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RTI Biologics, Inc. (NASDAQ:RTIX)

Q3 2008 Earnings Call

October 28, 2008 9:00 am ET

Executives

Wendy Crites Wacker - Director of Corporate Communications

Brian Hutchison - Chairman and CEO

Tom Rose - EVP and CFO

Analysts

Shawn Fitz - Stephens Inc.

Keay Nakae - Collins Stewart

David Turkaly - SIG

Matt Dolan - Roth Capital

Greg Brash - Sidoti & Co

Brooks West - Craig-Hallum Capital

Jayson Bedford - Raymond James

Operator

Welcome to the RTI Biologics Incorporated third quarter 2008 results conference call. Today's conference is being recorded. At this time, I would like to turn the conference over to Wendy Crites Wacker. Please go ahead.

Wendy Crites Wacker

Thank you for joining RTI Biologics for our third quarter 2008 conference call. Today we will hear from Brian Hutchison, Chairman and CEO, who will discuss operational highlights and future activities for the company as well as Tom Rose, Executive Vice President and Chief Financial Officer who will provide an overview of our financial results.

Before we start, let me make the following disclosure about forward-looking statements. The earnings and other matters we will be discussing on this conference call will involve statements that are forward-looking. These statements are based on our management's current expectations, but they are subject to various risks and uncertainties associated with our lines of business and with the economic environment in general. Our actual results may vary from any statements concerning our expectations about future events that are made during the course of this meeting, and we make no guarantees as to the accuracy of these statements. Accordingly, we urge you to consider all information about the company and not to place undue reliance on these forward-looking statements. Now I will turn the call over to Brian.

Brian Hutchison

As the year continues and 2009 starts to come into focus, we are pleased with the progress that we have made since our merger with Tutogen Medical this past February. As we continue to be excited about the opportunities in the future, we have achieved quarterly revenues of nearly $39 million. Net income for the quarter was $388,000 or $0.01 per fully diluted share based on 55 million fully diluted shares outstanding.

However, when excluding purchase accounting adjustments and restructuring charges, adjusted net income was $761,000 or $0.02 per fully diluted share. For the nine months ended September 30, 2008, we achieved revenues of $109 million.

Net income for the nine months was $2.5 million or $0.05 per fully diluted share based on 50.4 million fully diluted shares outstanding. Again, if you remove the purchase accounting adjustments and restructuring charges associated with the merger, we achieved net income of $4 million or $0.08 per fully diluted share.

Let me review a few key highlights of our quarter. We achieved record revenues in surgical specialties with $5.2 million in the quarter, an increase of 78% from prior year, in large part due to a $1.3 million increase in hernia repair revenues.

We achieved above-industry growth in sports medicine, increasing revenues by 29% compared to prior year. We achieved growth in domestic dental, increasing revenues by 15% compared to prior year. We launched bovine pericardium for dental applications at the American Academy of Periodontology and American Association of Oral and Maxillofacial Surgeons meeting. We shipped initial launch quantities of new lumbar grafts for Stryker and Orthofix.

In general, given the country's macroeconomic climate, we feel RTI is in a comparably good position with our industry seeing elective, non-critical surgeries such as some dental and sports medicine procedures being postponed during this recession. We are not seeing any delays in major or critical surgeries such as sports medicine for athletes, general orthopedic and spine surgeries.

As a company, we are taking action by controlling our expenses. We have no major investments required, and we do not need to raise cash in the near future. For these reasons and more, we believe we are in position to weather the economic storm better than many other companies.

Let's drill down on each of our lines of business a little further. Spine results were again heavily impacted by lower orders for Medtronic, which declined in both the third quarter and nine-month period. As a result of ongoing discussions with Medtronic, we believe that we have reached the bottom of the ordering spectrum. Prospectively orders should grow over the next 15 months. We also plan to begin development of a new lumbar implant with them for 2009.

One of our goals with our merger with Tutogen was to diversify our business and reduce reliance on one major distributor. To illustrate this, note that Medtronic accounted for 22% of our revenues for third quarter 2008, but accounted for 47% for the same period of 2007.

For the nine months, Medtronic accounted for 23% of our business, but accounted for 49% the same period in 2007.

We are pleased with the progress we had with spine distributors, we brought on in the past 18 months. The impact of lower orders from Medtronic is being offset by the progress we are making with our new spine distributors.

In the third quarter spine revenues from Zimmer, Stryker and Orthofix/Blackstone accounted for $2.5 million. In the third quarter, we launched new lumbar designs with both Stryker and Orthofix as we continue to broaden the allograft portfolio of each of our spinal construct distributors. We are on track to deliver another cervical construct for Zimmer Spine, which should have an initial shipment in Q4 with the remainder in 2009.

With each of our spine distributors, we are evaluating or already developing additional new spine grafts which we will launch in the next 12 months. After a difficult transition this year, we anticipate that our spine business will start to grow again in 2009 with a much diversified platform.

Sports medicine revenue growth was impacted during the quarter due to a seasonal decline in elective surgeries and as we added a significant number of direct biologic representatives to replace independent distributors in certain territories, as we discussed in our second quarter call.

Although replacing underperforming independent distributors with direct reps has been a key strategy that we've been pursuing, we had to accelerate our efforts in Q3. A major supplier of instrumentation and fixation that used some of the same regional distributors as RTI has made it economically unfeasible for those distributors to continue carrying our sports medicine implants.

This has been an unfortunate event for the impacted regional distributors as the BioCleanse sterilized sports medicine implants are the safest and highest quality tissue in the marketplace today. As of today, we have 24 direct biologic reps in key geographic locations around the country, and we will be adding to this team over the coming quarters.

