Dan McFadden - Vice President of Public and Investor Relations James Schutz - Chief Executive Officer Robert Miller - Chief Financial Officer.

Laura Engel - Stonegate Capital Partners Gabrielle Zhou - Maxim Group.

Good day, ladies and gentlemen, and welcome to Sonoma Pharmaceuticals fiscal first quarter 2018 conference call. Currently, at this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. [Operator Instructions].

Also as a reminder, this conference call is being recorded. I would now like to turn the call over to your host, to Dan McFadden. Sir, you may begin..

Thanks, Dylan. Good afternoon and thank you for joining us. With me on the call today are our CEO, Jim Schutz, and our CFO, COO, Bob Miller. We will open the call with Jim's update on our business strategy moving forward, followed by Bob's review of our financial results for the fiscal first quarter 2018, which ended June 30, 2017.

This afternoon, Sonoma issued a press release detailing fiscal first quarter 2018 financial results and recent corporate developments. A copy of the release can be downloaded from our website, which is at sonomapharma.com or you can call Investor Relations at 425-753-2105 and we'll be happy to assist you.

Before we begin, I’ll remind listeners that this conference call contains forward-looking statements within the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. These forward-looking statements are identified by use of words such as expect, to expand, would and anticipate, among others.

These forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially, including risk inherent in the development and commercialization of potential products; the risk that potential clinical studies or trials will not proceed as anticipated or may not be successful or even sufficient to meet regulatory standards or receive the regulatory clearance or approvals; also, the company's future capital needs and its ability to obtain additional funding; and other risks detailed from time to time in the company's filings with the Securities and Exchange Commission, including the quarterly report on Form 10-Q and the annual report on Form 10-K.

Identified product applications and/or uses are intended to highlight potential applications for the investment community and does not infer that the company is marketing for these indications. The company does not provide any assurances that such applications will receive regulatory approvals.

Sonoma disclaims any obligation to update these forward-looking statements. I will now turn the call over to Jim Schutz, our CEO..

Thank you, Dan. And thank you all for joining us today. For my portion of today's call, I'll highlight several key metrics of our business, spend just a moment looking ahead to the next several quarters, Bob will then cover the financials, and then finally we'll open the call for Q&A.

We had a solid quarter on all of our key metrics, including top line revenue growth versus the same period last year, prescriptions filled at the pharmacy counter, and our profit center businesses. Product growth was strong, up 49% versus the same period last year, with continued solid performance from many of our top products.

One data point shows a solid upward trend. For the June 2017 quarter, the following product lines experienced double-digit growth versus the March 2017 quarter. Our Alevicyn product for atopic dermatitis was up 26% just in one quarter. Celacyn, prescriptions filled for our scar treatment product was up 31% in the quarter.

Mondoxyne for severe acne was up 31%. And Sebuderm, a recent product launch for us, indicated for seborrheic dermatitis, was up 42% June versus March. Dermatology prescriptions filled for the first quarter were up 66% over last year and up 24% even versus the March 2017 quarter. Our growing sales team now totals 30 sales reps and 5 managers.

All reps have been trained, are out in the field generating prescriptions, and we are pleased to see the team hitting new weekly sales records for prescriptions filled at the pharmacy counter almost every week.

From a clinical trial perspective, we saw a publication of two studies, describing the benefits of Celacyn, our prescription scar management product, and for Sebuderm for the treatment of facial and scalp seborrheic dermatitis.

Both studies are available online, in print and are great tools for our growing sales force when speaking with our customers, the dermatologists. Our profit center businesses, which we define as our international business, acute care, animal health and our contract lab testing, are all on track for profitable growth for our full fiscal year.

And finally, our cash is healthy and we have almost no debt. As Bob and I discuss often, it's a great time to be running this growing company with a dedicated team, all pushing towards the same goals and objectives. Switching gears, a brief look ahead.

Loyon, our skin descaling product, licensed from a German pharma company, was recently approved by the FDA and is on track for a launch in October. You may have seen, we just received our 17th FDA approval last week for a new product and a new indication.

For competitive reasons, we're not in a position to discuss this product or the timing for the launch. But suffice it to say that we should have an active nine months ahead with the FDA. In Brazil, the regulatory equivalent of the FDA, which is Anvisa, asked us for more information on our pending dermatology products in the June timeframe.

We've already answered their questions and provided all requested information. We now expect up to seven new dermatology product approvals – and I'm going to repeat that, not launches, but approvals – specifically for the Brazilian dermatology market this fall.

As you'll no doubt remember, Brazil has become the world's third-largest market for beauty products after the US and Japan. And in plastic surgery and in dermatology procedures, Brazil is now the world's second-biggest market after the US. Additionally, we have a handful of new approvals pending in the Middle East and in China.

