudible). Is that the correct way of thinking about it?

Yes. I mean, I've not too much more to add. Kieran said at the moment it is around 60%. In the short term, we'll likely going to need expansion on that, probably not. If you look at September to December, that margin was around the sort of 60% mark with a whole various factors. Obviously some mix and outperformance in masks, generally speaking would mean that you would get some benefit on the margin.

Okay. Very good. And then one question. Either to Kieran or Keith in terms of the S8 recall, can you give us an update please on where you stand on that in terms of completion and remediating it and how long you expect it will take to complete, please.

I'll throw that to Keith.

We believe that -- well, first of all, there's two different ways to break that down. One is the world -- the ROW recall which I think, at this point, is pretty well -- pretty much on its way to total completion. In the U.S., we believe that we're about 70% completed with this. We believe that we're at the point where there's no further distraction to the sales force or very minimal going forward. But we also believe that we will be in this for another, probably one to two quarters. Which is what we had anticipated when we first announced the recall.

Your next question comes from the line of Alex Smith of J.P. Morgan. Please proceed.

Hi, guys. Just a question on the heart failure trials.

Yes.

How much is that going to cost in terms of financing and are you going to be paying for that? Or someone else?

We will be funding it. And Brett, you want to go through the estimates?

Yes, so it will be -- looking at the study, it will be -- it's around four to five years, four and a half years with a total cost of between $10 million and $12 million over that period of time. Spread reasonably evenly but you might get a little bit of a kick up in the FY '09 on that study but in terms of the total funding, it is around the $10 to $12 million over the period. And the spend -- how quickly we go through the spending depends on how quickly we recruit through the clinical trial and so on. But in terms of overall ballpark figures, that's what we're talking about.

Is that in addition to the 7% or so of silos you spend on R&D or part of that ongoing commitment?

That will be part of the ongoing commitment we think will run around the 7% to 8% including funding that trial.

Okay. And I guess another question is obviously with that home testing, the role of auto setting devices becomes a bit more important in terms of setting the pressures in the home. Kieran, do you think that we could see a mixed shift toward APAPs, as to the CMS ruling does comes through pretty much as the proposal?

Yes, I think -- again, I think we're going to have to wait and see how the proposal pulls through the finish line here but certainly you would think it would open the opportunity for the additional use of auto setting technologies. Here's the -- the whole question of how the titration then occurs at home if the diagnostic process happens at home. One of the great benefits of auto setting technology is that it adjusts night by night, day by day over the entire time period that the individual uses it. So, it is absolutely perfectly tailored to those types of opportunities.

And I should note that we didn't waste any time. Within even -- as soon as the preliminary decision came out within a couple of weeks we were back as we have before. We're trying to take advantage to see if we can get increased compensation and increased reimbursement for our customers to be able to supply those auto setting devices. So it is a long shot. I wouldn't necessarily model in success at this point but I think that there is a very good economic rationale for the increased use of auto setting. It is going to simplify the process. It is going to improve patient care. It is going to reduce the expense of the HMEs in handling these patients. But, I think that they need to be appropriately compensated for it so we're going to drive on that.

Just one more, by the way, on the congestive heart failure. I don't want to pass by that question without noting, this is a very significant event for us I think in putting a stake in the ground of congestive heart failure. We've talked quite a bit about the co-morbidities and we've taken some significant actions over time but this is a very interesting and pivotal study that should help demonstrate benefits in both mortality and hospitalization. That's an important aspect in the health economics and the continued reimbursement in this area. I think it is very important role and leadership role that we're taking in this market.

In addition, there is a side benefit while you're doing that is that you're increasing the awareness and the understanding of the role that Adaptive-Servo ventilation plays within the heart failure community and we look forward to generating benefit during the life of that study. So, it is a very important study from multiple aspects.

Kieran, you mentioned that you basically are applying to get a new code for APEC. How long do you think that process might take?

Why don't I throw that over to Dave Pendarvis who leads many of our efforts in that area.

Alex, as you know, we've gone through this code in the past and haven't received it. So, as Kieran said, we don't want everybody to immediately model in increase reimbursement for our automatic device. But that would come up during the first half of calendar '08 and again that's at the CMF level. So, as with all of these things, both home testing and any increased reimbursement, that impacts the U.S. Medicare reimbursement first and anything that would happen positively would take awhile to roll through the commercial payers throughout the rest of the U.S. So, we look for, if we got something positive, we would hope to see an answer in the first half of the year.

Thanks very much, guys.

You bet.

your next question comes from the line of Joanne Wuensch of BMO Capital Markets. Please proceed.

Hi. Thank you for taking the question. You told us that FX was a negative penny contributor to EPS. What was the impact to the top line?

Hi, Joanne. It is Brett. On the top line, we had favorable currency movements at around $10 million for the revenue number.

Okay. How many patients are you going to be having in your congestive heart failure trial?

The objective is 1,200 patients. So, it is quite a sizable study, particularly for this industry. It is certainly the largest study of its nature.

Okay. On previous conference calls, you talked about the OS market growing 15% to 20% and your goal -- or, it wasn't a goal because you guys don't give guidance, but verbiage around getting to just sort of within that range for '08, what are you currently thinking?

