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Wright Medical Group Inc. (NASDAQ:WMGI)

Q3 2008 Earnings Call

November 3, 2008 4:30 pm ET

Executives

Gary D. Henley – Chief Executive Officer, President

John K. Bakewell – Chief Financial Officer

Analysts

Raj Denhoy – Thomas Weisel Partners

Taylor Harris – J.P. Morgan

Matt Miksic – Piper Jaffray

Michael Matson – Wachovia Capital Markets

Jeff Johnson – Robert W. Baird & Co., Inc.

William Plovanic – Canaccord Adams

[Anin Alva] – [Buoyant Advisors]

Operator

Good morning ladies and gentlemen and welcome to the third quarter 2008 Wright Medical Group Inc. earnings conference call. (Operator Instructions)

This conference call may contain forward-looking statements as defined in the Federal Securities Law. In fact every statement made during this call, except for those of historical fact will be forward looking statements.

Forward-looking statements reflect the current knowledge, assumption, belief, estimates and expectations of our management. They also express our management’s current views of future performance, results and trends. We caution you that actual results might differ materially from those described in these statements.

Forward-looking statements are subject to a number of risks and uncertainties, including those discussed in our filings with the Securities and Exchange Commission. These said filings include our 10-K for 2007 and our subsequent 10-Qs during 2008. These risks and uncertainties could cause our actual results to materially differ from those described in the forward-looking statements.

Although we believe that each forward-looking statement is accurate there can be no assurance that it ultimately will prove to be so. You should not view the forward-looking statement as a representation by us that the described results will be achieved. We caution you not to place undue reliance on any forward looking-statement.

All forward-looking statements are made as of today’s date and we assume no obligation to update any such statements after this date. I will now like to turn the presentation over to your host for today’s conference, Mr. Gary Henley, President and CEO of Wright Medical Group. Please proceed, sir.

Gary D. Henley

Good afternoon everyone and welcome to our third quarter earnings call. I’m very pleased to share with you the details of our third quarter 2008 financial results which reflect strong sales levels and operating leverage resulting in top and bottom line performance at the upper end of our communicated target guidance ranges.

With me on our call today is John Bakewell, our Executive Vice President and Chief Financial Officer. Together John and I will be discussing our third quarter results, the progress that we’ve been making in our business and the outlook going forward.

We’re quite pleased with our Q3 performance which reflects continued revenue momentum and significant operating leverage as we posted out third straight quarter of top line growth greater than 20%. And achieved adjusted operating income growth of 48% despite the short-term dilution created by our recent INBONE acquisition.

Before we begin I would like to note that we will be using a number of non-GAAP financial measures to describe our performance. Regarding that, I will refer you to reconciliations that appear in tables of today’s press release as well as on our website. Note further that our Form 8-K filed today provides a detailed narrative that describes our use of such measures. Please note that unless otherwise stated, all of today’s discussions regarding results of operations refer to our as adjusted results.

I’ll start today with a summary of our top and bottom line results and then move into a detailed review of our revenue performance. John will then address the other key line items that make up our financial performance. Together we will wrap up our prepared section of today’s call with some business updates before we begin taking your questions.

So with that, let’s get started. Net sales for the third quarter 2008 totaled $111.1 million representing a 22% increase over net sales of $91.4 million in the third quarter of 2007, finishing at the upper end of our previously communicated guidance range of $109 million to $111 million.

Excluding the favorable impact of foreign currency on our international revenues which totaled approximately $1.6 million, global net sales increased 20% during the third quarter. This sales performance included growth in excess of 20% both domestically and internationally and in three of our four major product lines.

Additionally we achieved adjusted income of $7.6 million or $0.19 per diluted share for the third quarter of 2008 finishing again at the upper end of our adjusted EPS guidance range of $0.17 to $0.19.

Our strong sales performance combined with excellent Q3 operating leverage resulted in adjusted operated income totally $12.5 million representing a year-over-year growth of an outstanding 48%.

Now looking at our sales results in detail first geographically, we had a strong third quarter both in the U.S. and in our international markets. Domestically our sales totaled $70.9 million, an increase of 22% over prior year period. Extremities and biologics led the way in the United States with extremities growing 45% and biologics 18%. Our large joint reconstructive business also had a strong performance, with a 16% domestic growth rate.

