Natus Medical Incorporated
Q3 2016 Earnings Call Transcript

Published: 19 Oct 2016

[Operator:]

Ladies and gentlemen, thank you for standing by. Welcome to the Natus Medical Third Quarter 2016 Financial Results Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. [Operator Instructions] As a reminder, this conference call is being recorded today, October 19, 2016, and contains time-sensitive information that is accurate only as of today. Earlier today, Natus Medical released financial results for the third quarter 2016. If you have not received the news release, or if you would like to be added to the Company’s distribution list, please email your request to Investor Relations at Natus.com. This call is being broadcast live over the Internet on the Company’s website at Natus.com, and a replay of the call will be available on the website for the next 90 days. The agenda for today’s call will be as follows

[Jim Hawkins:]

Thank you, operator. Our third quarter results, that we released earlier this morning, reported revenue of $90.9 million compared to $94.6 million last year. We also reported non-GAAP earnings of $0.39 compared to $0.39 in our third quarter last year and generated cash flow from operations excluding the net cash received from Venezuela of $22.4 million. We also repurchased $1.5 million of stock during the third quarter. I am pleased with our non-GAAP earnings per share that remain constant with last year despite lower revenue. As previously reported, revenue was lower than our initial guidance, due to a voluntary ship-hold placed on certain products produced in our Seattle facility, and further softness in our international markets. Our Peloton and GND service businesses continued to grow well during the quarter, growing a combined 53% from the previous year. Earlier in the quarter, we announced the acquisition of RetCam. RetCam is the market leader in NICU ophthalmic imaging used in the detection and documentation of retinopathy of prematurity, or ROP, and other eye diseases. As expected, RetCam achieved approximately $3.4 million in revenue during the quarter and was accretive to our gross margin and earnings for the quarter. We are excited about RetCam’s potential as we continue to add Natus global sales and marketing reach to the RetCam product line, increasing market penetration and growth potential for this very important newborn technology. As we announced late in September, we entered into an agreement to acquire the Otometrics business from GN Store Nord in an all-cash transaction for $145 million. With annual revenue of approximately $110 million, Otometrics is a manufacturer of hearing, diagnostic and balance-assessment equipment, disposables and software. We believe the acquisition of Otometrics will benefit our customers by increasing focus on the hearing screening, hearing diagnostic and balance-assessment markets, and providing the best technology and solutions in the market. Customers will also benefit by having a source of very high-quality hearing aid fitting products from a source independent of a hearing aid supplier. For those not familiar with Natus or Otometrics, I’d like to spend a few minutes describing each of these markets and how they fit strategically within our business. First, let’s review hearing screening. Natus is the leader in newborn hearing screening. The addition of Otometrics hearing screening product line and customer base will broaden our global footprint in this area. Otometrics Madsen brand hearing screeners are used by audiologists worldwide for infant hearing screening as well as hearing screening for all ages. Madsen brand products include the Acura screen, a lightweight portable OAE-ABR screener that offers an alternative to a larger, cart-based system like Natus flagship ALGO hearing screening systems. Next is hearing diagnostics. Otometrics is an industry leader in the hearing diagnostic market. Otometrics products serve audiologists in major healthcare facilities and those in private practice. Audiologists use Otometrics wide selection of advanced clinical devices and software solutions to diagnose hearing disorders. Combining Otometrics Madsen and ICS brands with Natus Navigator and AuDX hearing diagnostic solutions will provide Natus much-needed scale in this market. Together, Natus and Otometrics will have an industry-leading product offering for the hospital, clinic and private audiologist practice. Otometrics also brings its world-class Oracle product line of hearing aid fitting systems to Natus. Oracle fitting systems are used by audiologists to fit and tune hearing aids. As part of the Natus family, Otometrics will be the largest independent provider of hearing aid fitting systems, providing a new model to customers who want to choose Otometrics fitting systems independently from the hearing aid manufacturer. And finally, Natus and Otometrics will have the most complete product line of balance-assessment tools used by EMTs in hospitals, clinics and private practice. Otometrics’ ICS and HORTMANN brand BNG balance-assessment solutions complement Natus NeuroCom balance products. We expect to close the Otometrics acquisition on January 1, 2017, and we have set an initial operating profit margin goal for Otometrics of 10% in 2017 and 20% in 2018. We also believe that Otometrics can grow organically by 5% or more in the years ahead. We will provide further financial model guidance in early 2017 once we close the acquisition. Lastly, I wanted to provide an update regarding our Venezuela supply agreement. As previously announced, we received the first payment – prepayment of $20 million towards our $120 million supply contract in early September. This first payment allows Natus to begin service and shipments of products per the contract. We expect quarter revenue from service and shipments to Venezuela to be approximately $7 million. We expect operating margins on the total contract to be in line with our overall corporate average margin. In summary, we are pleased with our third quarter earnings and cash flow. We look forward to finishing the year and we’ll continue to strive to achieve our 2016 operating margin goal of 20%. I will now turn the call over to Jonathan Kennedy, our Chief Financial Officer, for a review of the financial results. Jonathan?