And we look forward to providing you with more information on our international dermatology growth soon. So, in closing, we had a strong quarter due to our team's focus on our execution. We are well positioned for the remainder of this year and beyond. Bob, I'll turn the call over to you. .

Thank you, Jim. I'll first discuss the financial results of our first fiscal quarter ended June 30, 2017; secondly, a review the financial results of our derm strategy; and finally, talk about our path to EBITDA breakeven, driven by the 30 derm sales reps and their 5 senior managers, 13 of which have been hired in the March and June quarters.

Moving now to a review of our financial results for the first fiscal quarter of fiscal year 2018 and covering only the highlights with the details in today's earnings press release. Total revenue was $3.8 million for the quarter ended June 30, 2017, up 45% or $1.2 million compared to $2.6 million in the same period last year.

Total product revenue of $3.6 million was up 49% over the same period last year, with strong growth in US dermatology and acute care markets and in products sold to the new owner of the Latin America assets.

More specifically, during the first quarter, US product revenue increased $486,000, up 35%, to $1.9 million, mostly related to the increase in dermatology and acute care product revenue, partially offset by a decline in animal health sales.

Total international product revenue was up $706,000 or 68%, with increases in Mexico, Middle East, Europe, Hong Kong and Singapore, partially offset by decreases in China and India. Revenue from products sold to Invekra is temporary until Invekra sets up their own manufacturing facility.

We expect that revenue related to Invekra will be in the $250,000 to $350,000 per quarter until they assume their own manufacturing. We further estimate that it will take about six to nine months from now until Invekra manufactures at their facility.

The gross margins have been impacted by the historical separation of the discontinued operations and the very low margins of the current Mexico sales to Invekra. Since the current sales to Invekra are almost sold at cost, they reduce our overall gross margins.

Once Invekra starts manufacturing and we discontinue manufacturing, then our gross margins will improve. Operating expenses minus non-cash expenses for the June quarter were $4.7 million, up $570,000 or 14% compared to the same period last year.

Increase in the cash operating expenses was due to the higher sales and marketing and administrative expenses in the United States, related mostly to the increased number of our direct dermatology sales force.

On the balance sheet, our cash position at the end of June was $12.6 million compared to $7.4 million on June 30, 2016 and $17.5 million on March 31, 2017 with only minimal debt.

The decrease in cash from March 31 was $4.8 million, consisting of a cash operating loss of $2.8 million, $659,000 of prepaid expenses – mostly taxes paid to the Mexican IRS related to the Invekra transaction – and $157,000 of capital expenditures, both of which are one-time and non-recurring cash payments.

The remaining difference is the use of funds for the decrease in accounts payable and the increase in accounts receivable, which equals about $1.1 million, of which $663,000 was the increase in receivables which has now been collected.

Over the next several quarters, the primary use of cash will be the cash operating loss while taxes related to the Mexican transaction and capital expenditures will be minimal, if any. The accounts receivable will rise as our sales increase and accounts payable will remain fairly flat.

Going forward, as we progress to break even, our best estimate at this time is that we have sufficient cash to achieve breakeven. What would have been the financial results of our dermatology efforts for the quarter ending June 30, 2017? There are several ways to measure our success in the derm market.

One is through the sales of our products to our wholesale distributors, which are recognized as revenue when shipped to them. This is the common way of recognizing revenue.

Our total US product revenue was $613,000 for the June quarter in 2015, $1.4 million for the June quarter in 2016, and $1.9 million for the June quarter 2017, up 35% over the same quarter last year.

More specifically, our US dermatology net product revenue was $1.2 million for the quarter ending June 30, 2017 compared to $686,000 in the same period last year, an increase of $510,000 or 74%.

While we recognize our derm revenue when we ship to our wholesalers, a second method to objectively gauge the Sonoma dermatology performance is the number of prescriptions filled for patients via the pharmacies, multiplied times the price paid to us by the wholesalers. This is traditionally called demand dollars.

This information is available to the public for a fee via several well-known databases and is widely shown via Bloomberg.

According to the Symphony monthly data, the total prescriptions filled by patients via the pharmacy times the price paid by the wholesalers for all of our derm products was $4 million for the June 2017 quarter, up $2.3 million or 142% from $1.7 million for the same period last year.

The growth in demand dollars for the June 2017 quarter over the March 2017 quarter was 44%. The number of prescriptions filled for the June quarter was 17,180, up 24% over the March quarter of 13,794. Over the last nine quarters, our average quarter-over-quarter growth rate has been 20%.

There are three primary factors which have generated this strong growth. First – in order of importance – has been the quality, effectiveness, leadership and the number of our direct sales force. In the March and June quarters, we added, as we mentioned, 13 veteran derm sales reps, a 75% increase, with now a total of 30 sales reps.

