IRIDEX Corporation (IRIX) Q3 2013 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen. Thank you for standing by. Welcome to the IRIDEX Corporation Third Quarter Earnings Conference Call. [Operator Instructions] This conference is also being recorded today, October 31, 2013. I would now like to turn the conference over to our host, Mr. Will Moore. Please go ahead.

Thank you, operator. Good afternoon, and thank you for joining us as we discuss the results of the third quarter of 2013. My name is Will Moore, and I'm CEO of IRIDEX. I'm joined by Jim Mackaness, our CFO and COO. Jim and I will be delivering some prepared remarks related to the quarter and to the business, and then, we'll open the floor for questions. Before we get started, Susan Bruce will read the Safe Harbor statement. Susan?

Our discussion today will include forward-looking statements, including statements regarding the adoption of our products, including our MicroPulse product offering; trends in the domestic and global healthcare markets; planned product releases and development efforts; the success of the reorganization of our sales and marketing teams and the results of our education, sales and marketing campaign; sales of our consumable products and the anticipated mix of sales of consumables and capital equipment; our long-term margin goals and performance against those goals; our anticipated fourth quarter operating and financial results, including projected revenues, gross margins and operating expenses; and our goal to turn IRIDEX into a more commercially oriented, market-driven company and leverage the respected IRIDEX brand. Forward-looking statements are only predictions and involve risks and uncertainties that may cause our actual results to differ materially from those expressed or implied by these statements. Factors that may affect our results are summarized in our quarterly release and described in detail in our SEC filings. Forward-looking statements are made as of today's date only, and IRIDEX disclaims any obligation to update any forward-looking statements. Any future products, features or related specifications that may be referenced during today's call are for any informational purposes only and are not commitments to deliver any technology or enhancements. IRIDEX reserves the right to modify or cancel future product plans at any time.

Thank you, Susan. I'm pleased to say we had a very good third quarter, actually, a record quarter for IRIDEX. Our revenues for the quarter were $9.5 million, a year-to-year increase of more than 21%, and a solid sequentially over our second quarter 2013 revenues of $9.2 million. Q3 continued to be prove out the fact that our new model is resonating, and we believe we're executing very well as a company. As most of you know, our goal has been to turn IRIDEX into a more commercially oriented, market-driven company. The medical community and investors have always known IRIDEX as a company that develops sound, innovative laser products. Jim and I developed and are executing a plan to leverage respected IRIDEX brand, add better execution and more commercially orientation to that reputation. At this point, I believe we're about 80% there. We have made some key personnel changes, adjusted our sales channel, become more responsive, implemented quicker product development cycles, improved our overall efficiency and opened the doors to new partner relationships. I'm comfortable in saying we have made adjustments that we planned, and we should continue to see operational and financial improvements as we move into 2014. If you look closer at our revenues for the quarter, you can see why I'm optimistic. Domestic and international sales systems were both up significantly over the prior year. We beat the top end of our revenue guidance by $400,000, and we generally see that momentum carrying into the fourth quarter. Not only were the system sales strong, but also, we're seeing improvements in gross margins. We are tracking well with the sale of consumable products, but the ratio of consumables to capital equipment continues to be lower because of the growing demand for lasers, both traditional and MicroPulse equipped. This phenomena was expected, and we believe it will remain with us for the foreseeable future. One of the most important reasons for my optimism is what we are hearing from our various customer segments, including leading ophthalmologists, government healthcare officials tasked with the delivering of broader, value-based solutions for their citizens. They're excited about our new MicroPulse product, and especially internationally at this point, about the value of lasers in general for the improved safety profile, durable outcomes, the preservation of vision and sustainable economics. MicroPulse is a unique proprietary IRIDEX technology, and its adoption is one of our major initiatives. We believe it's also a disruptive therapy and one that fits in the broad concept of value-based medicine. MicroPulse was designed for treating serious ophthalmic conditions by allowing tissue to cool between laser pulses, thereby, preventing tissue damage and increasing patient comfort, all while creating an extremely safe and effective procedure with durable outcome at a reduced cost compared to alternative drug therapies. The broad concept of value-based medicine coupled with a rapidly growing incident of diabetes, and to some extent, glaucoma, is rapidly changing throughout the world and will be in the U.S. as soon as Obamacare value-based concept takes hold. In Europe, Brazil, India and other developed and developing countries, people are looking at the huge number of diabetic patients and realizing they can't afford their current mode of repeated drug treatments for DME. It's too expensive and not financially sustainable, let alone the logistics of having millions of patients repeatedly visiting their physicians to receive costly injection every 6 to 8 weeks. This is especially true as our education efforts are taking hold and clinicians recognize that phobia friendly MicroPulse technology can deliver a durable clinical solution for the patient's with an equal or better safety profile. As evidence of this, some payers are questioning the number of injections that a patient may receive. Others are investigating a laser-first approach or making treatment decisions based on the sickness of the ocular edema, and others are suggesting a combination of injections and lasers. These are watershed events that are happening around the world. We believe we are migrating towards a tipping point. Not in the U.S. yet, where physicians and payers have not made the leap from a fee-for-service model to a value-based model, but it is coming. As we get our message to the patients and the payers and continue to provide clinical data to physicians, physicians in the U.S. should adopt MicroPulse in greater numbers. That's our plan. Again, we are seeing the marketplace react to MicroPulse. Physicians come up to our booth in conferences and without prompting or asking about it. At a recent conference in Hamburg, physicians actually paid a fee to see presentations from 4 MicroPulse-practicing physicians. In Amsterdam, we sponsored a workshop, and more than 100 physicians gathered to learn how it could benefit their patients. Again, these are watershed events; and we believe MicroPulse delivers safe, durable outcomes that are the same, if not better, than drug therapy, but with the cost of treatment substantially better. This message is beginning to resonate quite well. Before I turn the call over to Jim for more details on the financial along with the Q4 guidance and our plans for the American Academy of Ophthalmology, I'd like to say thank you to Jim, his entire team and all of our employees for a well-executed Q3. Jim?

