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Executives

Anthony Conway -- President and CEO

David Jonas -- CFO

Analysts

Tyson Bauer -- Kansas City Capital Associates

Bruce Jackson -- Northland Capital Markets

Beth Lilly -- Gabelli Investors

Ross Taylor -- CL King & Associates

Rochester Medical Corporation (ROCM) Q4 2012 Earnings Conference Call November 13, 2012 4:30 PM ET

Operator

Good day, ladies and gentlemen, and welcome to the Fourth Quarter 2012 Rochester Medical Corporation Earnings Conference Call. My name is Crystal and I will be your operator for today. At this time, all participants are in listen-only mode. Later, we will conduct a question-and-answer session. (Operator Instructions).

I would now like to turn the conference over to your host for today, Mr. Anthony Conway, President and CEO. Please proceed.

Anthony Conway

Good morning. Thank you for joining Rochester Medical's fourth quarter conference call. I'm Jim Conway, the Company's President and CEO. And with me is David Jonas, Rochester Medical's Chief Financial Officer.

Before starting, let me remind you that we will be making some forward-looking statements today, and I would refer you to the Safe Harbor statement found in today's press release and also to the Risk Factors section in the Company's Annual Report on Form 10-K for the year ended September 30, 2011. These statements further clarify the risks and uncertainties that are associated with the forward-looking statements.

First today, I'll provide a brief overview of our fourth quarter and discuss our recently announced decision to discontinue our Foley catheter line. Dave will then provide you with more details on our financial results and our outlook for fiscal 2013. Then, I'll give a quick update on a few items and summarize, and we will take your questions.

Fourth quarter total revenues increased 13% on a reported basis and 16% on a constant current basis to a record of 16.7 million. Our global direct sales business reported growth of 14%, driven chiefly by the 34% growth achieved by our US direct sales of business.

Our international direct sales of business also grew, up 8%, led by the continuation of strong 18% growth in the UK. Our business in The Netherlands Laprolan showed some improvement, growing sequentially in the quarter.

Results in the rest of Europe and the Middle East regions did rebound in the quarter, as we had been expecting, given the last quarter's soft performance which primarily related to the timing of key orders.

While Europe admittedly remains challenged economically, we continue to experience acceptable rates of growth and generally expect this to continue. Global Private Label grew 7% in the fourth quarter consistent with our expectations for steady moderate growth.

We reported fourth quarter GAAP earnings of approximately 1.1 million or $0.08 per share and on a non-GAAP basis, excluding certain non-cash expenses, we posted a doubling in net income to 1.4 million or $0.11 per share.

For fiscal 2012, total sales improved 15% on a reported basis and 17% on a constant currency basis. Full year non-GAAP net income reached 3.5 million or $0.28 a share, up from 1 million and $0.09 per share a year ago.

A number of positives should be inferred from these results. First, growth in the US remains robust driven particularly by how well our intermittent catheter line was doing. Intermittent catheters grew 44% worldwide in the fourth quarter, as we continue to expand our share in this $800 million global market.

Second, our business in the UK continues to do well and we are pleased with our business in The Netherlands is showing signs of improvement. Third, our Private Label business remains a steady contributor and is performing nicely in line with our expectations. Finally and importantly, this fourth quarter performance marks top line and record operating income for Rochester Medical.

Now, turning to last Tuesday announcement of the discontinuation of our Foley catheter product line, I'd like to say a few words about this decision and Dave Jonas will provide more color on the financial impact.

While we had made a concerted effort to grow the acute care business the distribution channel for Foley catheters, given the high barriers in this market coupled with extensive costs associated with manufacturing and marketing the product, the Foley business has remained a meaningful drag on Company profitability.

As such, we began a process in the spring of this year with our investment bank Piper Jaffray to explore strategic alternatives for the Foley business, including the possibilities of exiting or selling the business. And based on a very deliberate and thorough evaluation process, we determined that the best course of action is to simply exit the business as no acceptable purchase offers have been made.