[Jonathan Kennedy:]

Thank you, Jim. Today, I will be discussing our financial results on a GAAP basis as well as a non-GAAP basis. Our non-GAAP results exclude amortization expense, restructurings, certain other charges, and the related tax effects. We believe that the presentation of these non-GAAP measures along with our GAAP financial statements, provide a more thorough analysis of our ongoing financial performance. And you can find a reconciliation of our financial results on a GAAP versus non-GAAP basis in today’s press release. As Jim stated, we reported third quarter 2016 revenue of $90.9 million, a 3.9% decrease from the same period last year. Revenue from our Neurology business was down 4.5% to $56.7 million, or 62% of total revenue during the third quarter of 2016, compared to $59.4 million and 63% of total revenue during the same quarter last year. Revenue from Newborn Care business also decreased about 2.9% to $34.2 million, or 38% of total revenue during the third quarter of 2016, compared to $35.2 million, or 37% of total revenue during the same quarter last year. In total, revenue from Devices and Systems contributed approximately 55% of total revenue in third quarter 2016, compared to 58% in the 2015 period, while revenue from Supplies and Services was approximately 45% of total revenue in the third quarter of 2016, compared to 42% in the 2015 period. Revenue from domestic sales was approximately 69% for the third quarter of 2016, compared to 56% in the same period in 2015. Revenue from international sales was approximately 31% for the second quarter of 2016, compared to 34% in the same period 2015. On a non-GAAP basis, our gross margin increased by 214 basis points in the third quarter to 64.6% compared to 62.4% in the third quarter of 2015. The increase in gross margin was driven by a more favorable product mix, higher relative domestic sales and the addition of RetCam. Non-GAAP operating expenses increased by $2.5 million compared to the same quarter last year. Our non-GAAP operating margin decreased to 17.6% compared to 19.9% for the same quarter last year. The increase was driven by costs added from the acquisition of RetCam, and growth in OpEx to support our Peloton and GND service businesses. Our third quarter non-GAAP effective tax rate was about 15.6%. This lower rate is due to higher profitability outside the U.S. driven by the implementation of a more efficient operating structure, and a lower overall forecast for domestic profitability. Looking ahead to the full year, we expect our overall non-GAAP 2016 tax rate to be between 23% and 24%. Non-GAAP other income was an expense of $0.9 million primarily result of FX losses. On a GAAP basis, net income was $13.2 million, or $0.40 per diluted share, a $2.3 million increase from the same quarter of last year. Non-GAAP net income decreased $0.1 million, compared to the same quarter last year, and non-GAAP earnings per share was $0.39. In the third quarter, we recorded about $4.4 million of depreciation and amortization expense. Our share-based compensation was about $2 million during the third quarter. Now let’s look at the balance sheet and cash flow. We repurchased $1.5 million of company’s stock, and net cash and investments increased by $10.6 million during the quarter. As Jim stated, cash flow from operations was $35.5 million during the quarter due to the Venezuela prepayment. Excluding the net cash increase from the prepayment though, adjusted cash flow from operations would have been $22.4 million. So we attempted to adjust for the increase in cash from Venezuela. Our days of sales outstanding decreased by 2.4 days during the quarter to 85.9 days. Our diluted shares outstanding decreased slightly to 33.0 million shares compared to 33.2 million shares in the third quarter of the prior year. With that, I will turn the call back over to Jim. Jim?