Thanks, Will. As we noted in our press release and in Will's comments, we had a record quarter in Q3 as revenues reached $9.5 million, up 21% from Q3 2012, and up 3% sequentially from Q2 2013 where revenues were $9.2 million. This is particularly noteworthy because historically our third quarter is our lighter revenue quarter with the sale of systems impacted by the holiday season, particularly internationally. With that said, system sales for Q3 2013 were $4.7 million, up from $3.7 million in Q3 2012, with significant increases in system sales both domestically and internationally. On a sequential basis, system sales were up from $4.3 million reported in Q2 2013, driven by a growth in domestic system sales. International system sales were lower, but that's not surprising given the 2 large tenders we have previously reported which had occurred in Q2. And we saw a good sales momentum as we exited the quarter. Recurring revenues increased to $4.8 million in Q3 2013 compared to Q3 2012 recurring revenues of $4.1 million, a 16% increase, and remain constant with recurring revenues for the preceding quarter, Q2 2013. The increase in recurring revenues was a result of a combination of factors, including the introduction of the independent channel selling Peregrine-branded products in the U.S. and the continued benefits of the Alcon relationship. Even with this growth, as a result of the significant increase in system sales previously mentioned, recurring revenues were 50% of the aggregate revenues in this year's period, a reduction from 52% reported in Q3 2012. Gross margins were 49.6% for Q3 2013, which illustrates our continued improvement over the last several quarters where we reported 47.0% in Q4 2012, 47.3% in Q1 2013 and 48.7% in Q2 2013. This brought us back to the gross margins of last year's comparable period and, allowing for rounding, met our stated short-term goal of 50%. We will now turn our attention towards making progress on our long-term goal of 55% gross margin. As we've said in the past, with the adoption of MicroPulse growing, we anticipate having more pricing leverage as we go forward. We've launched a significant cost reduction program concentrating on the IQ platform that supports MicroPulse, which should start to bear results towards the end of 2014. In this current quarter, Q4 2013, we will launch a new TxCell product that benefits from cost reduction efforts that is typical with a second iteration product. And we see opportunities to innovate on the consumable side of our product portfolio and grow that business. Contributions from consumable products typically come with above-average margin. These efforts, together with the leverage we expect to see from increased revenues over our stable operating overhead, give us confidence that we have a plan in place to achieve our long-term goal. Operating expenses for Q3 2013 were $4.1 million, which was at the top end of our guidance but as anticipated, down from $4.5 million in the prior-year period. The total includes the expense of the domestic independent sales channel, which we did not have this time last year, and increases in G&A expenses due to medical device taxes and compensation-related items. In general, I believe we are seeing good control of expenses by department managers. Operating income for Q3 2013 was $0.7 million, a substantial improvement from an operating loss of $0.6 million for the prior-year period. Please note Q3 2012 did include a one-time expense related to severance cost of $0.7 million. Our net income from continued operations for the quarter were $0.5 million, or $0.05 per diluted share, compared to a net loss of $0.6 million, or $0.06 per diluted share for Q3 2012. Our 9-month results help illustrate the progress we are making. Revenues for the first 9 months of 2013 were $27.7 million, up 12% over last year's first 9 months; operating income was $2.1 million, up $3.2 million from last year; and net income from continuing operations for the first 9 months was $1.8 million, compared to a loss of $0.4 million for the first 9 months of 2012, or earnings of $0.18 per share compared to a loss of $0.05 per share on a diluted basis. Looking to the fourth quarter 2013, we are projecting revenues between $10.2 million to $10.5 million, which would represent an increase over Q4 2012 revenues of between 11% to 14%. Gross margins between 49% to 51% and operating expenses between $4.4 million to $4.6 million. Our operating expenses are expected to increase because this quarter with the AAO conference, which is a large expense for us, and due to the start of the cost reduction program for the IQ platform. Speaking of AAO, we will be launching 3 significant products as previously referenced. Second version of the TxCell, a high-speed delivery device that now will integrate with the entire market of slit-lamp adapters, not just eye style; a green scraper product, which is a new consumable design for membrane scraping that is a derivative from our very successful GreenTip cannula; and 27-gauge, Peregrine-branded straight and curved-style EndoProbes, which highlights the value of our Peregrine relationship, demonstrating our combined ability to identify a growing need in the marketplace and to quickly design and launch consumable products to meet that need. We did have some activity in the stock repurchase program. We bought approximately 20,000 shares at $6.01 during the quarter, bringing the total purchases under the plan to 37,000, and we still have 2.8 million available to invest. We remain active, although with the recent performance of our share price, buying opportunities have been few. Beyond the financials, I would like to echo Will's comments and compliment the team and our employees on their performance. Their efforts led us to having a very good third quarter. And this leads me to an organizational announcement. On the last earnings call, Will mentioned that he had taken over interim responsibility for international sales and Tim Buckley, our Vice President of Marketing, had taken over interim responsibility for domestic sales. Effective today, I'm pleased to announce the promotion of Tim to Vice President of Marketing and North American sales. Tim will continue to report to me; it's just now he's permanently on the spot for the number for North American sales. This includes our direct and independent sales forces in the U.S. and our distribution relationship in Canada. Tim's efforts have been very impressive, and I am confident that under his leadership the marketing and sales teams will continue to build on the momentum and success they have shown during the first 9 months of 2013. And with that, I'll turn the call back over to Will.

