Minneapolis, MN-based ATS Medical, Inc. (ATSI) develops, manufactures and markets medical devices needed in cardiovascular surgery. The company's products have been used in more than 140,000 heart implants across 61 countries. ATS Medical s core product, ATS Open Pivot a mechanical bileaflet heart valve is used to treat heart valve failure. The natural aging process, rheumatic heart diseases, prosthetic valve failure and congenital defects are the usual causes for heart valve failure. Through partnership arrangements and acquisitions, the company operates in three synergistic platforms: Heart Valve Therapy comprised of mechanical heart valves, tissue heart valves and repair products Surgical Arrhythmia Therapy comprised of Cryocath cryotherapy products and Surgical Accessories that include blood filtration products, and minimally invasive tools used in robotic valve surgery.
ATSI has the goal of becoming the #2 mechanical valve company in the world. The ATS Open Pivot Valve has been implanted in over 140,000 patients and is gaining market share, which the company believes is around 17% worldwide. The valve has a unique pivot design that results in better performance and a lower risk profile. The design allows the valve to open and close faster than other leading prosthetic heart valves and more naturally accommodate transvalvular flow. In August 2007, the company received FDA approval of 25mm and 35mm size extensions for its Open Pivot Valve product line. At the end of July 2006, the company received European CE Mark approval for the AP360 version, which features a new cuff design that is easier to implant as well as improves the mechanical valve's hemodynamic performance. U.S. approval came in December 2007.
In addition to growing the heart valve market, the company has substantial manufacturing leverage. Originally, Carbomedics, Inc. supplied the carbon components that make up the heart valve under an inventory supply agreement. The components manufactured by Carbomedics represented approximately 80% of the total cost of the ATS heart valve. ATSI consumed the remaining high cost Carbomedics component inventory during the first quarter of 2006. The company now has its own pyrolytic carbon plant that is expected to increase gross profit from 44% in the fourth quarter 2005 to 59%-60% when fully ramped by the end of 2007. Coming in at a 51% fourth quarter 2006 gross margin after a 57% gross margin third quarter 2006, ATSI obtained less gross margin improvement than expected given weaker-than-expected mechanical heart valve markets (down 6% in 2006), unabsorbed manufacturing facility costs and a greater mix toward lower ASP international heart valve revenues. However, gross margin increased to 57.8% in first quarter 2007 as the company expanded production. In second quarter 2007, gross margin moved lower sequentially to 55.3% driven by weaker-than-expected mechanical heart valve markets (down 20% in 2Q07). Third quarter 2007 gross margin also came in below expectation at 56.3% vs. 57.3% in the year-ago period. However, this included $62,000 in higher surgical arrhythmia therapy inventory purchased prior to acquisition and $187,000 in under-absorbed period costs at the tissue valve facility. Excluding this, gross margin was estimated to have been 58.3% for Q307. We expect further gross margin improvement to 64% in 2008.
Further expanding their product portfolio, in November 2004 the company acquired U.S. co-promotion and international distribution rights to Cryocath's surgical ablation products to treat cardiac arrhythmias. An estimated 40-50% of mitral valve patients and 10-20% of coronary artery bypass patients also suffer from some sort of cardiac arrhythmia. An estimated 375,000 patients are candidates for a combined arrhythmia ablation procedure along with either a bypass or mitral valve procedure. ATSI began selling the ablation products in the U.S. in January 2005. Their international distribution deal was effective April 2005. Cryocath ablation products increased 39% in the fourth quarter 2006. In first quarter 2007, CryoCath products increased approximately 40% year-over-year (+10% sequentially) to $1.5 million. In second quarter 2007, CryoCath products increased approximately 16% year-over-year (-13% sequentially) to $1.3 million. Importantly, in June 2007, the company acquired the surgical cryoablation business of CryoCath Technologies. The assets being acquired include the SurgiFrost, FrostByte, and SurgiFrost XL family of products. ATS Medical paid CryoCath $22.0 million upon closing of the transaction, $2.0 million upon the achievement of certain manufacturing transition milestones, another $2.0 million two years after closing and up to $4.0 million in contingent payments based on future sales of Surgifrost XL. Given the late closing of the transaction, ATSI only derived commission revenue in the second quarter. If they had owned CryoCath for the second quarter, they would have generated $2.9 million in revenues. With full ownership of the products in third quarter 2007, while the company believed end-user demand increased about 15%, revenues from CryoCath products increased 230% year-over-year, up 154% sequentially, to $3.3 million, and up 14% sequentially on an "as if" pro forma basis. CryoCath gross margins exceeded 60%. The company believes end-user demand increased about 15%. The surgical ablation market is projected to grow to more than $400 million by 2011. The company expects to begin pilot clinical studies of its FDA-approved Surgifrost XL followed by a limited market launch in the fourth quarter of 2007 and full launch by 1H08. The XL product has been designed as a true standalone atrial fibrillation procedure. With the acquisition, allowing ATSI to capture the full margin of the product, management expects to be profitable during 2H08, one year ahead of its previous forecast. The transaction is expected to add approximately $16 million-$19 million in total surgical cryoablation revenue in 2008. Management also believes that the transaction provides some operating leverage while allowing the company to penetrate the rapidly growing $1.5 billion cardiac arrhythmia market.