Internationally we had another strong quarterly sales performance as well. International sales totaled $40.2 million, representing an increase of 21% as reported and 16% before the favorable impact of currency. This growth was driven by double-digit growth in substantially all of our major international markets.

We’re also pleased with the early success of our recent acquisition of the total ankle replacement product line of INBONE Technologies, which alone contributed approximately two percentage points of growth to our domestic revenue performance this quarter.

Sales from all products acquired during the past 12 months, INBONE included, contributed three percentage points to our Q3 domestic revenue growth rate and two percentage points to our global growth rate.

Now I'd like to discuss the sales by product line. Knee products totaled $28.7 million in Q3, a 21% increase as reported and a 19% increase over prior year before currency. Domestic knee sales in Q3 increased by 17% over third quarter prior year. The strong domestic knee performance was driven by the continued success of the advanced stature specific components as well as our limited availability of the ADVANCE BIOFOAM Tibia Base.

International knee sales increased by 27% on an as reported basis and 23% in constant currency, driven by growth in certain European markets as well as in Asia. During the third quarter our global hip sales totaled $37.6 million, increasing by 22% as reported and 18% in constant currency.

Domestic hip growth totaled 15% during the quarter, reflecting strong unit sales gains in most of our popular Acetabular and primary stem systems and also in revision systems, while international hip growth totaled 29% as reported and 22% before currency.

International hip growth was broad-based with strong growth in certain European markets, Canada and Asia as well as in Japan.

Extremities totaled $21.7 million during the third quarter increasing by 38% in Q3 as reported and 37% before currency. Domestic extremities grew 45% during the third quarter while international growth totaled 16% as reported and 11% before currency.

Excluding acquisitions within the last twelve months, domestic extremities grew 30% in the third quarter, driven by the continued success of both new and core products within our Charlotte line of foot and ankle products as well as the excellent performance in our DARCO product line. Acquisitions within the last 12 months contributed nicely, adding 15 percentage points to our U.S. extremities growth rate.

Our global biologics sales totaled $20.2 million during the third quarter representing a 12% increase over prior year as reported, and a 12% increase on a constant currency basis. Domestic biologics sales increased 18% in Q3 driven by our PRO-DENSE injectable synthetic bone graft. Success of our CANCELLO-PURE wedges as well as continued success of our GRAFTJACKET soft tissue repair lines.

International sales of our biologics products decreased by 9% as reported and 10% before currency, primarily due to the impact of our disposition of the Ad Con related assets during late Q3 2007.

So in summary we are quite pleased with our financial performance this quarter. Both net sales and third quarter earnings met the upper end of our previously communicated outlook ranges and we posted our third straight quarter of top line growth in excess of 20%.

So at this point I’d like to introduce John Bakewell, our Chief Financial Officer, to discuss additional financial details of our third quarter.

John K. Bakewell

Thanks Gary, and good afternoon to all of you joining us today. I’ll follow our usual format and pick up where Gary left off by reviewing with you our P&L components below the revenue line that contributed to our third quarter results. Then I'll discuss our current financial outlook for Q4 and for the full year 2008.

As has been our practice in the past, today's press release provides you with our P&L results in accordance with GAAP requirements, and also includes tables which provide reconciliations of certain of our P&L components from an as reported GAAP basis to one that's adjusted to exclude the impact of those items noted, including the impact of restructuring charges related to the initiative we previously announced to close our Toulon, France based operations, our non-cash stock based expense and charges related to ongoing Department of Justice inquiry.

We recognize that most of you evaluate our performance on a basis that excludes non-cash stock-based expense, as well as other nonrecurring items, so we've provided you with all the information necessary for you to model our P&L on that adjusted basis. So with that let's move into the discussion of our as adjusted results. I'll begin with a review of our gross margin performance and from there I'll work downward through the rest of our P&L.

So beginning with our Q3 gross margin, overall we achieved 71.5% for the quarter, which is approximately 260 basis points lower than the 74.1% posted in prior year Q3, and slightly below the expectation that we set for Q3 during last quarter's call. The variance from expectation and from prior year is due primarily to the geographic mix of sales that we experienced this quarter, as well as to some higher than anticipated levels of inventory reserves.