Thanks, Jim. Most of you know we have been, for the past years, focused on the retinal specialists treating vision impairment caused by diabetes, which is growing at an alarming rate all over the world. But we also have a growing presence in glaucoma. Today, we provide 2 treatment options for glaucoma, with an additional product offering under development, which we hope to bring to market by the second half of next year. Finally, I'd like to conclude by offering some remarks about the broad market opportunity for IRIDEX. On a macroeconomic level, we are gaining a lot of traction. We are not saying drug therapies are going away. What we are saying is the pendulum is swinging back towards laser technology and that some combination of laser and drugs will be the likely clinical outcome in all regions. But in terms of efficiency, durability, logistics and economics, it is our opinion that our laser systems solutions are substantially better on a number of fronts. We are hearing from physicians globally that it is unsustainable to continue the current protocol of giving injections. As more physicians and facilities understand these dynamics, we are confident that the market will come our way. From our viewpoint today, that shift is already occurring. With that, I'd like to thank you for your time and interest in IRIDEX. At this point, I'd like to turn the call over for questions. Operator?

[Operator Instructions] Our first question comes from the line of Sam Bergman with Bayberry Asset Management.

I'm not sure which is better, the Red Sox winning the World Series or the third quarter IRIDEX earnings report.

You're asking me or are you making a statement?

I'm making a statement.

Okay.

A couple of questions I have. One, regarding the share repurchase. I realize you purchased a small amounts of 37 -- plus 37,000 shares. With medical device companies selling at 3x to 4x sales, shouldn't you be a little bit more active at these prices because it's only selling at 1.25x sales?

Sam, this is Jim. The biggest challenge we have at the moment is the SEC volume restrictions. In other words, I think our sentiment is a little bit similar to yours, so that's why we remain active even as the share price has gone up. But we do find that the SEC volume restrictions is one of the major truffles for what we would desire to do.

Okay. Besides some of the increase in sales coming from perhaps the Peregrine deal and increase in consumable sales, were there any sales to international countries this quarter that you can talk about?