And further, last week's publication of the UK NHS sponsored Foley catheter study in The Lancet did not support a decision to continue to devote substantial resources to this product line. That study did not find a clinically significant difference between anti-infection catheters and regular catheters in preventing symptoms of urinary tract infection. While we were disappointed by the study's findings, we made the decision to suspend the Foley business and all the cost needed to support it even clearer.

In fiscal 2012, revenues from Foley catheters amounted to $3.9 million, about 6% of total revenues. While the product line significantly reduced operating profit, so in sum we cannot justify the poor returns and in the best interest of shareholders, it is time to focus on our profitable business.

I'm pleased to say we will be much stronger and more profitable going forward. We will be tightly focused on the core parts of our business that are profitable and growing, intermittent catheters and male externals. While it clearly is a difficult decision, we firmly believe it is the right strategic decision for Rochester Medical. I want to thank all the people who have worked to support the Foley business. Thank you. We appreciate the many contributions you have made over the years.

Let me now turn the call over to Dave who will give you further detail.

David Jonas

Thanks, Jim. I'm going to start with a review of the results reflected in our just released fourth quarter 2012 earnings release. Then, I will provide details on the financial impact with both the previously announced decision to exit the Foley business and the revised revenue and after-tax profit expectations for fiscal 2013 provided in today's earnings release. For ease of discussion, unless otherwise noted, all sales information will be discussed in constant currency. I'm doing this to exclude the impact of foreign currency exchange in order to show a true reflection of our sales growth.

Foreign currency dampened our top line this quarter by approximately $346,000. The euro is weak in this year and is the primary driver for foreign currency impacts this quarter. The average euro exchange rate in the fourth quarter of fiscal 2012 was 1.25 compared to 1.41 in the same period last year.

Total fourth quarter sales increased 15.5% to $16.7 million from $14.5 million last year. Direct sales were the primary driver of growth increasing 19% to $13.6 million from $11.4 million last year.

Private Label sales also reported higher sales year-over-year increasing 7% to $3.1 million with $2.9 million last year, fueled by a high teens growth domestically which offsets somewhat soft Private Label sales in Europe.

Given that approximately 80% of total revenues are derived from product sales, I will focus the revenue discussion on the drivers of this strong direct sales performance. Globally, direct sales reported another solid quarter of results led by the US and UK growth of 33.7% and 18.4%, respectively.

Global direct sales benefitted from improved trends in The Netherlands where our Laprolan business operates where sales increased 5.2% year-over-year after experiencing softness in the prior two quarters of fiscal 2012. For the proper context, I want to highlight the fact that while we do business in more than 75 countries around the world, almost 90% of our total global direct business comes from three regions of the US, the UK and The Netherlands.

US and UK direct growth was specifically driven by positive performances in each of our four product lines; intermittent catheters and external catheters, Foley catheters and FemSoft in the fourth quarter with the largest contributors to year-over-year growth coming from intermittent catheters and external catheters again this quarter.

Let me now turn and discuss direct sales in terms of the channel served, specifically home care and acute care. Home care accounts for almost 90% of our direct sales and is thus the primary driver of total Company performance. In the fourth quarter, direct sales in the home care channel increased 13.7% to $12.1 million from $10.7 million last year, fueled by 49% growth in sales in intermittent catheters.

Direct sales in the acute care channel increased 18.2% to $1.5 million from $1.2 million last year, driven by growth in Foley and male external catheters. We are pleased with the performance of our intermittent and male external catheter lines, as Jim alluded to his remarks, as these lines continue to generate growth consistently above market growth rates as our home care sales force continues to win market share through deeper penetration into existing accounts as well as solid and consistent new account conversion. FemSoft, albeit still a minor product line, continues to grow sequentially in both the US and the UK.

Now let me review the rest of the income statement. Our fourth quarter gross margin was 49.5% and again our gross margin has stayed very stable this year. Total operating expenses of $6.6 million declined 2% compared to both the prior year and prior quarter, driven by lower sales on marketing and R&D expenses which more than offset a modest increase in G&A expenses for the period.