Although Q3 came in a little bit lower than we had predicted our earlier outlook for Q4 remains intact. Therefore we continue to expect a Q4 gross margin performance somewhere in the range of 72% to 72.5%. This should result in a full year gross margin outcome something close to 72% overall for 2008.

Turning to our operating expenses, on an as adjusted basis total-operating expenses for the third quarter totaled $66.9 million, or 60.2% of sales compared to $59.4 million or 64.9% of sales for Q3 of last year, a 470 basis point improvement which was slightly better than our expectation going into the quarter. As you know, we're committed to improving our operating leverage this year, and we had an especially good outcome this quarter, particularly within the SG&A line.

So it was quite encouraging and provides us with just another bit of assurance that our plans to produce and sustain operating leverage are working and working quite well. As for the line items making up our Q3 operating expenses, on an adjusted basis selling general and administrative expenses totaled $57.7 million, or 52.0% of sales for the third quarter compared to Q307 SG&A expense of $51.6 million, or 56.5% for a 450 basis point improvement.

As adjusted, our R&D expense totaled $7.9 million in Q3, or 7.1% of sales compared to $6.8 million, or 7.4% of sales in Q3 of last year. On a full year basis you should continue to expect R&D spending of approximately 7% of sales overall for 2008.

Finally, amortization expense totaled approximately $1.3 million for the quarter compared to about $970,000 in Q3 of '07. You can expect quarterly amortization expense to remain at the Q3 level of $1.3 million for the remainder of 2008.

To summarize our performance at the operating income level, our third quarter op income as adjusted was $12.5 million, or 11.2% of sales, up from $8.4 million, or 9.2% of sales in Q3 of 2007, reflecting operating margin expansion of 200 basis points overall, and a very strong adjusted operating income growth outcome, as Gary noted previously, of 48% for the quarter.

Below the operating income line, net interest expense totaled approximately $717,000 for Q3, which was slightly higher than our expectations. With approximately $173 million of cash and marketable securities on our balance sheet, we're moderately sensitive to interest rate changes as we've explained in prior calls.

Since last quarter's call we have continued to monitor our cash investments carefully, and consequently we've made some adjustments to our asset allocations to avoid the risks that have been developing in the fixed income markets as of late. As a result, our excess cash portfolio now consists entirely of U.S. Treasury-based assets. This move to better safety and liquidity during Q3 does have an in impact on our Q4 investment income outlook.

We now anticipate net interest expense for Q4 of approximately $1.1 million, which reduces our Q4 EPS outlook by approximately $0.01, and is reflected in the guidance that's included in our press release today. Given the current safety and liquidity issues that exist in today's fixed income market, we feel this is the correct choice for us. Positioned as we are today, we're very comfortable with both the safety and the availability of our cash balances.

Moving to taxes, our Q3 effective tax rate as adjusted was approximately 36.6% for the quarter, as compared to 30.5% in Q3 of '07. The variation between this year's and last year's effective tax rate is primarily the result of two factors. First, last year's Q307 effective tax rate included the effect of some tax savings initiatives that accounted for about a penny of EPS for that quarter.

The second factor is the expiration of the research and development credit, which has increased our effective tax rate during all three quarters so far this year. As you know, the R&D credit was just retroactively reinstated for October. Therefore, as we've been guiding all along this year, our Q4 affective tax rate will include a catch up to reflect the benefit of the R&D credit for all of 2008. Consequently, you should expect our Q4 effective tax rate to be approximately 35%, bringing the full year effective tax rate for 2008 to approximately 37%.

So to wrap up our P&L review, as Gary reviewed with us earlier, net income as adjusted totaled $7.6 million, or $0.19 per diluted share for the third quarter of 2008. On the strength of 22% top line growth and SG&A leverage, third quarter adjusted operating income grew by an outstanding 48%, but net income and earnings per share as adjusted growing by 25% and 12% respectively over the prior year despite the impact of short-term interest rates, as well as a difficult effective tax rate comparison.

Briefly, regarding share count, our third quarter per share results as adjusted are based on an adjusted diluted share number of 44.2 million for Q3 of this year, and average diluted shares of 36.7 million for Q3 of last year. Going forward we expect that our average share count for 2008 will be approximately 44.4 million shares diluted, reflecting the additional shares represented by our convertible debt using the if-converted method.