As a comparison, we had eight direct reps at the beginning of 2008. We anticipate that when we have our full complement of direct biologic reps in place by the first quarter of 2009, we will be able to regain much of the business displaced by these impacted regional distributors.

Long term, the increase in our direct representation is very positive. We should see increased overall revenues and provide more stability to our sports medicine business. That being said, we are still very pleased that our sports medicine business continued to turn in above-industry growth, driven by superior implants and strong demand by our surgeon customers.

We are pleased with the overall performance in our dental business compared to current industry trends that are down across the board. Our domestic business grew by 15%, an improvement compared to Q2. We reported an overall down quarter, including our international revenues due to the transition of direct distribution to a single distributor, which has taken longer than anticipated.

If we remove a one-time $1 million stocking order to our international distributor, which happened in September 2007, then we experience an overall of 7% increase in revenues for our worldwide dental business for the quarter.

While this business is certainly experiencing some of the fallout of a weaker market, we believe that specialty biologics in the dental market will have some degree of insulation, particularly in the domestic market.

As I mentioned, our other surgical specialty line reached record revenues of $5.2 million for the third quarter. In particular, quarterly revenues from U.S. hernia repair were up $1.3 million compared to prior year. Increased tissue availability has positively impacted our ability to meet the high demand for the larger implant sizes in our hernia repair line.

Increased tissue availability has also impacted our implants and breast reconstruction area. This business increased 117% compared to prior year.

As we look at the past two quarters following our merger with Tutogen, we are particularly pleased with the trends that have followed in our new lines of business. Most notably has been our surgical specialty business, which is experiencing favorable trends and solid momentum as biologics gain more widespread adoption in areas like hernia repair and breast reconstruction.

We believe our surgical specialty line is benefiting from a couple of dynamics, including an increase in tissue availability, as well as more surgeries being performed using a biologic implant versus synthetic. Zimmer, our potentially largest distributor in bone graft substitutes, has been successful introducing our new ready to use allograft piece through its trauma business. However, they will be fully launching this implant across their spine and dental division in February of 2009.

We currently have sufficient supply of these implants in stock, ready for the launch in Q1 2009. Looking forward to 2009, we plan to launch new bone graft substitutes with both Stryker and Wright Medical, and we have started development on an additional bone graft [BGS] implant with both of these distributors for late 2009 and 2010 launches.

General orthopedics had a strong quarter with substantial revenue increases compared to 2007. The increased revenues are principally due to the inclusion of revenues of Tutogen Medical, as well as the increase in distribution of xenograft wedges.

Our ability to better meet the demands of our lines of allograft implants in this quarter and for 2009 is a result of many successes of RTI Donor Services and our tissue recovery personnel in Europe. Donor tissue recoveries continued to increase in Q3 by adding new recovery partners, and we are seeing additional increases in dermis and pericardium tissue recoveries to meet unmet demands.

We were very pleased to receive word last week that in the civil cases regarding the BTS issue, the federal court agreed with our "science first" motion, that tissue distribution by RTI and Tutogen could not transmit disease.

Additionally, the court ruled that recipients of tissue who had not tested positive for any diseases within six months of their transplant had no basis for a claim. This is a landmark ruling which we anticipate will bring the end to this litigation.

Despite these extremely difficult times in the financial markets, RTI continues to make progress in its fundamental business. As a result of the merger, we have many more opportunities. Our business is much more diversified and thus stronger.

We have numerous implants launching in the upcoming quarters with exciting growth prospects and we will be entering new markets using our current technologies. We are profitable. We have sufficient cash to continue to grow our business.

Evidenced by the progress we have made in all of our lines of business following the merger coupled with our successful integration and recognized synergies, we see a confirmation of our decision to merge with Tutogen.

At this point, I'll let Tom discuss the financial results.

Tom Rose

Thank you, Brian. Revenues for the third quarter of 2008 were $38.5 million compared to revenues of $23.8 million for the prior year. Revenues for the combined company were slightly above the pro forma results in the third quarter 2007.

Revenues for the first nine months were $109.3 million compared to $68.7 million in 2007. Compared to pro forma revenues in the first nine months of 2007 for the combined company, revenues increased 8%.

Third quarter net income was $388,000, or $0.01 per share compared to $178,000, or $0.01 per share in the prior year. Net income for the nine months was $2.5 million, or $0.05 per share compared to net income of $507,000, or $0.02 per share in the prior year.

However, when excluding purchase accounting adjustments and restructuring charges, adjusted net income was $761,000, or $0.02 per fully diluted share for the third quarter and $4 million, or $0.08 per fully diluted share for the nine months.

Final construct revenues were $10.9 million for the third quarter and $29.7 million for the first nine months compared to $10.8 million and $30.7 million, respectively in the prior year. As Brian mentioned, spine results were heavily impacted by lower order levels from our largest distributor in both the third quarter and nine months period.

On a pro forma basis, spinal construct revenues were down 14% for the quarter and 14% for the nine months, respectively. Sports medicine revenues were $8.8 million for the third quarter 2008 and $28 million for the nine months, compared to $6.8 million and $18.7 million, respectively for the prior year periods.

In addition to across-the-board volume increases, revenues have recently introduced BioCleanse Meniscus and fresh OC grafts were up by approximately $700,000 for the quarter and $1.3 million for the nine month period.

General revenues were $7.8 million in the third quarter of 2008 and $19.5 million for the seven months of combined operation, compared to $8.3 million and $18 million, respectively, compared to prior year revenues of Tutogen on a standalone basis.