Fourth quarter selling and marketing, R&D and G&A expenses together represented approximately 39.4% of sales this year compared to 45.5% of sales in fiscal 2011. Fourth quarter operating income increased 187% year-over-year to $1.7 million or 10.1% of sales versus only 4% a year ago, due to our solid top line growth and expense leverage in making this the most profitable operating quarter in the Company's history.

On a GAAP basis, we reported fourth quarter net income of just over $1 million, up 152% than the $407,000 net income reported in the fourth quarter of last year. Excluding intangible amortization and stock-comp expense, we reported fourth quarter non-GAAP net income of $1.4 million or $0.11 per diluted share compared to a non-GAAP net income of $822,000 or $0.07 per share last year.

The non-GAAP adjustments are detailed in the reconciliation section of our press release that shows the underlying operating results of the business.

Let me now turn to a brief review of our fiscal year 2012 results, including an update on our cash flow performance this year as well as our balance sheet condition at year end. Total revenues increased 15.4% to $61.1 million in fiscal 2012, up 17.6% on a constant currency basis. Direct sales were the primary driver of this growth this year increasing 21% to $48.9 million. Private Label sales also posted year-over-year growth in fiscal 2012 increasing 5.7% to $12.2 million.

The robust growth in our direct sales this year was due to a combination of impressive results in our two largest direct regions, the US and the UK, which reported growth of 32.1% and 17.7% respectively for this year. And our full year contribution from our acquisition of Laprolan in fiscal 2012 compared to three-quarters of contribution in fiscal 2011.

Gross profit margin of 49.3% of sales remains steady with gross margins in fiscal 2011. Total operating expenses of $26.9 million or 44.1% of sales declined 3.1% year-over-year, driven by considerable expense leverage on the sales and marketing and G&A lines. Importantly that we exercise careful expense control on these two expense items this year, we did continue to invest in more R&D this year than we did in fiscal 2011 as we remain committed to internally funding our future growth through new product development.

Solid top line growth and gross margin performances combined with our expense leverage resulted in record operating profit of $3.2 million or 5.3% of sales compared to an operating loss of $1.7 million last year.

Fiscal 2012 GAAP net income of $2.1 million or $0.07 per share improved sharply over GAAP net loss of $1.3 million reported last year. Excluding intangible amortization and stock-comp expense, we reported fiscal 2012 non-GAAP net income of $3.5 million or $0.28 per diluted share compared to non-GAAP net income of $1.1 million or $0.09 per share last year.

The prior year non-GAAP figures include an after-tax adjustment from a material amount recurring costs associated with M&A costs. The non-GAAP adjustments are detailed in the reconciliation section of our press release which shows the underlying operating results of the business.

We ended the fiscal year with $20.7 million in net cash and equivalents compared to $35 million at the end of last year. Working capital efficiencies, particularly with respect to improving the inventory turns combined with the sharp improvement in net income this year, drove higher cash flow from operations in fiscal 2012.

We retired $18.3 million in debt obligations in the first quarter of fiscal 2012 and are debt free at year end. We also returned approximately $1 million to shareowners this year in the form of share repurchases.

Before I turn the call back to Jim, I'd like to spend a few minutes discussing the financial impacts of some of the items presented in our earnings release and in the press release last week, specifically our previously announced decision to exit the Foley catheter business, our revised revenue and net income projections for fiscal 2013 and our capital investment plans in fiscal 2013.

First, regarding the planned exit of our Foley catheter product line; as Jim mentioned, this is something that's been under consideration for a number of months and we evaluated all potential options for this business with an eye on the best use of capital for our shareowners. In the absent of a strategic or financial buyer, the best option for us was to discontinue manufacturing and marketing of Foley catheters completely. Exiting out of this Foley business will change our P&L materially, despite the loss of approximately $3.9 million in sales.