Before we get into our guidance review, let me point out that our balance sheet continues to remain very strong, with a combined cash and marketable securities balance totaling $173 million as of September 30th, reflecting the additional cash from the $200 million convertible notes we issued in Q4 of last year. We invested approximately $15 million in capital expenditures during the third quarter.

The final topic of my portion of today's call, our current sales and earnings per share outlook for the remainder of 2008, we're revising our anticipated target for full year 2008 net sales from our previously communicated outlook of $465 million to $470 million, to a new narrowed range of $464 million to $467 million, representing a sales growth objective of approximately 20% to 21% for the full year. This revision reflects our top of the range sales performance for Q3, combined with a revised foreign currency outlook for Q4.

For earnings, we have narrowed our previously communicated full year 2008 as adjusted EPS outlook to a range of $0.88 to $0.90 from our previous range of $0.88 to $0.92. Our new full-year earnings target reflects our top of the range EPS results for Q3 and a reduced interest income expectation for Q4 driven by our decision to ensure safety and liquidity of our excess cash balances by moving entirely into U.S. Treasury-related investments for now.

Note that we expect our very strong operating income performance to continue into Q4 with adjusted operating income growth exceeding 30% for the fourth quarter, which should result in at least 38% operating income growth for the full-year. And that is inclusive of the first year diluted impact of our INBONE acquisition.

As for guidance regarding the fourth quarter of 2008, I'd like to recap with you what we've just stated in the outlook section included in today's press release. Our anticipated target for the fourth quarter of 2008 for net sales is in the range of $119 million to $122 million, representing growth in the range of 15% to 18% for the quarter with adjusted EPS results ranging from $0.28 to $0.30 per diluted share.

Please note that these targets for both the upcoming fourth quarter of 2008 and the full-year of 2008 exclude the effect of possible future acquisitions or other material future business developments, restructuring charges associated with our Toulon closure, acquisition-related inventory step up amortization, the impact of non-cash stock-based expense as well as special costs associated with our current DOJ inquiry.

For those of you who consider stock-based expense in your models, our estimated full-year 2008 impact of expenses associated with FAS-123R is a range of approximately $0.24 to $0.25 per diluted share for the full-year 2008, which is an improvement over our previous outlook of $0.26 to $0.28. For Q4, our range is $0.07 to $0.08.

In applying the $0.25 high-end of our stock-based expense range to our adjusted EPS outlook for 2008, implies an EPS outlook inclusive of stock-based expense totaling $0.63 to $0.065 per diluted share, which represents a year-over-year earnings growth rate of 43% to 48% for 2008. Considerably better than the growth rates we're expecting with stock-based expense excluded, reflecting the success we're having in controlling, and leveraging our stock compensation costs.

In fact, stock-based compensation expense was lower year-over-year during both the third quarter and the first nine months of 2008, not only on a percent-to-sales basis but on an absolute dollar basis as well. As we move into the final quarter of 2008, it's likely that we will see continued year-over-year improvement in overall stock-based compensation levels.

In closing, I would also like to briefly discuss our expectations and provide some general directional guidance for 2009. As you've heard us say before, our long-term outlook for Wright Medical calls for percentage annualized net sales growth in the low- to mid-teens with percentage adjusted operating income growth in excess of our respected annualized net sales growth. For 2009, we expect to see continued low- to mid-teens constant currency revenue growth approximately in the range of 12% to 15% overall. Additionally, we expect another year of operating income growth at rates that meaningfully exceed our rates of net sales growth due to operating margin expansion within our business.

Recognizing that these are just general expectations for 2009, we intend to communicate defined ranges of net sales and profitability objectives for '09 and to assist investors in further developing more detailed financial models during a financial guidance conference call to be held after the Company has completed its 2009 budget preparation process.

That call is scheduled to be held at 3:30 pm Central Time on Tuesday, December 9, 2008; dial-in and webcast access instructions will be provided in advance of the call. In the meantime, please rest assured that we fully expect and are committed to insuring that the solid earnings growth dynamic reflected in our 2008 results will continue into 2009.

With that, I will conclude our financial review and I'll turn our call back over to Gary for his additional comments.