As Brian mentioned, although, we reported an overall down quarter including our international revenues, if we remove a one-time $1 million stocking order to our international distributor September 2007, we experienced an overall 7% increase in revenues for our worldwide dental business in the third quarter.

Surgical specialty revenues were $5.2 million in the third quarter 2008 and $11.8 million for the seven months of combined operations, compared to $2.9 million and $7 million, respectively, compared to the prior year revenues of Tutogen on a standalone basis for the comparable period.

The increases are substantially driven by higher amounts of tissue available for distribution, as well as greater confidence by our distributors and our ability to meet their market demand.

Revenues for bone graft substitutes were $3 million in the third quarter 2008 and $11.8 million for the nine months compared to $4.4 million and $13.1 million, respectively, in the prior period. The decreases are primarily due to lower orders from our largest spine distributor.

However, we've also reallocated cancellous tissue from this area to support dental demand accounting for a $550,000 decrease in BGS for the third quarter and a $750,000 decrease for the nine-month period.

Gross profit margins for the third quarter were 47% compared to 40% for the same period last year. Adjusted for purchase accounting effects of $348,000 or approximately 1%, gross margins would have been 48% in the period. Step-up adjustments of $1.3 million to Tutogen's beginning inventories have been fully amortized as of the end of the third quarter, and therefore will not impact the fourth quarter gross margin.

Gross profit margins were down slightly from Q2 due to lower processing levels and slower than expected processing activity at our German facility during the summer months.

In the third quarter, operating expenses totaled $17.3 million, an increase of $8.1 million over 2007. The increase was primarily due to the merger with Tutogen. During the quarter, fixed marketing, general and administrative expenses totaled approximately $15.3 million.

Variable incentive compensation was $132,000 during the quarter and variable distributor commissions totaled $3.7 million. Research and development expenses totaled $2.1 million, or 5% of revenues for the quarter.

As a result of our continued progress on identifying expense synergies, we are raising our estimate of annual savings resulting from the merger with Tutogen Medical from the current estimates of $6.5 million to $7 million to approximately $8 million to $8.5 million.

When reviewing the balance sheet at the end of the quarter compared to December 31, 2007 and cash flow for the first nine months of 2008, please note the following. Our cash position at the end of the quarter was $21.6 million compared to $18.6 million at December 31, 2007, an increase of $3 million. At this time, we feel we have sufficient cash to grow our business.

Accounts receivable increased to $14.6 million as compared to $9.8 million at December 31, 2007. The days sales outstanding of the combined company were 34 at September 30, 2008.

Inventories increased to $67.1 million compared to $39.8 million at December 31, 2007. Inventory days outstanding for the combined company were 267 at the end of the third quarter.

At September 30, 2008, unprocessed donor tissue totaled $17 million, tissue in process totaled $33.4 million and implantable donor tissues totaled $14.9 million. We are seeing increases in unprocessed donor tissue, which is a key indicator for future revenues. Tissue in process has increased partially as a result of the build of intermediates for two new bone graft substitute implants, which will launch in Q1 2009.

In addition, we've been increasing finished good levels of meniscus and fresh OC grafts, as well as several spine implants to support the ongoing needs of new spine distributors.

Working capital at the end of the third quarter totaled $88.7 million, increase of $18.1 million since December 31, 2007. Total debt is approximately $8.1 million.

In summary, to repeat, our balance sheet and cash position are in excellent shape as we enter our fourth quarter. I will now turn the call back over to Brian.

Brian Hutchison

Thanks, Tom. As many of you saw in our press release this morning with the company's integration nearing completion, Guy Mayer has announced that effective February 27, 2009, in accordance with terms of his contract, he will transition from his role as President of RTI Biologics to a Consultant to RTI. Guy will continue his role as a member of the company's Board of Directors.

This transition was contemplated in the merger with Tutogen Medical in February 2008. Guy is to be commended for his hard work and dedication to Tutogen Medical and RTI Biologics and helping bring these two companies together successfully.

One of our major goals of the merger with Tutogen Medical completed in February was to increase profitability of the combined company. We have made significant progress in meeting our expense reduction goals resulting from our integration efforts. And as Tom pointed out, we continue to increase our estimate of expense synergies.

However, additional expense reductions are still yet to come. As we complete the combined combination of the U.S. processing operations, while all plans are in place on this important component of integration, we now expect full complete to be late Q1 2009.

In addition, as we look ahead, we are confident that we can hold down increases in our G&A as we grow the topline. Therefore, just as we've seen significant improvements in profitability thus far in 2008, we should continue to see those improvements in 2009 and beyond.

As a reminder, we do not provide specific guidance on revenues and profitability and this quarter is no different. However, as a general outlook, we believe we will increase revenues and profitability over the remainder of 2008 and into 2009.

RTI is a fundamentally sound, solid company. All of our business lines are improving with double-digit industry growth rates with the exception of spine and bone graft substitutes. With the merger earlier this year, we continue to diversify our business. We have new implants in development for our current lines of business and we plan to expand into new markets.

Through the end of the year and into 2009, we are confident that our company can grow through our diversified portfolio, increases in tissue availability, upcoming product launches and continued post merger integration of distribution and marketing to achieve potential revenue synergies.

Our goals for 2009 and beyond include substantially increasing our operating margins and earnings per share as the top-line grows, as our business becomes more diversified and we capitalize on some of the highest growth segments in biologics.

Our management team is committed to these critical goals, and we've the proper infrastructure in place to achieve it. As I mentioned earlier for many reasons, we believe RTI is in a good position to weather the macroeconomic climate better than many other companies.