The 24% increase in prescriptions filled, of the June over the March quarter, reflects the initial impact of the 13 new sales reps and the continued sales growth of the 17 tenured and established reps. The second factor for the high growth rate has been the launch and growth of eight products and product line extensions.

The third and last reason has been our price increases. Our price per gram of product is currently well below that of our competitors. For example, Topicort, a solid branded mid-potency topical steroid for the treatment of atopic dermatitis, sells for $4.50 per gram. A comparable generic sells for $2.67 per gram.

And our Alevicyn gel sells for $1.11 per gram. While we achieved strong 24% growth in prescriptions filled in the June over the March quarter, our rebate costs and level of returns were higher, as a percent of gross revenue in the June quarter compared to the March quarter.

As of result, the net revenue of our derm group showed single-digit growth over the March quarter. We are actively implementing programs, which we believe will reduce, contain and will offset the rebate costs as a percentage of gross revenue. We estimate that the level of product returns will adjust back to normal levels with occasional spikes.

What is our plan to achieve commercial EBITDA breakeven, our current primary financial objective? Our plan to achieve EBITDA breakeven includes the same three factors, which I just mentioned, and it's very simple in concept including, one, sales growth from the new sales reps on a faster ramp and from the established reps on a slower sales ramp.

Number two, launch and growth of new and current products. Our Loyon descaling product, which Jim mentioned earlier, will be launched in this fall. And the Ceramax line extensions will be launched in the spring of 2018.

Number three, increased prices based on a pricing strategy of periodic and smaller changes, but remaining well below the price per gram of our competitive products. What is the possible timing of achieving EBITDA breakeven? Let me make it clear that we are not indicating breakeven in a specific quarter in the future.

What we are saying is, one, our prescriptions for the June quarter were 17,180 and have been growing at an average quarter-over-quarter growth rate for the last nine quarters of 20%, as mentioned earlier.

And two, if – and I want to emphasize the word if – our prescriptions filled grow at a quarter-over-quarter average rate of 13% to 20% starting from the June quarter, then we should breakeven in the range of the June to December 2018 timeframe. Let me now make some general comments about the plan to achieve EBITDA breakeven.

The gross margins will improve as we increase our US dermatology revenue, which has 80% to 85% gross margins. And at the breakeven level, we should have a blended gross margin in the range of the low 70%.

Looking at the big picture, in order for us to achieve EBITDA breakeven, we estimate that our total net revenue should be in the range of $6 million to $7 million per quarter and the prescriptions filled should be in the range of 32,000 to 35,000 per quarter.

My last general comment on our journey to breakeven is that we will update you on our progress on each quarterly earnings call. And if needed, we'll adjust assumptions and the impact of those changes.

As mentioned on previous calls, we continue to believe that Sonoma remains a strong investment candidate for the value investor, who is also looking for strong revenue growth and a strong cash position. With respect to valuation, I'd like to make – end with three points.

One, our cash position, $12.6 million, is a high percentage of our market capital of about $29 million. Number two, our product revenue growth was strong at 49% for the last three quarters ending June 30, 2017 compared to the same period.

And as I've mentioned before, our average quarter-over-quarter growth rate for a longer time period for the last nine quarters for filled prescriptions was 20%. Over the next several quarters, investors should expect to see continued strong dermatology revenue growth as the additional 13 sales reps follow an already demonstrated sales ramp.

Number three, we laid out a clear path to breakeven. As we get closer to that breakeven point, our market cap and stock price should in theory increase. Also, at a time of breakeven, our net revenue should be in the annualized $24 million to $26 million range and derm companies tend to have a revenue multiple of 3 to 5x of revenue.

Thus, a potential investor can benefit not only from the strong derm product revenue growth and reaching breakeven, but also from a potential expansion of the multiple. With that, I'll turn it over to the operator for Q&A. .

[Operator Instructions] Our first question comes from Laura Engel of Stonegate Capital Pa..

Good afternoon. Thanks for taking my questions.

How are you all?.

Doing good..

Doing good. So, just two quick ones. On the pricing, you discussed that some and compared that to the competition.

In keeping with what your plan is, is that still going to entail the 10% to 20% increases over 2017 or are you adjusting that range as well?.

I would say it still should be in that range. But, actually, we could have a higher amount just because our price per gram tends to be quite lower than the rest. But our plan – our current plan is still that 10% to 15%, yes..

Okay.

And then, I don't know if I know the answer to this, but the products you discussed that we are looking for some news from the FDA and some pending approvals, are the majority of those Microcyn-based or how would you characterize the in-house development that is going on right now as far as the products?.

Yeah, good question. We have an active R&D department in Seattle who is busy on all things hypochlorous acid-based. But please stay tuned also for some new product approvals and launches that are not HOCl. As you know, Laura, one of our goals is to diversify and provide more great products for our customers, the dermatologists, and for their patients..