Yes. I think -- I'll have first crack. Will can have the second crack. I think international sales were good. Obviously, they're slightly down from the preceding Q2 where we had a couple of large tenders. So I'd say the good thing about the Q3 sales internationally was it was a very steady rate that, obviously, aggregates into a record when combined with the domestic. And we managed to achieve that without the benefit of any significant tenders. So I think it was well dispersed, and it was a solid sort of business rate.

I think, Jim's answer, Sam, and I'm comfortable with his comments.

Okay. And the last question, is R&D going to uptick in the fourth quarter with sales or marketing or a combination of both? What's your expectations?

Expecting both to tick up a little bit. On the R&D, that was the -- that's the cost-reduction program that we've launched. So that's what's going to move the R&D up. And then, as you know, sales and marketing, that's where the AAO cost is anticipated to hit.

Our next question comes from the line of Raymond Myers with Alere Financial Partners.

Will, I want to ask you about the MicroPulse laser system market adoption. How do you track the market adoption and market acceptance of MicroPulse? Are there specific metrics that we use?

Well, there's some subjectives, Ray, and there are also some objective ones. On the subjective side, it's what I was talking about in regards to the watershed events that I mentioned in the call. First and foremost, the presentation at Hamburg, Germany, was sponsored not by us but sponsored by the European Society of Retina Specialists; and not only that, but the physicians had to pay, I think, it was EUR 25 plus tax, to attend. Those are events that have never happened. And so I look at that and say that's tracking well. The other thing that I look at is to deal with the government tenders, as Jim mentioned. When we talk to countries like India, we spend time talking to the governments; and their viewpoint, really, is dealing with this value-based side. And as I see more people accept the value-based solution, it becomes a marker for me. And by that, I mean, we sit down and do the math. If a patient becomes diabetic at 40, by the time they're 50, they're going to have to have -- they'll have a diabetic vision issues, and they'll start having injections. And you can just figure out taking that starting point of 45 or 50 until a life expectancy of 75, you're having injections every other month for the rest of your life. You can do the math and add it up, or you can take and deal with the laser treatment. And that's resonating well with the single-payer type systems. Now on the other side, when we start talking about it just on an objective, Jim has put together, with the sales team, a model of how many additional MicroPulse systems will sell in a year for satisfaction, and that's the part we're tracking quite well.

Okay, great. And also in the past, you had talked about approaching a technology tipping point. Do you have any update as to when you think you'll reach that tipping point? Obviously, it sounds like you feel you're tracking well.

Yes, I think that the situation -- we are tracking -- we're very satisfied. I'll put it that way. Just kind of in definition of a tipping point, you can take the number of physicians, in the U.S., for example, take the number of physicians that are out treating DME, whatever the number is. You need to have somewhere around 20% of those that have adopted your technology before it really starts to shift the herd over to an accelerated revenue. We're not there yet. We're moving there, but we're not there yet.

Okay. That's fine. One thing you said in your remarks was intriguing, that in the second half next year you expected some new glaucoma products to be launched. Can you elaborate on that?

Well, I can elaborate on what we're trying to do. As you know, glaucoma is a progressive disease that's not curable, and there's a variety of solutions. And we had one for the last number of years in our G-Probe, and people don't really realize that the G-Probe is one of our largest single-selling SKUs, and that's for very late stage glaucoma. We then started getting positive responses from comprehensive physicians with the use of MicroPulse to improve the drainage of the mesh. And we're working -- and that's kind of the midrange glaucoma. And we're working on another product that would be used in the early-stage glaucoma, and that we're hoping will be out by sometime late next year. It's not a scientific discovery we're working on, but more engineering discovery ended. It's not trivial, but it's straightforward. So from that point, we would end up with 3 product offerings across the entire spectrum of glaucoma, and we'd be the only one who would be doing that.

Well, that's great. And you think you're going to have some of those products to market next year?

You used of the term products. I use the term product. We have 2 on the market already.

Okay. Two [indiscernible] and one more.

The late stage glaucoma product, the G-Probe, that we use to turn the tap off or the inflow of fluid, and the MicroPulse we use for dealing with the mesh to improve the outflow. Those are already in the market. The next one I was talking about is early stage. That's what's we're working on to get out next year.

Our next question comes from the line of Larry Haimovitch with HMTC.

I'm kind of speechless, actually. When I saw 21%, I rubbed my eyes and thought, "Oh, my god, that is just tremendous." I'm sure you're very, very pleased.

Yes, we are pleased.