We will take control over areas that we can and while we cannot do anything about the global economy, we feel good about what we can do in our company. We have visited many investors in the first nine months of the year and we hope to see many of you this quarter.

We will be presenting at following conferences: The AeA Conference in San Diego on November 3rd and 4th; the Barclays Capital Conference, formerly the Lehman Brothers Conference in New York on November the 6th; and the Stephens Investment Conference in New York on November the 18th.

At this time, let's open up for questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions). And we will go first to Shawn Fitz with Stephens Inc.

Shawn Fitz - Stephens Inc.

Brian, Tom, good morning.

Brian Hutchison

Good morning Shawn.

Shawn Fitz - Stephens Inc.

Hey, Brian, just to try to dig a little more deeply into some of the work you all are doing in your distribution side of things on sports medicine, could you quantify for us maybe in some way how many territories you all have and how many are affected? Maybe even provide some kind of productivity numbers so we can try to understand exactly the dynamics at play here?

Brian Hutchison

Well, Shawn, it's a complex question. We've added a lot of territories in the last quarter, many of which were identified early in the year that we were going to do. So we've been busy doing that. The events that accelerated in the third quarter are I guess forcing us to move faster than we had originally planned, in about what we would call four of our old markets, but they represented multiple cities.

So we will put more reps in than four. It's probably going to be something along the terms of eight, yet to come. So we're moving as fast as we can. We're covering some of those territories with management personnel at this time. So they're not being completely left out there. We're working on them.

Shawn Fitz - Stephens Inc.

Brian, when we look at the territories were maybe you didn't have the forced timeline accelerated on the company, when you all are able to convert at your own pace to a direct sales rep from a distributor, is that normally dilutive initially from a revenue standpoint or is it neutral or additive?

Tom Rose

As we've discussed adding the direct biologic reps last quarter, we've identified that our past experience is that it takes a new direct rep about six months to hit full speed in the marketplace. So in the first three months, it is a somewhat dilutive effect. After six months, it becomes positive compared to the revenue of the independent distributor.

Shawn Fitz - Stephens Inc.

Okay. And so then, if we were to just quantify the headcount that you all need to put on the street between now and into the first quarter, how many direct reps do you need?

Brian Hutchison

Our plan right now, I would say, we're going to add 8 to 10 additional people and that's it.

Shawn Fitz - Stephens Inc.

Okay. And so as we think about '09, Brian, then it would be sometime mid '09 before you are kind of up to your normal full productivity based on kind of the way this thing rolls out with new reps?

Brian Hutchison

I would say it is more like late Q1, and then late Q2 you are seeing acceleration.

Shawn Fitz - Stephens Inc.

Okay. Also, Brian, you made mention of a couple of times new products and new markets. Would you be willing to provide a little extra detail maybe on specifically what new products and then also new markets?

Tom Rose

We rather not talk about the specific new products right now, but the new markets that we've targeted and we're looking at for primarily membrane products are ear, nose and throat, neurology and wound care. And potentially, Shawn, again most of these products will go through the human paradigm as far as regulatory concerns and we should be able to have new products on the market in these areas next year.

Shawn Fitz - Stephens Inc.

Okay, great. Tom and Brian, last question. Brian, in previous calls my recollection is you stated that you felt while not giving specific guidance you stated the belief that this is a company that can grow at 20% on top line. Is that something that you would reaffirm at this point or would you need to revisit that?

Brian Hutchison

At this juncture where the economy sits today I need to revisit that. The impact on totally elective surgeries, where some of these are surgeries that can be postponed, in very recent days I am seeing slowdowns that I didn't see before. So we're going to revisit that. I still see solid double-digit high teens, but I want to revisit the 20%. It is going to be a little bit more challenging to get there in these economic conditions.

Tom Rose

And Shawn, we've just completed some internal planning looking at the next three year horizons, and as we mentioned in the script, all the markets that we're playing in today are growing anywhere from 10% to 15% or more except for spine and bone graft substitutes, which are still single-digit growers. But with those industry growth rate and as we've talked about, we see the growing demand for biologics; we still see the great opportunities.

Now again those market surveys are all done, looking backward and making bets towards the future. In the current economic climate we've to temper our optimism a little bit.

Shawn Fitz - Stephens Inc.

Okay. Great, guys. Thanks for your time.

Operator

And we will go next to Keay Nakae with Collins Stewart.

Keay Nakae - Collins Stewart

Good morning. Brian, can you give us a little bit more color on the competitive dynamics you are seeing in sports medicine with some of the regional distributors?

Brian Hutchison

I wouldn't say it is a direct competitive situation, and I can't get into a great deal of detail other than to say that some of our distributors work with other companies, and one of those other companies made it really difficult for some of those distributors to continue to represent RTI. Negotiations were ongoing through the quarter. We expected a different outcome than what happened, which sort of collapsed late in the third quarter and will continue in the fourth quarter with those territories.

But we're responding to that by using management help and placing territory managers in as quickly as possible. We've had all kinds of issues to deal with to logistically to get tissue where it belongs, but we'll certainly continue to work on that.

Keay Nakae - Collins Stewart

How do you stand in terms of your supply of specific tissue for sports med? Is that continuing to be a strong point for you guys?

Tom Rose

The supply continues to be very good. Because of the slowdown in Q3 for these market factors we've talked about, we actually had a slight inventory build in finished goods relating to sports. We expect those tissues to be distributed in Q4, but supplies are very good, as we mentioned in the script. Across the board, we're in very good shape on tissues really for all the markets.