The overall profit profile of the Company will improve dramatically, specifically after working through the one-time expenses of the discontinuation we expect at least $3 million in incremental operating profit going forward. This is on a base of the $3.2 million in total Company operated profit reported in fiscal 2012 to roughly doubling of our operating income. We expect to see higher gross margins as the overall product mix changes and we will enjoy lower sales and marketing and G&A expenses due to the planned reduction in the associated headcount.

Turning to our revised guidance for fiscal 2013, the final year of our three-year strategic plan we originally shared at the end of fiscal 2010. Excluding any Foley catheter sales, we now expect to achieve fiscal 2013 sales of approximately $67 million, up approximately 17% from fiscal 2012 also excluding our Foley sales. This is down from prior guidance of $83 million in sales and primarily reflects two primary changes in our outlook.

First, our original three-year plan included $13 million of Foley sales in the US alone which we're now exiting and second, a more conservative rate of growth in our international direct business given the broader economic challenges in Europe.

Regarding after-tax profit, we now expect to achieve approximately $7 million after-tax, down from prior guidance of $9 million to $10 million. As you can see, this implies higher profitability than fiscal 2012 driven by the combination of our exit from the unprofitable Foley business coupled with our ongoing expense leverage. This new guidance does incorporate approximately $150,000 in expense in our operating expense budget through medical device excise tax which will begin to impact us in our second fiscal quarter.

Finally, as we shared with you on our last earnings call, we plan on expanding our manufacturing footprint in fiscal 2013. This facility will more than double our capacity to manufacture intermittent catheters and also us to meet the projected demand for our intermittent products for the next few years. The new facility will also be specifically designed for the next generation products we've alluded to due to be launched late next year.

We expect to begin construction on the facility immediately and estimate the total cash outlay to be approximately $12 million. We anticipate the facility to be operational in the next 9 to 12 months. And importantly based on our expected cash flow from operations in fiscal 2013, we'll be able to fund investment in our new facility entirely through internally generated cash flow.

With all of that, I will turn the call back to Jim. And thank you very much.

Anthony Conway

Thank you, Dave. I just want to emphasize again that our intermittent catheters and male external catheters are strongly growing profitable business lines. As I mentioned, the intermittent catheter market is about $800 million worldwide. We still only have a tiny fraction of that. Our share continues to increase and we have well above market growth in the line and you saw the figures earlier at the very high percentages of growth.

Similarly, although the MEC market is a lot smaller, about $130 million globally, it also offers compelling growth prospects particularly as we are the technology leader and continue to introduce meaningful new products to the MEC market, which I'll say more about that just shortly.

And as we continue to drive growth in each of these businesses, intermittent and MECs, we will see our profitability improve, as Dave said, and as we reach our production, we can even better leverage our fixed cost. We expect our global home care business paced chiefly by the strength in both the US and the UK to continue to be a very strong contributor for the top line and to operating profitability.

Now, let me update you on the new product that I alluded to on last quarter's call. On October 1, we announced the launch of a next-generation male external catheter with the introduction of the Spirit Hydrocolloid Adhesive Sheath. Spirit is important and that it is the first and only male external catheter to combine the moisture-wicking properties of a hydrocolloid adhesive with the superior breathability of silicone.

What that basically means is that patient comfort and wear time are maximized considerably compared to the current generation of MECs. These properties are extremely important for people who use these devices on a regular basis, most MEC users use them every day all day.

Typical of Rochester Medical, our hydrocolloid technology is unique and highly proprietary. It is currently patent pending, yet the bulk of Spirit's novel properties are embodied in the manufacturing knowhow the Company's evolved over many years of being a leader in this field.

While we are just several weeks into the Spirit launch, we are encouraged by clinicians and patients to early receptivity to the product. We expect Spirit to complement the growth we expect to generate in our MEC business in the coming year and beyond.