So, we historically said that we believe the ex-U.S. mark occurs at about 10% to 15% per annum and that the Americas market we expect to grow at 15% to 20% per annum as an average basis, and so when you blend those things together, you're somewhere around the 15% plus range. So, we continue to feel comfortable that in the long-range that that's the growth prospects of the industry. Certainly, there will be some times when it is a little bit above that and a little bit below that. We've seen that over the past X number of years. I'll just say again, I'm just extremely comfortable and pleased with some of the signals for the long-term health and growth in this marketplace particularly with the home testing.

Okay. What I'm trying to get my arms around, which is what a couple of other people are trying to do, it sounds like, is are we at a trough, do you move out of it and what is your pace of moving out of it? I know comps get easier. I know you've got new products. I know you don't like to give guidance. Can you just start to put some gait on some numbers though?

Yes, well, again, I think we'll continue to give you the directional piece that we've been given. Do you think we've troughed in the Americas side of this? Yes, I think we have. And we expect to be pulling out of that. As we go through Q3 and Q4, we've got partial impact of some new products in Q3. We've got some partial impact of other new products in Q4 and some that get the full balance. So our objective is to start to get back towards market rates of growth as we get towards the end of this fiscal year and then take it from there into the next year. So, to answer you directly do we feel like we've troughed in the Americas, yes, that's certainly our expectation.

Your final question comes from the line of Andrew Goodsall of UBS. Please proceed.

Thanks very much, Kieran. And congratulations on taking up the role there. Just, I guess, just thinking up ahead with the home diagnosis a potential powerful driver for the industry, we're sort of hearing some machinations of home healthcare dealers, and so on putting plans in place. Could you give some indication of sort of what steps you might be taking over the sort of next 6 to 12 months and whether there's any cost involved just to, I guess, align yourself to sort of take advantage?

Yes, so I think, you know, that will become more and more clear as we get to a final decision and we understand what's in and what's out, right. There are a lot of variables in this decision. Type three, type four devices. Who are -- is going to be able to be involved in the process. What's the titration process that's gong to be acceptable. How is that going to be reimbursed. So, there's some pieces in here that can influence the role that we can play and who will be addressing that.

So, at this point, I don't anticipate that we have certainly any increased expenditures to support that. And, but if an opportunity arises and we think that we can see a way of stimulating growth extremely quickly, would we jump on it? You bet. Is that immediately obvious at this point? No, it is not. I think at this point, we and others have -- already have technologies.

So we've got the apnea link which is a very unique device and a very powerful device that would certainly satisfy the requirements for the type four. There are others that have that. And there are a number of suppliers in the type three which is good because that indicates that there are a number of players that from an industry perspective can supply devices that can get these devices in the hands of those who need to use them.

And our intention is to work with our partners that we've worked with for quite some time to support the sleep community as they evolve through this process. And most importantly, to support the patient outcomes. How can we help them drive access to more patients. So, at this point, again, the short answer to your question, are we looking for some significant expenditures and support of this, I don't see that at this point.

Sounds like a quarter -- a next quarter question, you'll have a bit more detail then with the decision. But, perhaps a quick follow on. Just actually, Germany had been weak in previous quarters. Obviously, good rebound rest of world with currency. Could you just sort of outline where Germany is at in the moment and maybe anything else he's happening in Europe?

Sure. Yes, so, Germany as a results perspective continues to be relatively flat. That being said, I think we're making very significant progress in a lot of aspects of the German organization, the German market. The new management team has been in there for about a year. They took a bit of time to get their feet underneath them. They've made positive changes.

The thing to remember is that in the German marketplace, we are home medical equipment provider. And so, when we make changes, there's this process -- for instance with the SA2, you put the SA2 out there, they need to get out to labs, then there's a -- often a three month period where you have introduction not only to the physicians but then there's trial periods to the patients. Then there's a prescription written then we have to chase down the payment on that prescription over another 90 days. So as a result, when you start some seeing positive indicators, you start seeing the flow through a little bit later. And then in addition to that, of course you have deferred revenue because these are service contracts.

So, Germany, we tend to look for the sort of positive signals of improvement such as in prescription rates or other aspects of the market and we've started to see that. So, I'm comfortable that Germany is beginning the slow road back to recovery and it seems in good shape. What that does indicate is other parts of ex-Americas are doing quite well. We've got Asia-Pac that's doing quite well, we have other countries within Europe such as France and the U.K. that are really hitting the ball out of the park. That's both because of the product stream and because of fundamental execution. So it is a mixed bag in there but the mixed bag is for the most part Germany still sort of in that flat range but signals of improvement but other than that, very, very good progress.

Okay. Terrific. Thank you very much.

Yes, no worries.

And that is all of the questions we have for today. I would like to turn the call back over to Mr. Kieran Gallahue. Please proceed.

Well, great. I appreciate the interest and then the questions. As you can see, we did have some challenges in Q2 and particularly some challenges in the Americas. But I will -- would like to leave the call with the highlight that I'm feeling very optimistic about where this market can head in the long-term. We had some very good short-term signals. And if you look at the product flow over the coming five to six months, we're very encouraged by what it is going to mean to the organization and what it is going to mean to the sleep community as the release said. So, I look forward to updating you on future calls and demonstrating our progress. Thank you very much.

Thank you for you participation in today's conference. This concludes the presentation. You may now disconnect and have a great evening.