Keay Nakae - Collins Stewart

Okay. With respect to Medtronic, how would you gauge the prospects going forward there? First of all, has spine bottomed out? Do you anticipate selling them any new lumbar products going forward in the near term, or is that still going to be a longer-term proposition with them?

Brian Hutchison

I would definitely say we've hit the bottom, which we said in our script and I think that we're going to start to see growth returning over the next 15 months with Medtronic specifically.

And I'm going to let Tom add some more color to that specifically regarding cervical versus lumbar. I will also tell you that we're set up; now we're meeting with them on a regular basis. We're reengaging Medtronic and we're reinvigorating the product line and the relationship. And I suspect that it will continue to grow. It will return to growth in '09 and it will grow beyond '09, as well.

Tom Rose

Keay, just to follow-up on Brian's comments, you have made a good comment. As we look at the business with Medtronic this year, the declines are almost entirely in the lumbar area, where the cervical implants have been generally holding their own with just very slight decreases.

And as we move forward, they've recognized that they have to upgrade some of their lumbar implants. As we mentioned, we'll be working with them on that this coming year, but a couple of points. Overall, the dialogue with Medtronics has strengthened during the quarter. It continues to strengthen.

One point, contractual point, that is going to impact our business in the next 12 months is, under our current contract, if we have adequate supplies of tissue to meet Medtronic's forecasted needs that contractually they are required to procure all their tissue from us, and we are in that position right now.

Medtronic has terminated some relationships with other suppliers who are supplementing our supply. We're going to see a positive impact on that in '09. I don't think it's in the realm of totally material, but it'll be a positive impact on improving from the bottom of the spectrum where we are today.

And lastly, as I mentioned earlier, Medtronic has instituted a tissue initiative to regain some market share, increase revenues in this area and part of the development of the lumbar implants is a component of that initiative.

Keay Nakae - Collins Stewart

How about with respect to bone graft substitute sales to them? Is that permanently lost business?

Brian Hutchison

No. Actually, we don't believe so. Our bone graft substitute’s strategy has been to continue to focus on Exactech. Medtronic uses the product specifically internationally. Infuse here is their dominant product in the U.S. plus you all know they have their own, another version of bone paste that is theirs as well. So for our product, it's primarily used internationally. That will not decline. That will continue to move forward.

We expected in 2009 to launch the new product with Zimmer for a variety of reasons that did not happen this year, it will happen in February of '09. Things that have been done are, they've already made sure that their distributors are now licensed tissue banks, so they can handle the tissue.

There has been significant amount of training going on with field people in Zimmer and using RTI folks to help do that training. The sales meeting agendas have been set. We are invited. We will be there. I believe the launches are going to happen, and then I think you'll see nice progress in 2009 with them. They are potentially our largest distributor. They have enough presence to dominate in that space and we expect that they will. They've never had this product before.

Additionally, we said we're working on new products for Stryker. We have another product in the same category that will launch in early '09 that's very much ready to go. It's just down to the last steps of launching it. We're working on an additional product for them as well as a new product for Wright Medical. So, we continue to see progress there, and once those are on the market that then changes our prospects for inventory and days in inventory because those products are what's primarily building up in the tip and finished goods.

Keay Nakae - Collins Stewart

Okay, thank you.

Operator

We'll move next to David Turkaly with SIG.

David Turkaly - SIG

Thanks. Maybe comments on the international debt. Can you remind us exactly how you are selling there and what happened this quarter specifically?

Brian Hutchison

Well, in the third quarter of 2007 Tutogen signed a global agreement with Zimmer Dental. So, Zimmer Dental is our exclusive distributor now outside the United States as well as in the U.S. They took an initial stocking order last year. Throughout this year, frankly, they've had issues with distribution, management turnover and other problems that have slowed that down.

Now you add in a slowing economy in Europe as well and it's impacted their business. So we've had significant issues there, which caused that to underperform in our eyes. But we fully expect that Zimmer will address the changes in management and refocus on that product line outside the U.S. and return it back to growth.

Tom Rose

And Dave, as we went through the first six months of this year, the international business in dental was growing at rates in excess of 25% doing quite well. In Q3, in addition to the traditional summer slowdown in Europe, this was also a period where there was a conversion from some of the country distributors that were still distributing our dental products to fully convert it to Zimmer. So, Zimmer, currently, is covering most of the countries for us. That conversion in the quarter obviously caused some disruption and we expect things to pick up as we go through the rest of the year.

David Turkaly - SIG

Okay, that's helpful. And then on sports med, 24 reps, eight more coming, even though the environment I guess is some of these procedures, can you quantify what percent of your business you think is directly tied to, let's say, non-athletic procedures?

And then with these direct reps, I know that you said six months or so to get up to speed, but do you look at sports med and given that and our exposure to some of these procedures, that maybe if this is the bottom in spine, could it also be a bottom in sports med?

Brian Hutchison

It could be a bottom in sports because we don't have the ability to quantify what is an athletic versus non-athletic surgery. But what we've seen recently is that key surgery centers that we work with and we work with the dominant are large base performing centers. They do a lot of athletes at these places. We are seeing that their waiting rooms are less crowded than they were. So the guy who tears his meniscus is saying, I'll wait for a while before I get that fixed. Those things are what is happening.

But if you tear an ACL and you are an athlete and you want to play soccer or get out and play tennis, then, you are going to get that thing replaced. So at the end of the day, we maybe at a low point here. It depends on how rough the economy gets. That's what I can't predict. But in terms of the reps and representation, that's being addressed very rapidly and the plan is working.

And as Tom already laid out, they come up to speed fairly quickly for orthopedic reps. They come up very quickly. The good news is there's lots of talent available. It's a very exciting area. Reps want to be involved in this area. It's a great place to be. They enjoy it.

