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Volcano Corporation (VOLC - Analyst Report) reported earnings per share (EPS) of 4 cents in the third quarter of fiscal 2012.The results were in-line with the Zacks Consensus Estimate, but lagged the year-ago quarter’s EPS by a penny. Revenues for the quarter climbed up 9% year over year (up 12% at constant exchange rate or CER) to $93.7 million, but missed the Zacks Consensus Estimate of $95 million.

Revenues in the Medical segment increased 9% (12% increase at CER) during the quarter to $90.7 million with a 13% increase in disposable revenues at CER, on the back of a robust 54% growth in FFR (Fractional Flow Reserve) disposable business along with growth across all the key operating regions. The Industrial segment recorded a 5% year over year increase in Industrial revenues to $3.0 million in the third quarter.

Over the past few quarters, the company has been benefiting from a growing volume of data depicting improved patient outcomes and economic benefits from the use of functional percutaneous interventional (“PCI”) as well as the use of intravascular guidance to optimize and confirm the therapy during the procedure.

The European market recorded a decline of 23% in Intravascular Ultrasound (IVUS) disposable sales, with the U.S. recording growth rates of 5% and Japan declining 2%. However, in spite of this disappointing performance in this quarter, Volcano is optimistic about new Visions PV .035 Digital IVUS (Intravascular Imaging) catheter, which recently received market approvals in both the U.S. and Europe. The company expects these clearances to act as major boosters in improving the company’s IVUS disposable performance and will match its strategy to increase the market adoption of IVUS.

Volcano Corporation recorded a 106 basis points (bps) contraction in gross margin to 64.5% in the quarter. However, with selling, general and administrative increasing by 12.9% to $40.7 million and a 6.4% decline in research and development (R&D) expenses to $13.0 million, the company recorded a drop of  18 basis points in operating margin to 7.1% (excluding amortization of intangibles).

Volcano exited the quarter with cash, cash equivalents and short-term investments of $241.8 million compared with $219.3 million at the end of fiscal 2011. Year-to-date operating cash flow remained at $37.3 million compared with $20.5 million for the same period, last year.

Outlook

Volcano Corporation lowered its outlook for fiscal 2012 to reflect the several headwinds currently under play. Due to the continued softness in domestic PCI market and the transition to a direct sales model in Spain, the company now expects to report revenues of $380–$384 million (previous expectation $384–$390). However, it reiterated its EPS at 18–21 cents and gross margin guidance at 65–66%. Moreover, the outlook for operating expenses has been raised to 59−60% (58−59%) of revenues.

Recommendation

Volcano Corporation continues to face challenges in the form of tough macroeconomic environment, especially in Europe. Moreover, unfavorable currency movement during the quarter played as a major headwind for the company. We are also disappointed with the decline in margins that have adversely affected the company’s bottom line. We believe that the rise in expenses is primarily to support the various pipeline developmental programs and is related to the transition to a direct sales force in Spain.  Besides, economic uncertainties in Europe remain an overhang for the company. Moreover, the company witnesses stiff competition from players such as St Jude Medical (STJ - Analyst Report) and Boston Scientific Corporation (BSX - Analyst Report). However, the company is executing strategies to drive sales in the IVUS/FFR markets backed by new product launches and product enhancements. We are encouraged with a number of positive data on FFR, published in the quarter including FAME II data, which portrays FFR as an important contributor in achieving improved patient outcomes in a cost-effective way.

The stock carries a Zacks #3 Rank (“Hold”) in the short term. Over the long term, we maintain our ‘Neutral’ recommendation on Volcano Corporation.

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