Another portfolio addition, ATS Medical, Inc. and Regeneration Technologies, Inc.-Cardiovascular entered into an agreement in July 2005. Under the agreement, RTI will be responsible for the processing and delivery of human allograft tissue, used for cardiovascular surgeries, and regulatory compliance related to screening, testing, and processing of this tissue. ATS Medical will be the exclusive distribution services provider in North America for allograft tissue processed by RTI. RTI-Cardiovascular, formerly known as Alabama Tissue Center, is a wholly-owned subsidiary of Regeneration Technologies, Inc. The allograft tissue agreement represents an annual market opportunity of approximately $50 million in the U.S. However, management indicated RTI has been unable to secure sufficient donor tissue, and the tissue shortage affected operating plan and revenue assumptions in 2006. While we expected more normal levels in 2007, sufficient tissue has not been available.
Moving into the growing tissue valve market, the company acquired 3F Therapeutics in late September 2006. 3F is an early stage medical company developing a minimally invasive heart tissue valve replacement in beating hearts. ATS Medical issued roughly 9 million shares for the acquisition. 3F shareholders will receive up to an additional 10 million ATSI shares upon achievement of certain milestones. The three products in development are expected to cost about $6.5 million to complete over two years. While dilutive and increasing expenses, delaying company profitability, this transaction is a significant advance toward building ATS Medical's goal of more than $100 million annual revenues. The first product, the equine 3F Aortic Bioprosthesis, will compete with stentless aortic valves and began a controlled second quarter 2007 European rollout, with a U.S. launch expected in first quarter 2008. The 3F Enable sutureless valve, just starting clinical trials (the U.S. IDE was submitted in Q107) and expected to be marketable in Europe in 2009 and the U.S. in 2010, will compete against stented valves in standard incisions but with less cross-clamp and bypass pump time. The third product, the Entrata, is a less invasive version that is in animal trials. The tissue valve market is about $850 million and is growing in the low-to-mid single digits. Management believes the 3F deal expands their growth potential in the cardiac surgery market. We expect only nominal 3F Aortic Bioprosthesis (Model 1000) 2007 revenues. For 2008, the company expects tissue valve revenues of $7 million-$10 million.
In addition, the company late in the third quarter 2005 launched the Thoracic Port System, a proprietary instrument set for minimally invasive surgery, including robotic surgery. The company also received FDA approval for the ATS Simulus annuloplasty product line in January 2006, marking the entry of the company into the heart valve therapy market. In March 2006, the company announced the first implant of the ATS Simulus annuloplasty ring. The worldwide heart valve therapy market is estimated to be about $115 million and growing at 5% to 10% annually. The shape of heart valves change during the cardiac cycle and the ATS Simulus annuloplasty products are designed to maintain the normal physiologic function of the heart valve. These instruments and products provide the sales force with additional cardiac surgery offerings. In October 2007, earlier than expected, the company received FDA approval for its Simulus Semi-Rigid Annuloplasty Ring. Management plans a market introduction of the Simulus Semi-Rigid Ring by the end of 2007 or early 2008, and is looking for a $2 million revenue contribution in 2008. The company also received FDA approval for its next generation Flexible Simulus Ring with the expected launch also by the end of Q407 or in early Q108.
Despite solid valve sales and complementary products and a stronger pipeline, ATSI is operating in a tremendously challenging environment. Although the company has an advanced mechanical valve product, the mechanical valve market is declining in favor of tissue valves, and ATS Medical competes against larger competitors like St. Jude Medical and Edwards Lifesciences. Although the company is gaining U.S. share, we are concerned the migration toward tissue valves may be greater than previously thought. The overall trend suggests a continued soft mechanical valve market, estimated to have declined about 6% in 2006, with faster declines in the U.S. in 2007. While the 3F tissue valve products mitigate this somewhat, if the company is not successful in growing the mechanical valve market, profitability goals may not be reached.
Despite efforts to diversify its product portfolio, 64% of ATSI's current revenues are mechanical heart valves. The company remains largely a one-product company that exposes it to substantial market risk. Importantly, the tissue valve market, according to the company in second quarter 2007, has about 80% of the total valve market. If ATSI is unable to expand sales of the ATS Open Pivot Valve or Cryocath ablation products or unable to develop new products such as 3F Aortic tissue valves, growing the company will become much more difficult.
Despite solid top-line growth, which we expect to grow about 21% in 2007 and 37% in 2008, near-term pressure will remain due to increased R&D and sales and marketing expenses. The company has focused on physician education and conventions to drive awareness in lieu of a larger direct sales force. At present, the ATS Medical sales force in the U.S. consists of about 40 direct sales and 18 exclusive agents, a much smaller size force than larger competitors. In order to increase market penetration, we believe the company will need to invest in a larger direct sales force or expend greater resources to drive awareness. Marketing expenses will likely rise given new product launches and costs associated with product development, including the improved AP360 that received U.S. approval, as expected, at the end of 2007, and SurgiFrost XL to be launched in 2008 and the 3F Aortic BioProsthesis expected to be launched in the U.S. in early 2008.