David Turkaly - SIG

Last one then. If we look at your build out on direct, I'd say it's over time having these big distributors have been good at times and then also detrimental if their ordering patterns change. Is there anywhere else, first part would be, can these guys sell any of your other products to sports med direct, 30 or so people? Would it make sense for them to start carrying some other product? Do you have any other plans to go direct in any other markets? Thanks.

Tom Rose

Several good questions. I think one of the keys were going with the direct biologic reps, which is very important to us going forward, is the ability for our direct reps to get new products on the market, penetrate the market quicker than we believe independent reps normally do. We're able to train them faster, communications are better. I think we believe that's going to help us with our new products that we're going to be rolling out over the next couple years. So that's a key plus. With respect to trying to remember what a couple of the other questions were.

Brian Hutchison

Do we expect to go direct in any other--?

Tom Rose

Yes, with respect to going direct in other areas, before that one, actually, the second part of your question was can our sales reps carry other products. Currently, our sales reps do distribute some of the bone graft substitutes, as well as general orthopedic products. We expect to see an increase, as again, we have direct reps that aren't carrying competing lines to ours as the independent reps may.

And so, the other positive aspect that we're seeing with the direct reps is that as we look at some new products, as we've looked at it in the past with the independent reps, sometimes we run into channel conflicts. It's prevented us from moving on some add-on products in the past. And again, the independent rep network really gives us a lot more flexibility in bringing on new products. The last piece of the question of adding new direct areas, I'll let Brian touch on that.

Brian Hutchison

We've said this before. We will continue to evaluate all the spaces that we're in and [tissue] availability to create new products in new markets, and we continually evaluate that. Right now, there is no plan to take any additional area direct that we can discuss, but we continue to look at that. And one of our goals is to have better control of our destiny, and it's clear that when you have a direct organization, you can do a better job. So we will continue to look at that.

David Turkaly - SIG

Thanks.

Operator

And we'll go next to Matt Dolan with Roth Capital.

Matt Dolan - Roth Capital

Hey, guys, good morning.

Tom Rose

Good morning.

Brian Hutchison

Good morning.

Matt Dolan - Roth Capital

Brian, a follow-up on kind of the longer-term outlook here as we look into '09, and thinking of things possibly getting slower because of the macro environment and I guess offset by new product launches, et cetera, what are you anecdotally hearing from your distributors right now in this economic environment?

It sounds like procedures are slowing at the end-user level, but relative to credit and the economy, are they holding less inventory out there? Do you expect that to continue going forward? And therefore, should we expect kind of a lag period here as that works through their inventory levels? How do we tie that into looking at our '09 growth projection?

Brian Hutchison

Thanks for that question. It's a good question and I'll answer on a couple of fronts. Yes, we are seeing occasions where distribution partners are holding down inventory where possible. Whether it is for their own cash issues or balance sheet issues or because they see a slowing surgery volume, I can't tell, because we're not hearing that. We're not hearing the big surgery slowdown in most areas.

Where we see it is we're seeing it in dental and we're seeing it in sports right now, and then sports is just a brand new issue for us. But longer term, I see that just recovering. The demographics just play out very strongly for musculoskeletal repair, and I don't see that declining long-term. I think that's going to come on strong.

Internationally, a great deal of our export business is done through letter of credit. And with the issues going on in Europe right now with banking, it's difficult for some of these smaller distributors and countries to get lines of credit, because we do most of it by letter of credit. So that is causing an issue that we will work our way through. But, again, I don't see that as being long-term. So long-term, I think the prospects are very, very solid.

As Tom said, we just went through our planning and looking forward, we feel very, very good, because that gave us an opportunity to discuss every partner's business, what they are telling us in detail and ability for us to sort of channel check that. And right now I feel very, very good about every area we are in for 2009.

Tom Rose

And Matt, on the inventory issue with the large distributors, I think we said in the past that generally our distribution partners are not carrying significant amounts of our implants. In many cases, we're almost on a just-in-time situation on many sizes in the implant categories.

That being said, as Brian mentioned, as you can see in our Q3 results, as we've touched on in some of the comments we've made about Q4 launches, we are seeing the customers at least slowing down the orders on launches, the deliveries on launches until Q1. In most cases, there was some flexibility into the ordering process where they had the option to do that.

Matt Dolan - Roth Capital

Okay, great. That's helpful. And then Tom, as a follow-up as revenues coming in, I guess, a little lower than we had expected into the second half of the year, can you comment on gross margin? You gave a lot of detail on that I think with the last two quarters, and we were expecting at that time to exceed maybe 50% in Q4, but just help us with the variables that are playing in there.

Tom Rose

Sure. I think as we've talked about gross margin and we looked at the last quarter's revenues of 40.8%, gross margin hitting 48%, the key obviously to growing our gross margin is a fixed cost leverage with respect to processing higher volumes of tissue. As I mentioned in the script, our processing volumes were down slightly in Q3 just as we looked at the demand. That negatively impacted the margin in the quarter.

I think, again, as we look at the gross margin, as we fully optimize the combination of the two companies, the goal in the next three years is still to get our gross margins up to the 55% level. But as I mentioned on the last call, I think the way I would look at how we get to that 55%, is very linear with respect to revenue growth. If revenues fall, we see a hit to gross margin. As revenue grows, we'll see a linear increase over the next couple of years.

Matt Dolan - Roth Capital

Okay, great. And then, finally, on the merger side of things, it's good to see it looks like you're increasing your cost savings expectations as you bring the two companies together. Can you talk about any turnover you've seen? I know Guy is leaving, but within the Group are you seeing any excessive turnover or involuntary turnover? Is that leading to some of the savings here, or what specifically is going on in terms of the health of the overall group?