Gary D. Henley

Thank you, John. In closing, I'd just like to say how pleased I am with our team and their execution through the first nine months of this year. We have posted three straight quarters of top line growth in excess of 20% accompanied with operating leverage, even as we continue to make important investments in our business and integrate our acquisitions. This performance gives us excellent momentum as we move into the fourth quarter and positions us well to deliver a performance in 2009 that is in line with our long-term stated objectives.

That concludes the prepared remarks section of our call today and now we're ready to take your questions. So I'll turn the program back over to our moderator.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Raj Denhoy - Thomas Weisel Partners.

Raj Denhoy - Thomas Weisel Partners

I wonder if I could ask you about the U.S. hip number. I mean, it was nice to see it accelerate so much. Is there anything behind that we can point to?

John K. Bakewell

Well I can point you back to the last two quarters or last quarter especially when I said I wasn't too worried about it, that it was just off for the quarter. I think it's just the strength of the product and I expect you to see that kind of growth going forward.

Raj Denhoy - Thomas Weisel Partners

You probably heard earlier that one of your large competitors talked about losing some surgeon customers for the first time in the quarter, have you seen any gains in that regard?

John K. Bakewell

I don't know. I mean, it's sort of difficult to say on customer-by-customer basis. We have obviously worked hard to gain customers and I'm not sure it's a result of our competitors' problems.

Raj Denhoy - Thomas Weisel Partners

But you are picking up customers obviously with a growth number like that?

John K. Bakewell.

Yes.

Raj Denhoy - Thomas Weisel Partners

Maybe I could just ask a little about the SG&A, the decrease as a percentage of sales. I mean, it was a pretty big move in the quarter. Is there anything behind that? I mean other than the moves you've made recently with Toulon? Is there anything else that's really driving that number down so much?

Gary D. Henley

Raj, about – there are about 50 basis points of improvement year-over-year related to the Toulon closure. There's also a slightly easier comp but there wasn't anything big enough last year to call out but there were some things of relatively minor, kind of non-recurring nature last year that would account for a little bit of it as well. But by-and-large, it was just good old fashioned leverage and we were pretty effective in controlling expenses.

And when you're able to do that in your seasonally low sales quarter, it has just that much more profound of an impact on your leverage number. So that's really what happened; a little bit of Toulon, a tiny little bit of easier comp and a whole bunch of just good expense control.

Raj Denhoy - Thomas Weisel Partners

And then just one last one, you mentioned there was some inventory reserving in the quarter. What was that related to?

Gary D. Henley

Nothing specific, it was just a little bit heavier than we had expected. And again, that one kind of works the other way. When you have a reserve like that that lands in a quarter that's seasonally low from a sales perspective it's going to have also a more pronounced percentage impact on your leverage. So there is just a little bit of kind of non-specific reserving activity that landed in the quarter.

Operator

Your next question comes from Taylor Harris – J.P. Morgan

Taylor Harris – J.P. Morgan

I actually just want to touch on Raj's question again, because the U.S. hip number, I mean, in my mind it was a pretty dramatic change. You've had probably six quarters in a row of weak growth there and then now you're saying you see mid-teens growth in the U.S. sustaining. So was there really nothing more than products to attribute that to?

John K. Bakewell

Well product and execution, I mean, we've worked hard at taking our products to the marketplace and training surgeons on our techniques and our products. I think the PATH Technique continues to drive that, PATH and SUPERCAP, those are gaining some traction and momentum. We think we have again, some arguably, the best product line out there and I think people are beginning to agree with us.

Taylor Harris – J.P. Morgan

What was the impact roughly of price and mix in the U.S. hip and knee business?

Gary D. Henley

The price was pretty nominal impact. We were pretty flat, flat to maybe one percentage point favorable in the U.S. We were probably a little bit flat to maybe a percentage point unfavorable outside the U.S. So, when you average it all together, it was year-over-year pretty comparable from price perspective.

Taylor Harris – J.P. Morgan

And John wondering if you can quantify what you think the foreign exchange impact is to the top line in the fourth quarter and if you had to peg it for ’09 right now, what would you say?

John K. Bakewell

Year-over-year, did you say for fourth quarter or for ’09?

Taylor Harris – J.P. Morgan

Let’s start with fourth quarter, because I want to understand how much that’s affecting the top line range.

John K. Bakewell

Yes. Sure. Well year over year we should, checking here real quickly, I think we’re going to see about, we’re probably going to see about a percentage point negative on a global basis.