Turning to the outlook for fiscal '13, as Dave reviewed with you, we have taken more conservative posture to our outlook for the third year than we originally provided. While we generally pleased with the growth and profitability improvements Rochester generated over the first two years of this plan, as we have discussed we encountered challenges with the slower than expected ramp up of the acute care business and some underperformance in our business in Europe. We believe we are addressing those challenges head on.

We remain as optimistic as ever in the growth prospects for our global Rochester branded direct sales. The Private Label business also remains a reliable, stable grower for us. Taken together all of these changes are reflected in improvement and conservative outlook that Dave articulated. This new guidance marks still robust growth of approximately 17% on the top line versus 2012 without the Foley's and is doubling of earnings.

In summary, we are pleased to have closed out a successful year at Rochester Medical and we are well positioned to achieve the strong growth targets we have laid out for the current fiscal year. We look forward to reporting back to you in the coming quarters.

With that, we'll be happy to take your questions.

Question-and-Answer Session

Operator

(Operator Instructions). Your first question comes from the line of Tyson Bauer [Kansas City Capital Associates]. Please proceed.

Tyson Bauer -- Kansas City Capital Associates

Good afternoon, guys.

Anthony Conway

Hi, Tyson.

David Jonas

Good afternoon, Tyson

Tyson Bauer -- Kansas City Capital Associates

Well, congratulations on making the hard decision and now focused in on shareholder value here, so I think everybody should be pleased with that decision. Doing some of the back of the napkin numbers taking out the Foley's in 2012 in your guidance for next year, it would appear every dollar of sales you're doing is dropping in net contribution margin of 30% to the net income line. Is that how the numbers are going to work as we go forth?

David Jonas

It's pretty close, Tyson, that's really close.

Tyson Bauer -- Kansas City Capital Associates

That significant leverage obviously that should excite people. CMS, we're getting in the time of the year where we start to talk about rate reviews. Anything on tap there or expectations either plus or minus on rates?

David Jonas

Nothing that we've seen.

Tyson Bauer -- Kansas City Capital Associates

In regards to the Foley line, is there any residual value that you see there in the future or is that basically written off?

Anthony Conway

There's some residual value in the IP certainly, some of the IP that we have under development is likely usable in the intermittent catheter line that's not in our current plan. Obviously some of this space that we used, which is fairly significant, is usable for our other production. And actually some of the dipping equipment is also usable for our other products. So, yes, there is some value still there.

Tyson Bauer -- Kansas City Capital Associates

Okay. And Dave, you talked about being able to fund with internal cash flow, your $12 million expansion implications as we're expecting over $1 share of free cash flow then next year?

David Jonas

Yes.

Tyson Bauer -- Kansas City Capital Associates

You excluded that expansion to CapEx?

David Jonas

Right.

Tyson Bauer -- Kansas City Capital Associates

You talked about the growth rate changing in Europe from your original three-year plan to a more modest rate now. Can you provide any quantitative numbers to that?

David Jonas

We had anticipated growth in the teens in Europe and we've got that now at single-digit growth.

Tyson Bauer -- Kansas City Capital Associates

Okay. Implying then US intermittent markets growing 30% plus then?

Anthony Conway

More than that, in markets over 40%, it's about 47% in the US. As far as Europe goes, the UK is still marginal very, very strongly. Laprolan, as we said, is still underperforming our original expectations but starting to show growth. And then outside of that, our direct sales business, that makes up 90% of our direct sales right there, those three places. And outside of those three places, our growth is fairly slow in that final 10% single digits growth.

Tyson Bauer -- Kansas City Capital Associates

Given that growth rate in the intermittent in the US market and the small market share that you have, are people taking notice of that? Are you starting to become a bur under the saddle?

Anthony Conway

I don't know about a bur under the saddle, but people are certainly taking notice of it. And the ones that we want to take notice of it, the clinicians are really taking notice. Our whole sales approach is to show the clinician why our product is better for their patient with no extra cost and it's working really well.

Tyson Bauer -- Kansas City Capital Associates

All right. Congratulations guys and I'll look forward for a bright future.