So I just want to make sure I got an understanding of the quarter. The only thing I looked at that surprised me that wasn't as good as I hoped because everything else was so strong was the gross margin. But if I understood your prepared remarks, it was simply that you sold a lot more box than you did disposables, and the boxes have a lower gross margin than the disposable. Is that basically accurate?

Yes.

Okay. And Jim, it sounds like the initiatives that you discussed in terms of manufacturing improvements, productivity, et cetera, should over time be raising the gross margins on the capital equipment side considerably. I meant the gross margin pressure should be upward as you get more efficiencies in the capital equipment manufacturing?

Yes, yes. I think that's the -- exactly. I think the key point there, as you said, is the programs that we're currently going on are on the capital side. So that will help, yes.

I don't know if you'll be willing to answer this question because I know you've got several competitors, I'm sure, listening to the call. But would you provide any ballpark guidance as to what the gross margins are? Again, in the ballpark sense of the capital equipment side versus the disposable side, is it sort of 45 capital equipment, 55 disposables leading to a blended 49 or 50?

Yes, I might shade the slope a little more, but you're in the ballpark.

Okay. And so do we have opportunities on the disposable side to improve the gross margins as well, particularly as you get better with the Peregrine relationship?

For sure, there's work going on, on that side as well. So to us, it's continuous improvement. So yes, I wouldn't exclude that. It's just the current focus a little bit more is, particularly on the IQ platform, on the capital side.

And Jim, how much cash did you generate in Q3?

We ended up at $14 million. I can tell you that.

Yes. And I didn't look at the June 30 number. I know it's up from the year end of the last year.

Yes.

How much cash did you generate in Q3 you have? Is it [indiscernible] million dollars?

Well, I'm going to ask someone -- I got someone sitting next to me who's going to run the numbers while we -- I can't [indiscernible] that on the top of my head.

Okay, great. But you're certainly cash flow positive, of course?

Yes, yes. Yes, absolutely.

Okay. And as far as the share repurchase, someone raised it in previous question, but it's mainly the volume limitations that keep you from being more aggressive.

Yes. As you can see, our average purchase price for the quarter was at $6.01. So it wasn't really throttled by a pricing ceiling. So you could see that therefore, logically, most of it was through the volume restrictions.

Right, right. Okay, I'll wait on the call. I'll wait -- you can call me later, Jim, if you have the number on the cash flow. You can chime back in when you have it.

Yes, sure. Will do.

Our next question comes from the line of Joe Munda with Sidoti & Company. Joseph P. Munda - Sidoti & Company, LLC: Well, I guess I'll start off with the Peregrine relationship. How much did Peregrine contribute to the overall revenue growth in the quarter?

I'm going to leave that question for Jim.

Yes. So when we brought Peregrine on, our expectations were that if we could get it to be on an annual basis contributing above $1 million, that would be a success. The ultimate goal, when we try and get all products through all channels, would be to try and get it approaching $2 million on an annual basis. And I think we've made pretty good strides for the -- what are we at -- second quarter in to get to north of the $1 million target. [indiscernible]. Joseph P. Munda - Sidoti & Company, LLC: Okay. Yes, that's helpful. As far as sales force, you guys spoke a little bit about the independent reps. I'm just wondering if you can break out the size of the sales force, U.S. versus international?

We have 4 direct people internationally, 10 direct U.S. and another 10 independents, U.S. Joseph P. Munda - Sidoti & Company, LLC: Okay. So international seems to be -- I'm sorry, I didn't mean to cut you off, Will.

I will just say and those 4 international ones work with -- I think it's 85 distributors around the world. Joseph P. Munda - Sidoti & Company, LLC: Okay. So is it safe to say that the growth going forward or the emphasis -- I know I saw Jim's interview, I believe, talking about the opportunities in the BRICS nation. By the way, Jim, very nice interview. Is that where we should expect you guys to really invest in reps? And is that where the gross margin improvement that you're forecasting, that 55%, is really going to be switching that model from distributor to direct?

Yes, I think when Will mentioned we had the 4 international guys, they sort of -- they manage the distribution network. So international countries we go through distribution. So that kind of segues a little bit onto the last part of your question, which was going direct. And I would say certainly at this stage, we're very comfortable with the distribution that we've had. We had it for many years, and it works very well. Joseph P. Munda - Sidoti & Company, LLC: Okay. Just a few other questions here. I guess getting back to Ray Myers' question regarding market adoption and acceptance, I'm just wondering, can you give us some hard numbers on the size, the -- I guess just U.S. and how many docs currently are utilizing MicroPulse?