[Jim Hawkins:]

Thanks, Jonathan. Before opening up the call to questions, I would like to review our financial guidance for our fourth quarter and full year 2016, all on a non-GAAP basis. For the fourth quarter of 2016, we expect revenue of $107 million to $109 million and non-GAAP earnings per share of $0.52 to $0.55. For our full year 2016, we expect revenue of $381.2 million to $383.2 million and non-GAAP earnings per share guidance of $1.63 to $1.66. We will now turn the call over to questions. Operator?

[Operator:]

Thank you. [Operator Instructions] Our first question comes from the line of Brian Weinstein with William Blair. Your line is open.

[Brian Weinstein:]

Hey, guys, thanks for taking the questions. I’ll try and jump through these in kind of rapid succession here. Can you give an update on the ship-hold situation, when you expect to start shipping product out again? And just any other comments on what’s going on in Seattle?

[Jim Hawkins:]

Sure, Brian. Yes, just to review, we did put a voluntary ship-hold on some Newborn Care products up in Seattle, at our Seattle facility. We announced that at the end of September, I believe. We are working through, as planned, to remediate and to validate all of our processes and procedures, and design controls that we had communicated. We are hopeful that we will be able to ship some product in the fourth quarter, but we have not included any of those shipments of these products on ship-hold in our guidance for the fourth quarter. So, we are taking a conservative approach there.

[Brian Weinstein:]

Okay. And that leads to the second question I had, on the guidance for the fourth quarter. When you back out the $7 million from Venezuela, you are looking for kind of a sequential increase of $10 million to $12 million, which would be a pretty healthy step-up for what you guys have done typically, Q3 to Q4. And given that you do have limited visibility, and you’ve talked about how a lot of stuff comes in at the end of the quarter, what gives you the confidence that you can get to a pretty decent sequential dollar increase, Q3 to Q4, if you’re not including some of the ship-hold stuff?

[Jonathan Kennedy:]

Hey, Brian, it’s Jonathan. One thing you can add in there, that’s new this year, is RetCam. RetCam has got some seasonality to it, so expect that to be maybe another $1 million over Q3. And then we’ve got the snowball effect of the service businesses of GND and Peloton. And then, as you mentioned, Venezuela being out of there, but Venezuela will definitely push it to the higher end. But excluding Venezuela, we think we have pretty good visibility. We’ve had a number of orders that, at the end of the third quarter, that were close but just didn’t get signed and into the hands of our shipping area. And so we have pretty good confidence where we stand today, but a lot happened in the last few weeks of the quarter.

[Brian Weinstein:]

Okay. And then, I noticed that you guys had a decrease in the expected earnout for GND; I think it was a couple million dollars in the anticipated reduction in the earnout payment for GND. Can you talk about what that’s about? I’m sorry, for Otometrics.

[Jonathan Kennedy:]

GND – that’s GND. Yes, there’s no earnout for Otometrics, and that’s going to be next year anyway. So, let’s stick with here. So GND, when we bought GND, just typical of buying smaller businesses, you typically have an earnout, or can have an earnout. And the earnout was based on achieving revenue targets that Natus and the seller agreed to. And while we haven’t reached that point in time yet, you have to estimate every quarter where you think you’re going to end up. And right now, we don’t think we’re going to end up at those revenue targets that we agreed to with the seller. So we’ve made an adjustment to the reserve for that.

[Brian Weinstein:]

Okay, and then we non-GAAP that, I guess…

[Jonathan Kennedy:]

A $2.8 million benefit that we non-GAAP’d, yes.

[Brian Weinstein:]

Okay. And last question is inventory. It was up a pretty sizable amount, from $43 million to $52 million. Can you just talk about that? Is that a build for Venezuela? Or what’s going on with that? And then also in the other current assets, that was up from about $13 million to $23 million. Can you just talk through those two things? Thank you.

[Jonathan Kennedy:]

Sure. The inventory, some of it – a little bit of it is Venezuela, but a lot of it is the ship-hold that we have in Seattle. There’s a number of units that we’ve built up inventory that we’re not shipping. We don’t believe there’s going to be a terrible – we don’t believe that that inventory is at risk. And then also, don’t forget we acquired RetCam in the quarter two, and RetCam came with inventory. So, about $3 million, so that’s going to be an addition to the inventory as well.

[Jim Hawkins:]

Thanks, Brian.