If you’re doing the year over-year comparables, so in the-- so constant currency growth is probably going to be a percentage point higher than as reported growth, just based on where currency is right now.

Taylor Harris – J.P. Morgan

So that trends a little over $1 million from the fourth quarter?

John K. Bakewell

Well it trends, well if you, it trends $1 million on a year-over year-basis. Yes. If you want to look at what we just did with our guidance outlook the change from FX where it was last quarter when we gave guidance, which was up and hovering in the 150 range to where it is today, that’s a full $3 million. That accounts for the entire reduction in our top line guidance for Q4.

Taylor Harris – J.P. Morgan

Great and then we’re asking this and everybody is pretty focused with all of our companies but your hedging policies, can you just remind us what you do, you’re estimate of what drops the bottom line?

John K. Bakewell

Yes. Sure. It’s pretty straightforward with us. We hedge away any balance sheet exposure. Our balance sheet exposure is basically inner company receivables and payables and we enter into foreign exchange contracts to offset that entirely.

On the P&L we’ve historically held enough expense in local currencies to minimize any P&L exposure at the operating income line in foreign jurisdiction. So if that continued to be the case in Q3, we’d expect the same in Q4. That also means that there’s not been any material, you know, positive currency impact in our P&L in past periods. So that means I guess that we haven’t generated any difficult comps for ourselves in our historical results.

Taylor Harris – J.P. Morgan

As you look at ’09 does anything change? You're obviously eliminating some cost structure outside the U.S. We’ve had larger than normal swings in the dollar and in particular in currencies in let’s say Latin America, other emerging markets that perhaps re harder to hedge; maybe you don’t have the same kind of natural hedge position in place.

So is anything changing for ’09 that might make you either need to start putting cash flow hedges into place? Or, that would affect what flows through to the bottom line?

John K. Bakewell

Well, and Taylor, I am not going to get into a lot of detail on’09, I’ll save that for our December call. But I can tell you – first to answer your question about Latin America. We sell into our, of our indirect markets in U.S. dollars. So we don’t have currency issues associated with that.

We’re mainly dealing with the Euro and the Yen that’s where our exposure is and, going forward into ’09 since we no longer manufacture anything in Euros there’s likely to be a little bit of additional P&L exposure to manage at the gross margin line although we thing we can keep that exposure quite manageable.

There’s lots of things we can do there. One of which is we still buy a fair bit of product. We vend out some products and if we vend those out and denominate them in Euros that actually creates a bit of a natural hedge there. So, we can do that.

We can consider some hedging strategies. At the end of the day we’re pretty comfortable that we can manage it and neutralize it. Like I said the good news is we don’t have any big favorable comps in our history as a result of the Euro or as a result of the dollar weakening over this past year or so.

Taylor Harris – J.P. Morgan

And then last question and I’ll hop, but you, I guess, this time last year gave guidance for ’09 of $1.10 to $1.16 is that, have you updated that? Is that stale? Is that still in place?

Gary D. Henley

We’ve not updated that. You know, that’s a placeholder. Every year in our December guidance call we will give some pretty specific guidance for the upcoming year and a placeholder for the out year. And, no, we’ve not updated that and that would be the topic for our 2009 guidance call in December.

Operator

Your next question comes from Matt Miksic – Piper Jaffray.

Matt Miksic – Piper Jaffray

So one, just a follow-up on this FX impact as helpful color to the top line; the bottom line impact you said about $0.01 to your guidance in Q4 was impacted by this interest income change. I guess how much of what of the other there was another $0.01 there to sort of account for relative to your prior guidance. Was that is your FX impact of the other $0.01? Is it $0.02? Is it $0.03? Can you give us any sense?

John K. Bakewell

Now Matt the FX impact on Q4 is pretty nominal. I mean it’s not meaningful due to the fact that we just don’t have a lot of net exposure. Now that extra penny, there’s a little bit of rounding in the numbers whenever you get to the end of the year you’ve got to make sure that you’re quarters add up to your full year.

So there’s a tiny little bit of rounding in there and then there’s probably another little bit of just kind of caution just relative to the economy and how it’s been behaving here recently and we just don’t want to step out. So we’re still within the guidance range we’ve just nudged it down into kind of the lower end of what we previously communicated.