No, I think at this point in time, I can't. It's -- I'd prefer not to at this point. Joseph P. Munda - Sidoti & Company, LLC: Okay. That's fine. And then as far as CapEx through the first 9 months, Jim, do you have a hard number?

Well, the cash flow from operations for the third quarter was $691,000. So that's really back towards Larry's question there. For CapEx, I'm flipping through. So we got CapEx for 9 months of this year was $235,000. Joseph P. Munda - Sidoti & Company, LLC: Okay.

So we spent $235,000 on capital so that -- to remind everyone. For the third quarter, Larry had a question on cash provided by operations, and we we've got it down at $691,000. Joseph P. Munda - Sidoti & Company, LLC: Okay. So I guess, Will, in closing, my last question here, you're talking a lot about the transition from pay-for-services model here in the U.S. to a value-based medicine. And really, the driver you're seeing is the Affordable Care Act. And how long, in your mind, do you really think that you guys will start to reap the benefits of that transition?

Boy, that's a tough question. Joseph P. Munda - Sidoti & Company, LLC: I don't make them easy. I'm sorry.

That's okay. The speed of that adoption is going to come from a few things. We all know that the problem we're talking about, diabetes, is a large problem. And so when you sit down and try to figure out who's problem is it, is it the physician's? Is it the patient's? Is it payer? Right now, I don't think it's the physician's problem is that -- because they can do injections. So they're taking care of things. What you've probably seeing with us is moving our web page to a bifurcated method of having scientific data for doctors and more colloquial-type data for patients. And when you're talking about these disease states, when you have managed care, you get good care if you take care of yourself. And I think what's happening, in the days when -- well, back to the days when I was a marketing executive, I was paid to be clever. Today, it's more how to be transparent in providing data to people. And so our idea here is to get the information to the patients because we think their sons and daughters are compassionate enough against these -- the older people to take care of it. They'll read it and start to put pressure on the physicians. At the same time, with the recession over the last few years, capital allocation has become a very, very important subject. And I think the Obamacare kind of moves into that area. We already seen that outside the U.S. But when we're seeing a good change with the younger based physicians, the older based physicians, they've got their patient population, so they'll just keep doing their thing. The younger ones are looking at efficiency and trying to find ways to do things faster and be able to touch more patients. So they're adopting a little bit faster. But that's kind of a long-winded answer to probably say, I really don't how long it's going to take for this to make a change, but it's -- I know it's coming. It's probably a couple of years away before it really takes hold. But when doctors start to realize how much money they're getting for doing something as reimbursement, they'll look at things differently. And that's how it goes. Joseph P. Munda - Sidoti & Company, LLC: I'm sorry. So are you convinced that then, I guess, that reimbursement for the injection is going to start to come down, start to fall, and there might be parity between the 2?

No, I'm not convinced of that. What I'm convinced of is that the logistics of doing injections on the emerging population of diabetic patients will become overwhelming to the physician base. If you simply take the number of doctors practicing versus the numbers of doctors retiring versus the number of doctors that are coming into the business and look at the diabetic population, they can't treat them. It's just mathematically impossible to do it with drugs. Joseph P. Munda - Sidoti & Company, LLC: Do you have a -- I'm sorry, the size of the diabetic population, is there number that we could basically reference?

I don't have it off the top of my head.

The next question comes from the line of Stan Maine [ph] with Maine [ph] Investors.

Good job on sales. I have some puzzling questions. The second quarter, you had tenders, lots of tenders that helped the number. In this third quarter, you said you did not. It was a broader mix. So I would expect with the volume you had, with overabsorption picking up, pricing picking up because they're not tenders, I assume that the mix of sales would be better, that we would have a higher gross margin in the third quarter. So I'd like to kind of explore what's holding our gross margin down. Because for a healthcare company with even laser equipment, that's a pretty low gross profit. So can you kind of fill us in on what is holding back the gross profit numbers with the sales growth?

Well, again, I would say that we had always said that we thought our short-term target of 50% was what we're aiming for. And so that was what we were concentrating on getting to. So just for the dynamics of what we have in our business, we felt that was a realistic short-term target. And obviously, exiting Q4, we were at 47%. So we're a little bit south of that. So it took quite a lot of effort to get us up to the 50% rounded that we're at. It's just really the nature of the products that we have on the laser side. We have a wide portfolio of products. We're trying to continue to take expense out of the newer capital ones and move it forward, and the goal is to move it up to 55%. So apart from saying it's the nature of the beast that we have in front of us, I'm not sure what else that I can offer to illuminate on it. We do...