[Operator:]

Thank you. Our next question comes from the line of Chris Lewis with ROTH Capital Partners. Your line is open.

[Chris Lewis:]

Hi, good morning guys. I wanted to start on the fourth quarter guide. I think if you look at it, it’s largely in line with your previously implied guidance. Understand there’s basically a net loss there between Venezuela, offset by an implied lower core Natus outlook. So, I guess on the latter part of that, within that lowered implied Natus core outlook for the fourth quarter, how much of that revision is related to the Seattle ship-hold versus continued international softness?

[Jim Hawkins:]

Yes, Chris. I think it is – mainly the Seattle ship-hold is certainly the vast majority of it. We’re hopefully taking a conservative approach on the international shipments as well. And we did reduce Venezuela, where we had at least talked about being $8 million in Q4 and now we’re saying $7 million in Q4.

[Chris Lewis:]

Okay. So if I look at it, you did kind of $5 million from Seattle, kind of got pulled back in the third quarter, maybe another $5 million or $6 million here in the fourth quarter. Is it your expectation that basically all that comes back as you lift that ship-hold and begin shipping those products at the end of this year/early next year?

[Jim Hawkins:]

Yes, that’s, I think, overall a very good assumption. We’ve had very few order cancellations at this point, very, very few. And we anticipate those customers waiting for our products. So, it would certainly give us a nice lift next year.

[Chris Lewis:]

Right. And then, on the international front, understand it’s only been, I think, three weeks since the preannouncement call, but any update you can just provide us into what you’re seeing so far this quarter would be helpful. Thanks.

[Jim Hawkins:]

Yes, not really, Chris. You know, the beginning of the quarter is the way international works when you go through distribution, typically, and even tenders, a lot of times they are towards the latter half or back half of the quarter. And so we never really get a lot of indication internationally the first couple weeks of the quarter.

[Chris Lewis:]

All right. And then maybe just one more for Jonathan. In terms of gross margin, it came in above our expectations. You mentioned product mix and RetCam. Can you quantify or elaborate on kind of each of those factors and the impact it had on gross margin in the quarter? And then going forward, is there any kind of one-time benefits that you saw in the third quarter that will not reoccur? Or is this kind of a normalized level that we should think about, at least on the core Natus business side? Thanks.

[Jonathan Kennedy:]

Sure. No, I think this is a fairly normal, plus or minus, let's say, 50 points. We should be in that 63, 64 range in a given quarter. For the third quarter, about – I'd say we were up about 214 basis points year-over-year; about three-fourths of that would have been product favorability, and then the other largest piece was RetCam. RetCam's been a solid addition to gross margin – and operating margin, for that matter. And so that kind of gives us a little bit more ballast in that gross margin number going forward.

[Chris Lewis:]

All right. Thanks.

[Operator:]

Thank you. Our next question comes from the line of Jayson Bedford with Raymond James. Your line is open.

[Jayson Bedford:]

Good morning, thanks for taking the questions. Just, Jonathan, on the last one there, the gross margin expectation for the base business kind of going forward – and I realize it will vary with each quarter – but do you think it's in that 63% to 64% range?

[Jonathan Kennedy:]

I think it is on a normal quarter when we don't have extraordinary warranty reserves or some sort of fallout from something, typically that's the case.

[Jayson Bedford:]

Okay. And that's what you're assuming for the fourth quarter as well? Sorry, if I missed that.

[Jonathan Kennedy:]

Yes, we haven't put out guidance out there, but our fourth-quarter assumption would be in that high 63%, 64% range.

[Jayson Bedford:]

Okay. And I hate to kind of come back to this fourth-quarter guide on the top line, but are there any kind of chunky, larger orders assumed in that fourth quarter?

[Jonathan Kennedy:]

No, I would say not, Jayson. You know, our fourth quarter historically is always, we get a nice lift there. And our forecasting of work that we've done shows that that should certainly happen again. And – but there's not like any $2 million, $3 million order out there that we are counting on. It's just regular business. Just strong fourth-quarter activity.

[Jayson Bedford:]

Okay. So then maybe just the international business has always been a source of frustration for you. You'll start to anniversary some easier comps next year. But is there anything on the distribution side that is changing? Do you feel like there's some pent-up demand? I've got to believe some of this equipment out there is aged. I'm just trying to get a sense of any visibility onto – into an improvement in the international business.