Brian Hutchison

Well, all of the things that are happening were contemplated in the merger discussions. We've seen no significant surprises whatsoever, and we're not having an issue with turnover. We do a process each year where we measure employee engagement, and we did that this past quarter. The level of engagement was almost exactly the same as a year ago prior to the merger with 97% participation rate of our employees. So I felt very, very good about the level of engagement of our employees.

Matt Dolan - Roth Capital

Okay, great. Thanks a lot, guys. Take care.

Brian Hutchison

Thanks.

Operator

We'll go next to Greg Brash with Sidoti & Co.

Greg Brash - Sidoti & Co

Hi, guys. Thanks for taking my call.

Tom Rose

Good morning, Greg.

Greg Brash - Sidoti & Co

Good morning. Going back to the sports medicine, I wonder if it would be possible for you to quantify maybe how much revenue was lost in the quarter due to some of the issues you had with your independent distributors?

Brian Hutchison

I asked that question of Tom this morning, and we really cannot quantify exactly what was due to that versus what was due to the slowdown.

Greg Brash - Sidoti & Co

Okay. And then in the past demand has always outweighed supply if you are in implants in the sports medicine area. I mean are you somewhat insulated in that space? If say procedure volumes are flat or even decline over the next six months? Do you still expect to see growth?

Brian Hutchison

Yes, we do actually. Your point is exactly correct. We do.

Greg Brash - Sidoti & Co

Okay. Then the other revenue side is around half as much as it was last quarter. Just curious what was going on there and if that's something we should be looking for going forward more along this range, instead of the $2 million range?

Tom Rose

The other revenue line contains amortization of upfront deferred fees that we receive from the various distributors. It includes recovery fees as we recover tissues for other tissue banks, and it includes some shipping costs that is directly correlated to volumes. I think overall, Greg, the run rate for this quarter and last quarter, which is around $1 million, is probably the appropriate number to look at for other revenue going forward.

Greg Brash - Sidoti & Co

Okay, that's helpful. And then just on the hernia side, can you just touch on what's going on with your animal tissue product and maybe when we can expect a launch?

Brian Hutchison

It's ready to go. And they are in the process of building initial quantities. We do expect to launch early next year is what I would say right now. It's still up in the air, although, I would say for '09, right now we are planning to develop a small presence in the United States on our own and take this product to market. It will not be a large bump in 2009 as we really begin this very slowly and carefully.

Greg Brash - Sidoti & Co

Okay. And then just one more, just curious the dollar has been appreciating. What affect the exchange rates had maybe on dental sales in the quarter, if that played a big part in international being weak and maybe how that's going to affect the revenues going forward?

Tom Rose

The impact of foreign currency in total on revenues compared to prior quarter was only about $300,000. So it didn't have a significant impact on any one revenue category. But as a point of reference, as we look into next year, our direct revenues from Europe are running in the range of about $18 million. That has been based on an average exchange rate year-to-date in the $1.50 to $1.55 range.

As we look to our planning cycle for next year, the euro today, it's bouncing around in the low 1.20s. So, obviously, as we set an estimate for next year, we are going to see a negative impact on revenues. But we should also have a positive pickup on expenses, as well.

Greg Brash - Sidoti & Co

Okay. Thank you, guys.

Brian Hutchison

Thanks.

Operator

We'll go next to Brooks West with Craig-Hallum Capital.

Brooks West - Craig-Hallum Capital

Good morning, guys.

Tom Rose

Good morning.

Brian Hutchison

Good morning.

Brooks West - Craig-Hallum Capital

Could you, Brian, go into a little bit more detail on Guy's transition and where those distribution relationships are going to fall within the organization going forward?

Brian Hutchison

Sure. This was discussed with Guy during the whole merger process, and he has been working with me on this for a while. Now, what I'll tell you is all of the membrane type relationships will fall under Roger Rose, and everyone knows he today runs donors and sports. He will now pick up all the membrane businesses.

The dental business will fold under Robby Lane. Robby already has a relationship with Zimmer, the dental relationship is Zimmer. So it's him just picking up another product line with the same distributor. So those are where that's going to go.

Our international business will report directly to me, and I'll be getting more involved in what's going on there. So those are the ways of those areas of the business rollout. For the product development cycle, those people and processes will be folded under Carrie Hartill, our Chief Science Officer, who already has the R part, so she will have R&D.

Brooks West - Craig-Hallum Capital

Okay. And can you give kind of a timeline on how that all unfolds?

Brian Hutchison

It's starting now, and it will transition through the quarter. And we will finish this year and enter next year in this situation.

Brooks West - Craig-Hallum Capital

Okay. And one last question on the sports med. Can you or maybe you already gave this number, how many direct reps did you have at the end of Q2, and how many did you add in Q3?

Brian Hutchison

Well, I don't have those numbers on hand, of how many we added in the quarter. We started the year with eight. It seems like we've added a number of eight to 10 in the quarter, but I don't have an exact number for you.

Brooks West - Craig-Hallum Capital

Okay, eight to 10 on the quarter, great. And then on the inventory ticking up pretty substantially here quarter-over-quarter and I realize you're building from some product launches, but if the macroeconomic environment stays down, do you worry that you may have to take your foot off the pedal in terms of tissue sourcing as maybe inventory starts to get a little bit too high?

Brian Hutchison

We had this discussion last week with our directors. The conclusion we came to was, of course, we'll be selective, but we have no intention of slowing down our efforts in that area today. We're going to continue to monitor that situation very, very closely. If we had to, we would do some things.