[indiscernible] -- my question, Jim -- Jim, I have a simple question, are prices held down by competition? Is there some room to raise our prices on equipment and disposables?

Stan, it's Will. So if you look at the product line on the laser side, and let's take that for a second because that's where really the most of the margin hit is, if you will, and bifurcate it into continuous wave lasers and MicroPulse lasers. Continuous wave lasers are pretty commodity, and there's a lot of competition. And when the yen went down, their prices for Nidek got better. I mean, it's -- and it's competitive. And we still sell a majority of our products through continuous wave lasers. And you get to MicroPulse. And you've heard Jim talk earlier saying he's spending a lot of money to go after a cost reduction in the production side componentry, et cetera -- I won't call it a redesign, but it's kind of a redesign -- on the IQ platform, which is the MicroPulse platform. That will take place sometime -- it'll be completed sometime next year. We're cognizant of what your question is. The issue is, as Jim said, it's the nature of the beast. The MicroPulse was relatively new. It wasn't selling that well a few years ago until we figured out how to -- what the right duty cycle was, what the right density or spacing of the spots were, what the appropriate power levels were. Once that's been done, it started to take off. And guess what? We're behind the 8 ball at getting the costs driven out of it when it did. So I think you're looking at a team that is improving it. It'll go to 50%, and we're working and shooting, as Jim said earlier, to 55%. And that's about what you can expect at this point in time.

So is outsourcing completely out of the question?

Outsourcing what? The laser?

Manufacturing of the lasers.

I won't say that -- enough -- I mean, for me, generally there's not a lot that's outside of the question. We'll look at it. I mean, we're talking about something that has to be manufactured with precision because we're dealing with the eyes. And I kind of get nervous about that. But can it be done? Sure, it can be done. Will we do it?

I don't know [indiscernible]. A lot of these companies do a lot of outsourcing that requires very, very tight specifications. And when I looked at the fourth quarter projection, by the way, I didn't come out with a great increase in bottom line. And that's why I asked the question about the gross margin improvement. You would think with volume growth you would get some leverage. And I don't -- I can't find it and possibly you'll surprise us. But the operating margin, when I ran the calculation, I didn't get a big -- any growth in operating margin going into the fourth quarter. Then again, I'm just working with your numbers.

Sure.

I think it's something you ought to look at.

[indiscernible].

But my other question is, I noticed that inventories were over $1 million. And my question is, what is -- is that new products that you're adding? Or -- that's a large number. It's over 11%.

Okay. So we're going to bifurcate your question. I'm going to take the first part. Jim is going to take the last part.

Okay. Okay.

All right? On an annualized basis, I'm very comfortable with what we're doing on improving margins and operating income. Q4 is always difficult in this company because the largest congress we have on a worldwide basis is the American Academy. It costs a lot of money, and all of that is burdened in the fourth quarter. The second part of that piece, Jim highlighted in his comments that he is spending money on a cost-reduction product -- program to decrease the cost of production of the IQ platform, which we think we're selling more of every day. I have a choice. I'm going to invest in the business to reduce the cost because that expense will go away shortly. And we'll be left with a better priced product as far as cost. And therefore, if it takes a little bit of money out of the fourth quarter or the first quarter to be able to do that program, I think it's a good investment, and that's what we've looked at. So your observation is correct, but I think our investment strategy is correct.

Okay. Well, I'm just looking for how, as we're growing and we're starting to grow, we're going to bring some of that to the -- earnings per share to the bottom line.

Absolutely correct, Stan, and that's the reason for the strategy on the investment on the cost reduction. It's going to take us 6 to 9 months to have that done. When that's done, we'll have a lower cost to produce the IQ line, and the margins will go up substantially.

Okay. Two last questions.

Oh, wait, wait. Just -- Stan, it's Jim.

Oh.

Never mind. Go ahead.

Go ahead. Excuse me. Jim?

Stan, you'd made a question on the inventory?

Yes.