[Jim Hawkins:]

Yes. You know, I guess, for a lot of years, international was a real positive for Natus, and certainly with the dollar's strength, it has hampered us somewhat. And then not to go through it all again, but there's just a lot of country-specific areas where business has just dried up, due to be it political reasons or economic reasons in those countries. We think that, when we're looking at Q4 – and though we haven't given guidance for next year yet, but I think we're – let's say we're hopeful that certainly we've seen the bottom in the international business, but I think we're going to be – continue to be conservative in our guidance until we really see a big comeback.

[Jayson Bedford:]

I realize that the deal hasn't closed yet, but maybe can you talk about what the Otonomics business does for your core Natus business internationally?

[Jim Hawkins:]

Yes, that's something we're very pleased to talk about. Otometrics, once we have Otometrics in, it will actually give Natus more than 50% of its revenue – of our revenues outside the United States. And to be a global business, that – to have that kind of footprint, we think is very good. Being that they manufacture, I would say, everything for the most part, outside of the United States, it's going to just be a nice hedge for us. You know, their costs are down now, with – versus the dollar, of course, with the lower-priced euro. It's going to make their products competitive. It's going to – in the United States, it will – with the Natus name, I think, it will help get them into open some doors. And vice versa Otometrics has a very good name that will help Natus out there. So, we're very encouraged. On top of that, if you look at hearing diagnostics, it is a very strong – what's the word I'm looking for – demographic area. I think everyone is aware that hearing issues are becoming more prevalent. Certainly, my generation and below, with hearing deficiencies, are certainly popping up. And so we really believe that this can be certainly at least a 5% grower for many years to come, at Otometrics. And along with just new product and also breaking away from GN Store Nord, they are going to be able to now sell to other hearing aid manufacturers that they weren't able to do in the past. So, we're very excited about the acquisition.

[Jayson Bedford:]

Okay. And then just lastly, maybe for Jonathan, on the tax rate – Jonathan, 23%, 24% is pretty low versus what you've been putting up. Is this kind of – is there something atypical here? Or is this kind of a new range going forward? And then maybe if you can talk about how GNO fits in as well on the tax side.

[Jonathan Kennedy:]

Sure. So, the biggest impact to tax rate is where your profitability is. And you always have a – it's based on your profitability forecast. So, going into the year, we had forecast more profit in the U.S. than the way it's turning out. And that's turning out different for two reasons. One, we've got a little weaker revenue in the U.S. than we had thought; but two, we have also been able to migrate our IP over to Ireland. And we've also been able to move some more manufacturing and other profit-generating activities outside the U.S. So, in a scenario like we are for 2016, then this would be a normal tax rate. In a scenario where a U.S. business, like Peloton or GND or any other U.S. business, became much more profitable, then, of course, that would increase our tax rate, because U.S. taxes are higher than those outside the U.S. In terms of adding Otometrics, Otometrics is a very – more heavily-weighted international business. The manufacturing, the IP, all of that occurs primarily in Denmark today. We will run it through our Irish entity, which will have an even lower tax rate. The Denmark tax rate is 22%, Ireland is 12.5%. So, no matter how you do the math, the Otometrics addition will dilute our tax rate further from where it stands today. We haven't quantified how much that's going to be; we will probably look to do that in early January when we give guidance, once we have a really good understanding of the final structure of the deal. But there really isn't anything that points to an increasing tax rate. It will all decrease the tax rate on a blended basis, with the addition of Otometrics. And then don't forget, Jayson, too, the acquisition of Otometrics was done outside the U.S. with foreign cash. So we get the benefit of using today's foreign cash as well as some future foreign cash that we don't even have yet, to dilute – to better use our – the cash flow from operations.

[Jim Hawkins:]

Yes. And just to add on to that, tax – the lower tax rate in the end is cash. And I think, boy, getting – having $22.4 million of cash generation in the quarter, I believe it's the biggest quarter we've ever had, especially when we backed out the Venezuelan net difference there. And so, cash generation is still a big part of our story, and we're looking to really continue to ramp that up. So we're very excited.

[Jayson Bedford:]

Thanks, guys. I appreciate the color.

[Jim Hawkins:]

Thanks, Jayson.