Matt Miksic – Piper Jaffray

Yes, I guess that was the same with the strengths in the hips, which certainly was a surprise to us as well. Heading into the fourth quarter and I think everyone can understand the trim for FX but it does feel a little cautious for Q4. Is there any sense that some of this concern over the general economy and the impact on ortho could sort of start to materialize?

Gary D. Henley

Well, as I sit here today, as we all set here today, the world is a little bit different than it was 90 days ago and you can read into just a little bit of cautiousness here. I mean it’s hard to predict these times. So we want to make sure that we put something out there that’s conceivable.

Matt Miksic – Piper Jaffray

Okay, but certainly nothing so far in your numbers that would indicate that the economy is sort of dragging down your business?

Gary D. Henley

Not as yet, no.

Matt Miksic – Piper Jaffray

Some color on the competitive comments that come up here in Q&A around surgeons, one of your competitors losing some surgeons. We always talk of have talked in the past about this kind of being a black and white; somebody is losing surgeons, somebody is winning surgeons, sort of. Are you also seeing, I mean is it a little bit more of a – I’m wondering if you’re starting to see folks who are sampling some of your parts of your product line or using some of your products without necessarily switching wholesale over to your line.

In other words if it’s – I don’t know if it’s metal on metal or some of your porous metal products or something that starts to look a little bit more like a, I don’t want to call it a fragmented orthopedic market, but one that’s a little less regimented in terms of I am committed to this manufacturer or I am committed to that manufacturer. Are you seeing anything like that?

Gary D. Henley

Well I think we’ve lived that life for a long time. I think because of our market share and our position here we’ve had to live that way with a lot of surgeons that would pick our knee or some of our hip products and yet not use both of them.

So I think we probably historically have been in that situation more and longer than our large competitors. But I think it’s real. I think doctors are willing to take a look at things. I’ve said all along that whenever our products get evaluated on the performance of them, the innovation of those, and the outcomes, the clinical outcomes that they provide for patients that our products do well. So maybe that’s the case here.

Matt Miksic – Piper Jaffray

And some of the recent recalls or withdrawals from products on the market opening that door?

Gary D. Henley

Oh, I don’t know again as I said earlier in a couple of statements that it takes awhile. I mean you’ve got inventories out there. You’ve got contracts in place. You’ve got a distributor relationship so it’s not like flipping a switch.

Matt Miksic – Piper Jaffray

Right, yes, I can understand that. One thing on the CapEx spend and the inventory comments that you made, John can you talk a little bit about where some of that CapEx was in the third quarter?

John K. Bakewell

Sure we had about $15 million in CapEx and the lion’s share of that was in instrumentation and in the facilities expansion project that we’re pretty much finished with now. We’ve got a little bit that’s going to bleed into Q4 but we’re just about through the other end on that one.

Matt Miksic – Piper Jaffray

So are these instruments for your existing lines or instruments for forthcoming products?

John K. Bakewell

The lion’s share of it is new products and it’s, more specifically, it’s for our foot and ankle extremities initiative.

Gary D. Henley

It’s like the INBONE. We made the acquisition they were a small company and had a limited number of sets and to fuel the growth that we’re seeing here in market penetration we needed to make a pretty substantial investment.

And we’ve talked about expanding our sales force and specialization in foot and ankle. As we continue down that path those sales reps need additional instrument sets so that’s what you’re seeing there.

Matt Miksic – Piper Jaffray

Got it and the last one the obligatory CONSERVE PLUS question, I guess one way to ask it, last quarter to this quarter are you feeling as confident or incrementally more confident than you were that things are kind of moving in the right direction towards an approval?

Gary D. Henley

I do believe that we’re moving in the direction towards an approval definitely. I mean that’s my opinion and nothing changed that in the last 90 days. We just, as I’ve said many times, not if but when and we’re honestly getting closer day by day.

Matt Miksic – Piper Jaffray

Just think some day we’ll be able to just notch that question right off the transcript.

Gary D. Henley

Well, and that’s going to be a great day for me as well.

Operator

Your next question comes from Michael Matson – Wachovia Capital Markets.

Michael Matson – Wachovia Capital Markets

Hi, thanks for taking my question. I guess I was wondering just looking out to ’09, I understand you’re not giving guidance at this point or updating your guidance at this point, but I know that we were expecting a pretty significant benefit on the cost of goods or the gross margin line from the Toulon closure.