Okay. And then, I guess, the last question, looking at the – you put out a separate press release that you mentioned about the Celacyn. You've been on the market with this a few years. What is your market share compared to the competition? I know there are limited products out there. Maybe really one or two others, I think we've discussed in the past.

But how does that compare a couple of years into this as far as your share versus others..

I think on the prescription, there are only really 2 products in the prescription Celacyn market. One is Recedo. And based on our data, it's probably about a 60-40. They actually have quite a few more sales people and they also sell into the women's health market. And that's probably the reason for the 60-40.

Their product stands – it is a relatively standard silicon-based product. But they tend to pick up the benefits of selling into the women's healthcare market..

Okay. Well, I appreciate the detail. And I will get back in the queue..

Thank you..

[Operator Instructions]. Our next question comes from Jason Kolbert of Maxim Group..

It's actually Gabrielle Zhou here for Jason..

Hi, Gabrielle. .

Hi. I'm looking at your US sales for this quarter and it seems flattish compared to the last quarter. And I know that you guys mentioned about the growth was kind of offset by the higher rebate product return.

And can you just give me some color on why is the return much higher this quarter because you seem to have a nice growth on the prescription sales..

Well, there are couple of factors that affect the overall US sales for the quarter compared to last year and even the prior quarter. The animal health care sales were actually down compared to last year. And so, that's one that reduced the overall growth of the US revenue. It was a factor.

In terms of the returns, the higher level of returns, they were more specifically related to a product that we introduced that didn't have very good coverage and we pulled that back..

And I can help there too. Gabrielle, we had three strengths on the market and we pulled back one strength due to insurance coverage not being very robust. Bob, I think you said in your script something about the returns being....

Yeah, the returns – the combination of the returns and the rebates were higher as a percentage of the overall gross revenue. And I think the returns of – the trend in the returns has been higher and higher, not just for us but for many other prescription type – prescription companies. And we've seen the impact of that in this quarter.

We've got a couple of – a number of major programs undergoing that we think that we'll be able to contain and reduce that cost over time..

Can I correct something you just said? We were talking returns and rebates. Rebates, we are seeing industry trends increase. Returns, we think we should more normalize, but expect an occasional spike at the end of shelf life or for some other reason, Gabrielle..

Yes, that's – absolutely. It was the rebates that have – the trend has been upward. The returns, we see occasional spikes, and this was one of them..

And do you think that will impact your [indiscernible] in terms of the growth rate for the US sales in the following quarter?.

In the following quarter, we think that we are undertaking programs. They won't be – they will have an impact on the quarter. But it will have an impact of dampening the growth that we expect to see on a gross level basis. But we still think it will be a strong growth even in net revenue basis for the quarter for dermatology, in particular..

Great. Just if I can just ask one more question, I heard that you guys mention some sales in China.

Can you just provide some update on that as well?.

Yes, we have two partners in China, primarily focused on the acute care business, but our international guru, Bruce Thornton, likes to describe our dermatology opportunity in China as just scratching the surface.

So, we know that he's waiting for some additional regulatory approvals in particular for one of our product lines that he's going to be very enthusiastic about. But two solid partners doing reasonably well. We know the size of the dermatology market in China. It keeps getting bigger and bigger by all that we read.

So, we want to make sure that we are partnered with the right companies and providing the right products there..

And you mentioned the partners in China, are they the role of – mainly to be the distributors for your products?.

Yes, that's well said. That's very knowledgeable too. No R&D. We provide them the products. They distribute in China. Correct..

Got it. Great, thank you. Appreciate the insights..

Thank you..

I show no further questions in queue at this time. I'd now like to turn the call over back to Jim Schutz, CEO..

Hey, thank you all for joining for today's call and for your continued support. We feel Sonoma is in the best shape we have ever been for several reasons.

One, we've effectively executed a turnaround strategy in a very attractive dermatology market with a strong, experienced and effective sales team, a robust and unique product portfolio, and our growing product pipeline. Our next step is to drive to commercial breakeven, which we believe will increase shareholder value.

Two, we believe our current cash position of $12.5 million – or more accurately, $12.6 million – enables us to aggressively grow our dermatology business with the use of only part of this cash. Three, our commercial EBITDA breakeven plan is relatively straightforward. And I'm going to repeat what Bob said.

A, we see a high growth from our additional 13 new sales reps, now totaling 30 sales reps. B, we are going to launch new products and continued growth of our current products. And, C, gentle price increases, consistent with other comparable products. We have the foundation and building blocks in place to achieve EBITDA breakeven.

We look forward to sharing our progress as we build this company to becoming a pure-play, multi-technology dermatology company and achieving our purpose of relentless passion for healing. Thank you again. And, operator, that's all..

Thank you, sir. Thank you, ladies and gentlemen, for attending today's conference. This concludes the program. You may all disconnect. Good day..