[Operator:]

Thank you. [Operator Instructions] Our next question comes from Raymond Myers with Benchmark. Your line is open.

[Raymond Myers:]

Thank you. First, let me ask you about the shipping-hold. Did you quantify what the exact revenue impact was in Q3, of the shipping-hold?

[Jim Hawkins:]

I don't think we gave it, but I think we had estimated – and I think it came in around that range, in that $5 million range, maybe as high as $6 million, but somewhere in that range, Raymond.

[Raymond Myers:]

Okay, great. That would be $6 million. And the marketing and selling expense was lower in Q3 than in some previous quarters. Was there something affecting marketing and sales expense, bringing that down?

[Jonathan Kennedy:]

Well, on a GAAP basis, that's true, but the adjustment for the GND earnout reserve of $2.8 million is in there on a GAAP basis. So if you are just looking at the face of the financial statements, that would look true. Go back to the non-GAAP reconciliations and add back in the $2.8 million, and it will come up.

[Raymond Myers:]

Okay, that makes more to me…

[Jonathan Kennedy:]

Okay.

[Raymond Myers:]

Okay, good. Thank you. Next, let's turn to the Otometrics. A large acquisition; congratulations. It sounds like you're all set to close that at the end of the year. Are you still pursuing more near-term acquisitions? Or should we expect that Natus is going to take a little bit of a step back and adjust this?

[Jim Hawkins:]

Yes – no, Raymond. We are, I would say, still looking to do other acquisitions. Certainly, the newborn and hearing side of our business will be involved in this, but the neuro side is really operating, plugging along. And so they have plenty of capacity to bring something else on. So, I can't comment too much, but no, we are – continue to talk and pursue other exciting businesses.

[Raymond Myers:]

Okay, that's good to hear. And you have the financial capacity to take on either more debt or you can deploy cash that way?

[Jonathan Kennedy:]

Hi, it's Jonathan, Ray. Absolutely. I mean, a lot of it depends on what you're buying, but the market for Natus, access capital is pretty wide open. Get a lot of it depends on what you're buying, but we don't see any issues with the universe of what we look at and being able to finance that.

[Raymond Myers:]

Good. And then, well, maybe one final question, again on Otometrics. Jim, you talk about how the – it's the only hearing fitting company that's independent of a hearing aid manufacturer. You say that quite a bit. Can you describe why that's important to the marketplace, and how you expect to expand the Company's business after it's breaking away from the Store Nord?

[Jim Hawkins:]

Sure. In this hearing aid business, let's say there's five major hearing aid manufacturers. And the last thing the other four – outside of GN Store Nord and the ReSound hearing aid business – the last thing the other four want is to be able to have a competitor hearing/screening device inside their shop and inside their distribution channels, with this. Having it be a Natus product, in the future, well, Natus non- – let's call it, it will be an Otometrics product, but it won't be owned by GN ReSound. These other hearing aid manufacturers will then look to buy the best product available, which we think is the Oracle products for Otometrics. And, in fact, through early discussions, we've already – they've already had communications with some of these companies that are now willing to look at these products that they were not interested to look at in the past.

[Raymond Myers:]

And do these five hearing aid manufacturers have their own line of comparable equipment, so such that you are competitive with them? Or is it – or not?

[Jim Hawkins:]

Yes, some do. Some do.

[Raymond Myers:]

And how – what percentage of the market would you estimate do versus don't?

[Jim Hawkins:]

Oh, boy, I hate to speculate on that, but I can get that information. But I don't have it off the top of my head.

[Raymond Myers:]

Okay, that's great. Thank you.

[Jim Hawkins:]

Sure, Raymond.

[Operator:]

Thank you. Our next question comes from the line of Larry Haimovitch with HMTC. Your line is open.

[Larry Haimovitch:]

Hey, good morning, Jim, hi, Jonathan.

[Jim Hawkins:]

Hi, Larry.

[Jonathan Kennedy:]

Hi, Larry.

[Larry Haimovitch:]

Jim, on RetCam, I know that you've – this was an acquisition you had pursued for several years. In my mind, that division of Clarity Medical Systems was a bit of an orphan. They weren't doing a lot of product development. I know that you, as part of the acquisition, acquired the Product Development team. Can you update us on what improvements or what progress you're making in bringing the product more modernized and better technology?