Anthony Conway

Thanks, Tyson.

Operator

Your next question comes from the line of [Matt Late]. Please proceed.

Unidentified Analyst

Good afternoon. Just a couple of clarifying questions here on the 2013 sales guidance, I don't know if I heard this correctly. It looks like international is about 3 million less than your original expectations. Are there specific regions at all that you can call out over here a little bit more specific in terms of where you may see a little slower ramp than what you were expecting?

Anthony Conway

Specifically, it's Europe outside of the UK, Matt, but that's where the – in 2010, we thought we'd get double digit growth in that area and we have not seen that. So we put in more single-digit growth for 2013.

Unidentified Analyst

Okay, thanks for clarifying that. And then if you take a look at the fourth quarter here, excluding Foley catheter sales this year and the comparable period last year, what was your sales growth?

David Jonas

I've not done that number. I don't have that in front of me now. I'm sorry. I can get that and give that for you offline.

Unidentified Analyst

Okay, sounds good. And then last year, there was a pretty sizeable ramp in your sales force. With the decision to exit the Foley business line, how are you feeling about your current sales staff levels right now?

Anthony Conway

Well, there will be a significant – we had two sales forces domestically, the acute care which is primarily Foley's and the home care which is primarily the intermittent and MECs. And the acute care sales force will essentially be eliminated. A small number moving over to home care, but overall domestically we will lose somewhere between 15 and 20 people in sales and marketing. And outside of sales and marketing related to Foley production and other processes, there'll be additional 30 to 40 people that we will be losing. And that's the sad part of this decision because they're good people.

Unidentified Analyst

Yeah. Improvement in Laprolan sequentially here, any – how do you take a look at that and then in relation to some of the senior leadership changes that you've made over this past year, how are you measuring I guess the success of that?

Anthony Conway

Well, so far we are very pleased. The new management team laid out a brand new plan that reorganized the sales force. We are very confident that they're focusing on the two product areas that are going to bring the growth. We've already seen that growth start, albeit small growth, but I think they have – it's a great team and I plan on being over there in two weeks and spend the week in the UK and in The Netherlands and again go over every detail of their plan, every part that's working and what's not working and we're in very good communications. I feel very good about it.

Unidentified Analyst

And the reimbursement challenges, any change over there?

Anthony Conway

No, that's not going to go away. The product line is mostly related to wound care and scar care. There's a headwind there and we're doing the best we can in that headwind. And as I say, we're starting to see improvement.

Unidentified Analyst

Last question is for Dave. I missed when you gave the medical device tax impact. Can you repeat that?

David Jonas

Yeah. We have a $150,000 in our plan and that only affects us for sales of Foley catheters and intermittent catheters in the US. And that would be our whole year's with Foley and whole year's with intermittent. And the reason I left the whole year of Foley in there is we're only going to sell Foley's for probably the next 90 days, but I don't know what levels people are going to order. Some of them might order a whole year's worth of Foley's, but I want to be conservative and leave $150,000.

Unidentified Analyst

Okay, thank you.

David Jonas

Yeah.

Operator

Your next question comes from the line of Bruce Jackson [Northland Capital Markets]. Please proceed.

Bruce Jackson -- Northland Capital Markets

Thank you. A follow-up question for Jim. I was wondering if you could just give us some commentary on the catheter trial on why you think the endpoints didn't fall your way? And then also if you think there's going to be any fallout in the marketplace, if infection control catheters are going to be less popular as a result of this study?

Anthony Conway

To answer your second question first, it's certainly not going to help promote infection control catheters. I don't have a good answer. I've got some theories as to why this study shows different results from the hospitals that use our product. I mean we still think very highly of our technology and the hospitals that use it show very significant reduction. I did notice and I know you noticed that one of the, I thought, curious things about this study is that the infections were self reported by the patient. And did that have an effect on it? I don't know. Also in the UK, the procedures for catheterizing patients are quite different. They're all assembled – all parts are assembled at bed site. They don't use kitchen trays or anything like that and whether that would mask some of the benefits, I'm not sure why it would but I'm just pointing out that's the difference. So I don't have a good answer.