And like yourself, that's one of the items, when we go through the whole process and observe during the quarter is definitely, to me, I put it as a flashing light on our side as well. So a couple of things just to comment, obviously, is the -- fundamentally an increase in business activity. This time last year we were 7.9%. And this year, we're at 9.5% going to 10.5 So that's a 33% increase in the business activity. So obviously, there's a component of growth for that. The other thing as well, intentionally we've added to our finished good units. Historically, at the beginning of 2012, we didn't actually carry any units of finished goods over quarter-to-quarter. We tended to make to build. The target we set ourselves is somewhere in the 70 to 80. This allows us to have much more linear production through the quarter and obviously allows us to respond to tenders. Obviously, the art and the science is matching your SKUs appropriately. We did also, as I said, intentionally put a little bit more into some of the safety stock. And again, the goal there was for linear production because -- it gets back to a margin sort of question, and we're looking to be [indiscernible] to try and take operation costs out through this linear production. We're looking to reduce the number of overtime hours and use that to improve the gross margins. But also, to be perfectly transparent, I do think we're a little overinvested in our infrared category at the end of this quarter. So I do think there's room to sharpen the pencil. And we do recognize that, that's an area that we -- we've done a lot of things intentionally, but we still need to improve them.

And our next question comes from the line of Jason Stankowski with Clayton Partners.

Great job in the quarter. I really appreciate the hard work you and the team are putting in. And I hope your inventory doubles this time next year because I think it'll mean really things good things for everybody.

Thank you, Jason.

I think a lot of questions I had have been attacked at different ways. But one of the market adoption questions that always comes to me, and I wondered if you guys have thought about it at all, is IRIDEX -- I know you've changed sales -- you've changed around some sales force people, and I'm not sure how deep the ERP type of system goes from the past or the one you're developing. But I'm curious if you're seeing new doctors. I noticed at the AAO you're going to have a comprehensive series with a couple of speakers. And I'm just curious if you're seeing new customers coming to you rather than just reselling to the same customers and maybe increasing the pace of buying a new box because of the MicroPulse. Are you seeing new business? And can you give us a sense of how that's ramping at all, if you are or are not?

I'll take the first swing at it, Jason. So the answer, and I'll put it more qualitatively than quantitatively, is yes, we do see with the extended reach of our programs new physicians showing up, particularly, as you identified, in the comprehensive category. So we are aware of that phenomenon. We don't at this stage have the sophistication you mentioned into the ERP sales force-type proposition. We don't necessarily have the sophistication all the way through. So really, we had to sort of make and track those metrics very well. So at this stage, I'm going to say we are making that progress, but it's more anecdotal than metric based.

Okay. And have you -- just in the process of your 10 direct U.S. salespeople, are you -- do you have plans or have you discussed plans to either -- to grow that number? And would you be basically adding -- subdividing territories? Or how would you be handling that if you were growing it?

Well, we have discussions between Jim, Tim and myself on a regular basis on the sales channel. And I think with the -- the main idea over the last number of months has been integrating the Peregrine independent channel and understanding that model, and we've made some adjustments in that as to what products they carry and they don't carry. And I think what we'll do going forward is really spend time understanding what's the most efficient revenue number for each and then make adjustments going forward. But we're not going to -- at this stage, I don't have any plans to expand the sales force on either side.

Okay, okay. And I was at -- just parenthetically, I was at an investment meeting, and there was a person presenting on India and some companies in India. And I know you guys had some nice orders from there. Part of their presentation was that by 2020 India will be home to 30% of the world's diabetic population just given their propensity for, I guess, sweets and just biologically from the World Health Organization. So it seems like that will be a nice market for you guys going forward.

We believe so, and we've been spending a lot of energy there. And I think you'll see this phenomena. Mexico, the obesity rate is getting -- is growing rapidly. Saudi Arabia -- [indiscernible] -- I mean it -- there's more diabetic patients in China than there are in the U.S. already. So this is a massive problem coming, and it's -- and it's the governments that are spending the time to look at this problem as an epidemic, like a tidal wave coming at them, and they've got to find solutions.

Good. Well, great job managing the P&L, and I trust, based on the performance you've had, that the investments you're making to increase the margins are money well spent. And certainly, we can wait a few quarters to see the fruits of those investments and really appreciate the hard work of all you guys and the team.

I would now like to turn the conference back over for closing remarks.

All right, thank you very much to everyone who's listening and interested in IRIDEX. We look forward to talking and speaking with you in the future. If anybody is attending the American Academy of Ophthalmology in New Orleans, please stop by our booth, and we'd enjoy talking to you face-to-face. Until then, we'll keep the hard work and try to make everyone comfortable with their investment. Thank you.

Ladies and gentlemen, this concludes the IRIDEX Corporation third quarter earnings conference call. If you'd like to listen to a replay of today's conference, please dial (303) 590-3030 or 1 (800) 406-7325 with access code 4646160. We'd like to thank you for your participation. You may now disconnect.