But at this stage, we view that our opportunities near term are to continue to bring the tissue in and focus on the revenue growth side. We think the opportunities are there today, so we're not planning to slow anything down right now.

Brooks West - Craig-Hallum Capital

And Brian, then, sort of given the nature of your inventory is there an aging issue that comes into play?

Brian Hutchison

No, there is not. We store that tissue at minus 80 Celsius.

Brooks West - Craig-Hallum Capital

Okay, great.

Brian Hutchison

There is no biologic activity.

Brooks West - Craig-Hallum Capital

And then lastly, what was Zimmer as a percentage of sales in the quarter?

Brian Hutchison

Good question. I don't have that number on top of my head. Tom is starting to sift through papers and he will find it.

Brooks West - Craig-Hallum Capital

Okay. And I can get that from you after the call. Great, that's it, guys. Thank you very much.

Brooks West - Craig-Hallum Capital

Thanks, Brooks.

Operator

And we'll take our question from Jayson Bedford with Raymond James.

Jayson Bedford - Raymond James

Hi, good morning, guys.

Brian Hutchison

Good morning, Jason.

Tom Rose

Hi, Jason.

Jayson Bedford - Raymond James

Morning, just a couple of questions. First, on Medtronic you mentioned that orders should grow over the next 15 months. A couple questions on that. Is that both spine and bone graft substitutes? Is that the next 15 months versus the last 15 months or do you expect a sequential increase going forward?

And then, finally on that, do you have standing orders or is there anything you can give us that makes us more confident in the increased visibility?

Brian Hutchison

Yes, several questions there. So okay, I do expect them to return back to growth. We do have a rolling forecast for them that is out for12 months. Those numbers do reflect increases. And as of late, those forecasts have become much more accurate than they used to be in the past.

We also have a dialogue going on with them at what I would call the proper levels. We are seeing all of the right signals in terms of reinvigorating the relationship from both sides. And we're seeing the kind of commitment we need to see and we are actually going to be hiring an individual to place them in Memphis to make sure we stay on top of that relationship closer than we have in the past. So I feel very good.

Your question is, is it sequential growth? What we are looking to see out of this relationship is improvement year-over- I mean it's sort of a quarter-over-quarter. But we really are trying to see this thing progress over time. So we want to see more effort placed on the field which Tom said is happening with our tissue initiative. We want to see more interface with the field than we've seen. And we want to see us getting into more surgeries than we have been. That's what they want to see as well, because they realize that Biologics helps bring along all the rest of their product line, as well. So we are monitoring that extremely close going through 2009. But I would expect to see progress sort of each quarter.

Tom Rose

And Jason, I think Brian's comments are relative to the spinal construct business that we have with Medtronic. Currently, in the bone graft substitute areas, they represent somewhere around 15, possibly as high as 20% of our current run rate in the bone graft substitute area. And I think as we grow other customers in the next year, you are going to see the Medtronic's share of that business decline. As we said earlier, it's primarily focused internationally. We see some growth there in some markets which we're trying to get through regulatory hurdles on. But it'll probably remain relatively flat-to-low growth rates going forward.

Jayson Bedford - Raymond James

Great. And just on that, Tom, on the bone graft; you mentioned a $0.5 million of reallocation of cancellous tissue. Are you operating in that bone graft substitute segment under supply constraints? Or is the number we see here reflective of true demand?

Tom Rose

I would say for the cancellous tissue, I don't think the number is reflective of true demand because we can sell very significant quantities of cancellous tissue. One of our key initiatives over the past six months has to get several months of cancellous tissue into our finished goods inventory to support really very high demands from the Zimmer Dental business, and make sure we de risk that business.

So that being said, probably what you saw this quarter was a reallocation of cancellous from one area to another. As we look forward, you'll see some return of cancellous to the bone graft substitute area, but probably not at the levels that we've seen in the past couple years with respect to cancellous tissue that we're just selling as a commodity product.

Jayson Bedford - Raymond James

And then I think you mentioned outside of I guess spine and bone graft, the market is growing in the single digits, but outside of that everything else is growing in the double digits. Is there anything that you see that would lead you to believe that you're going to grow less than the market or maybe faster than the market?

Brian Hutchison

I personally think we're going to grow at least at market everywhere we are and in many cases above market. And especially in the bone graft substitute area next year I believe we will well exceed the market growth rates. I think we have potential to exceed the market growth rate in spine, as well, due to all the product launches we have going on. In all the other areas, I don't see why we won't grow at or at least at or above those market rates.

Jayson Bedford - Raymond James

Lastly, it seemed like the business was running pretty well until early September. Can you just comment on intraquarter moves? Was September just a very weak quarter or month?

Brian Hutchison

September was, if you recall watching things happen in the market, that's sort of when things really hit the fan, so to speak. And that's when we really noticed number one, the slowdown in sports; and number two that's when this big distributor issue hit us was right in the middle of September. So early September right after Labor Day.

So those were two significant issues. The economy hit us in several places as some of our larger partners decided to take a harder look at what inventory levels they were either going to have in September or at the end of the year. So yes, there was a lot going on in September, none of it pleasant as you guys well know.

Jayson Bedford - Raymond James

Okay. Thank you.

Brian Hutchison

Thanks. Thank you all for joining us this morning. And as always, you can find more information about RTI by contacting our Investor Relation department. Thank you.

Operator

Thank you, everyone. That does conclude today's conference. You may now disconnect.

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Source: RTI Biologics, Inc. Q3 2008 Earnings Call Transcript
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