I also think the study, the way they describe the difference in results was a little bit odd. They showed the controlled catheter with approximately, I'm rounding here, 12% infection rate and our catheter which performed the best of all three with a 10% infection rate and then said that we'd only reduced infections by 2%. Well, in the absolute that's true, but that's a 20% reduction almost in infection. So anyway at this point that study's history. We were hoping for a big tailwind. We did not get it. All of the strategic analysis that we had done all this year, we left basically an option open for if that study had come out as we had hoped and it did not.

Bruce Jackson -- Northland Capital Markets

Okay. Then in the press release you mentioned that there is a new intermittent catheter product that you're planning to launch somewhere near the end of calendar year 2013. Can you give us any sort of hints as to what that might be?

Anthony Conway

Not really just for competitive reasons. We think that it's the next big thing in intermittent catheters. That's what we think.

Bruce Jackson -- Northland Capital Markets

Okay. So we know it's going to be in the intermittent catheter business and that it's going to be coming towards the end of calendar year 2013?

Anthony Conway

That's our current estimate for the timing on it, yes.

Bruce Jackson -- Northland Capital Markets

Okay. And then one last question on the corporate tax rate, do you anticipate any changes for fiscal 2013?

David Jonas

I do not. It should be right in that same ballpark. And as we become more profitable and the permanent differences make less and less of a difference, our tax rate should stabilize considerably.

Bruce Jackson -- Northland Capital Markets

Okay, great. Thank you.

Anthony Conway

Thank you.

Operator

Your next question comes from the line of Beth Lilly [Gabelli Investors]. Please proceed.

Beth Lilly -- Gabelli Investors

Hi, Dave and Jim.

Anthony Conway

Hi, Beth.

Beth Lilly -- Gabelli Investors

I have a couple of questions. The first question is in terms of the closing down of the Foley business, are there going to be charges associated with that?

David Jonas

Very immaterial ones to our total business method. There are going to be some severance payments that are going to be around $200,000. We expect to use the majority of that, all of the equipments so there won't be any equipment write-off. We expect to sell out of our inventories. So there might be some small inventory write-off, but nothing material.

Beth Lilly -- Gabelli Investors

All right. So the only charges will be severance related then?

David Jonas

Correct.

Beth Lilly -- Gabelli Investors

Okay. And then Jim, when you had laid out the three-year model two years ago, you articulated plans and I think at the time it was – the operating margin that I calculated which you could achieve was 15% to 16%. Is that still a good number to use maybe two years from now?

Anthony Conway

Yes, (inaudible).

Beth Lilly -- Gabelli Investors

Okay. And do you think it can exceed that or is that the run rate for the business that you expect?

Anthony Conway

Well, theoretically it can certainly exceed it, but that would be a little further out.

Beth Lilly -- Gabelli Investors

And that's dependent of course on volume.

Anthony Conway

Very much, absolutely so. Yeah.

Beth Lilly -- Gabelli Investors

Okay, all right. And so operating margins which were 49% this year, as you move up to that 15% to 16% operating margins, gross margins were 49 in this year so do you anticipate the model looks like mid-50% gross margins?

David Jonas

Should we completely exit the Foley business, the margin should go 52% to 53% almost immediately. As we leverage that fixed cost, we should be able to get in the mid if not the upper 50s eventually.

Beth Lilly -- Gabelli Investors

Okay. And then my last question is in terms of the additional capacity, so that will come on – you're breaking ground right now. Is that correct?

Anthony Conway

Due to start immediately, yes.

Beth Lilly -- Gabelli Investors

And so that will ramp up over the next – so you should be producing a product out of that facility in the next 9 to 12 months, did you say?

David Jonas

That's correct.

Beth Lilly -- Gabelli Investors

Okay. And how much additional revenue do you anticipate that facility generating?