[Jim Hawkins:]

Yes, sure, Larry. You're right – we are – that is an initiative that we look to do, is to certainly update the RetCam product. You know, technically, it's still very strong; number one, it does what it needs to do in the marketplace, but there are certainly some features that can be added to it, and to make it easier to use, and potentially to get more information. We hate to talk about it too much because, if you talk about new products and capabilities, customers have a tendency to want to wait, and wait for that product. So, we don't do that, Larry. But it is certainly something that, just in general, there's a big base of RetCam products out there in the world that they've sold for the last 10 to 12 years. And with a new product, we think it will give customers a real reason to upgrade to this new system. So, not only will we be able to continue to get new customers in general, but there can be an upgrade cycle, we think, once we get the new product out, that could last for two or three years and really boost sales.

[Larry Haimovitch:]

Yes. Jim, I can't remember if all their sales are capital equipment, or there was any recurring revenue attached to the sales cycle.

[Jim Hawkins:]

Yes, it's pretty much all capital equipment; it's maybe 5% disposable kind of products. But it's – it is a capital equipment business.

[Larry Haimovitch:]

Okay, very good. Thanks, Jim.

[Jim Hawkins:]

Sure. Larry.

[Operator:]

Thank you. And we have a follow-up question from Chris Lewis with ROTH Capital Partners. Your line is open.

[Chris Lewis:]

Hi, guys, just a couple of follow-ups on Venezuela, I guess, a handful of questions. One, not a huge difference, but $7 million, I think, is the new assumption versus $8 million that you stated a couple weeks ago. Can you just kind of walk us through that change? And then, what's the gross margin profile expected to be on that revenue stream? Thanks.

[Jim Hawkins:]

Sure, Chris. Let's see, on the revenue, the reason to bring that down is, as we went through the analysis of the quarter, to recognize that revenue, not only do we have to ship the product, but that product has to be installed and accepted in the hospital. And with – we just – we feel we will certainly be shipping, I believe, more than that product, more than that dollar amount down there; but trying to estimate how much will get into the hospitals and approved, we just wanted to be conservative on that front. But we're convinced that, by the end of March, everything will be shipped, and everything will be in the hospital. So, maybe it's $7 million this quarter instead of $8 million, but it will be $13 million in Q1 rather than $12 million. So, it just – we just wanted to be conservative.

[Chris Lewis:]

Okay. And the gross margin profile for that?

[Jim Hawkins:]

Yes. Jonathan, do you want to take that one?

[Jonathan Kennedy:]

Yes, the gross margin – on the products that we – that are Natus going through there, they are in the high 60s and 70s, there's some pretty good margin there. But then a lot of that contract is passed through, and we're going to get a normal distribution margin somewhere in the 30% or so. We've kind of wanted to look at this project as an operating margin project, not at a gross margin level. So, gross margin – operating margin-wise, we see it in the 20-ish-percent, plus or minus. Gross margin, if I had to put a number on it, it's probably somewhere near the 60% mark, all blended.

[Jim Hawkins:]

But on that service business, so we're going to get minimal margin on that. You know, that's a big part of the – a reasonable part of the contract as well. So when you add that in, it's maybe down 30% or 40%.

[Jonathan Kennedy:]

That's correct, yes.

[Jim Hawkins:]

So, all in – maybe I misspoke – all in, gross margin not 60%; it's in the 40% range.

[Jonathan Kennedy:]

Yes, 30%, 40%.

[Chris Lewis:]

Okay, thanks.

[Jim Hawkins:]

And I think our plan – Chris, I think our plan is to still break that out to show what the revenues and gross profit margin is on that business. So you will be able to see what the core Natus gross margin is.

[Chris Lewis:]

Right. Yes. I think that would be helpful. Thank you.

[Jim Hawkins:]

Sure.

[Operator:]

Thank you. This concludes today's Q&A session. I would now like to turn the call back over to Jim Hawkins for any closing remarks.

[Jim Hawkins:]

Thanks, operator. Well, in closing, we look forward to 2017 with Otometrics, and reaching the $500 million revenue milestone for Natus. I'd like to thank everyone for participating in today's call, and for your continued support and interest.

[Operator:]

Ladies and gentlemen, thank you for participating in today's conference. This concludes the program and you may now disconnect. Everyone have a great day.