Anthony Conway

When it's at full capacity?

Beth Lilly -- Gabelli Investors

Yes.

Anthony Conway

Well, I'd say it was – when the first production line that we're putting in is at full capacity, it will generate the next close to $25 million.

Beth Lilly -- Gabelli Investors

Okay. And how many lines can it support?

Anthony Conway

Well, we have to add on a little bit to put in a second line. We're pretty well filling it, but there's some extra space. But of course in addition is much less expensive than going through this whole groundbreaking thing that we're doing that now. So we would have to expand space to put in the second line.

Beth Lilly -- Gabelli Investors

Okay. So that facility when it's running at full capacity will generate – will support 25 million in revenue?

Anthony Conway

Yes.

Beth Lilly -- Gabelli Investors

Okay, great. And then my last question is, since you have announced that you're exiting Foley, has any interested parties contacted you about buying the technology or has anybody contacted you to – about that business?

Anthony Conway

There's some of that still going on yet.

Beth Lilly -- Gabelli Investors

Okay.

Anthony Conway

Where that will or will not lead, I don't know. We're going full steam ahead with the idea that we're exiting it. We're keeping the IP and full steam ahead. If something develops that's meaningful, we'll certainly let everybody know.

Beth Lilly -- Gabelli Investors

Okay, great. All right, terrific. Thanks so much.

Anthony Conway

Thanks, Beth.

Operator

And your next question comes from the line of Ross Taylor [CL King & Associates]. Please proceed.

Ross Taylor -- CL King & Associates

Thank you. Jim, can you comment on what you're thoughts are and how you've used the cash and the free cash generation going forward. We have a stock that's in some ways seems to get no respect, a little bit of the Rodney Dangerfield of the med space particularly with the moves you've recently made, you got net cash in the balance sheet. You can fund your CapEx out of your free cash flow. Do you wake up any morning and feel frustrated that you're only trading at $9 this year.

Anthony Conway

I don't think frustrated is the right word. I don't get frustrated very easily, but I think we're undervalued certainly. And I think at the right time that will all change. I think that the decision that we made and announced will make everybody realize that if we just keep doing what we're doing, we're going to be worth a lot more money that what we're currently trading for. And it's pretty easy I think for investors to see that we can keep on doing what we're doing. So I think it will change. We don't have any immediate plans to buy any shares back, but we're authorized to and we may.

Ross Taylor -- CL King & Associates

Given your thoughts that this should become pretty clear going forward, it would seem as a shareholder I'd argue it would be prudent for you to be more aggressive in buying stock if you actually have comfort that the story develops as you see it developing, because you basically have a free cash yield of right now projected of about 11% a year. You've got net cash in the balance sheet. Quite honestly right now, it would be a wonderful way to turn effectively a one multiple asset into an asset that should carry a much higher multiple a year, two years down the road as investors start to recognize the real power of the model?

Anthony Conway

Well, certainly I hear what you're saying. We've obviously kind of taken the position that we'd use our cash for like building new technologies, this kind of thing and for acquisitions. And we still remain very accretive, if you will. We're still out looking. We've got people in Europe right now that are looking. So we like to keep our options open, but we have bought stock back in the past and we may very well do it again.

Ross Taylor -- CL King & Associates

Okay, thank you. We'd encourage that given that stock buybacks are not subject to the risk of government funding and other factors that perhaps it'd be given a little greater weight going forward particularly given the power of the moves you've just made in writing off the Foley business and the like. Thank you.

Anthony Conway

Yeah, we'll take that into consideration.

Ross Taylor -- CL King & Associates

Thank you, sir.

Anthony Conway

Thank you.

Operator

(Operator Instructions). There are no further questions at this time.

Anthony Conway

All right. Well, thanks everybody. Appreciate you attending and we look forward to next time. So call if you have additional questions if you think of them later. Thank you.

Operator

Ladies and gentlemen, that concludes today's conference. Thank you for your participation. You may now disconnect. Have a great day.

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