I just wanted to ask where you stand with the inventory that was produced over there. As I understand you hand to burn that off before you get that benefit and then also just, are things still on track for that gross margin benefit in ’09?

John K. Bakewell

Sure Mike the answer to the first part of your question, we will have gotten through – we will have taken the entire variance and be in a position for the Toulon synergy to start flowing through first thing in 2009.

So that’s coming in just as we had expected. There are a lot of different, and there again I’m not, I don’t want to get this into the 2009 discussion, but there’s been a lot of discussion over the last couple of quarters about commodity pricing and things like that.

And of course there was some pressure on commodity pricing first half of the year. It seems to have abated a little bit. Metal prices have come down just a bit. But, net-net we still don’t know exactly where that's going to leave us for 2007. That could always produce a little bit of pressure on our 2009 standards.

The good news is we’re starting from a very good place and we’re starting from a pretty lofty place with the two Toulon savings kicking in, in 2009. So I guess that’s just a way of saying there are lots of variables to gross margin and we’ve, certainly – the Toulon savings will be a positive and we’ll be in a better solution to kind of size up gross margin for you here in December.

Michael Matson – Wachovia Capital Markets

And then with regards to the new BIOTAPE product the ZENOGRAFT, a biologic product that you have launched, what – ho's the pricing and margins on that going to compare to GRAFTJACKET and how are you going to position that in your product line up with GRAFTJACKET. Are you going to replace GRAFTJACKET? Are you going to supplement it, and so forth?

Gary D. Henley

I think supplement is probably the best word at this point. As we've been queried and talked about in previous calls about ZENOGRAFT competitive products in the marketplace, and we said, yes there are. And there's a philosophical need from some corners of the industry for ZENO product. More importantly for us, it's a regulatory issue for international markets. Having the ZENOGRAFT product to take to countries where we can't take a human-based, human tissue product, was a real big driver for this.

So A, it was to be competitive here in the states for physicians who had a preference for whatever reason for a ZENOGRAFT product, and to address the international markets as we go forward with ZENO product. Will it replace GRAFTJACKET? I doubt that. It's, GRAFTJACKET is the gold standard. The performance is long and well documented, and I think no product is going to displace that any time soon.

Michael Matson – Wachovia Capital Markets

The pricing and margins, how does that compare between the two?

Gary D. Henley

The margins are actually very good. Pricing is going to be a little bit different price point, more in line with what you see with the ZENOs that are out there in the marketplace today, but the margin's quite good.

Michael Matson – Wachovia Capital Markets

And one more product question on the BIOFOAM Tibial Bases, that you talked about, still being in limited supply, is there some sort of production issue there with the BIOFOAM material or just what's going on, and when do you expect it to start getting back to be more available for the needs and potentially into other products as well?

Gary D. Henley

We are working on increasing the production of that. As you know it is a proprietary unique product to us and it's not the easiest product in the world to make. We want to make sure we have the process finely honed, and we do at this point. So we're in the process of expanding our capability and the output should catch up with demand here hopefully in Q1 of '09. So, we're kind of looking forward to '09 being a year of BIOFOAM.

Operator

Your next question comes from Jeff Johnson – Robert W. Baird & Co.

Jeff Johnson – Robert W. Baird & Co., Inc

A couple of things here, going back to BIOTAPE if we could Gary, your comments about it, as it positions against GRAFTJACKET and other ZENOs, I guess the question more is have you seen any early evidence that some of your surgeons who may want to try a competitive product [Stratus] or something else, you can stem that loss by using BIOTAPE?

Gary D. Henley

Well, certainly, that's one of the reasons we have it, like I said, if there is a doctor who has a bias preference or just philosophically wants to try something on the ZENO side, why not us have the best ZENO out there? So that was the intent of it, and I think, to be the one stop shop as we've wanted to be with the broad portfolio, I think we're getting there with this product.

Jeff Johnson – Robert W. Baird & Co., Inc

Gary, would there be any plans to compare efficacies [Stratus] versus BIOTAPE?

Gary D. Henley

Whether we do it or they do it, I'm sure the marketplace will do it.

Jeff Johnson – Robert W. Baird & Co., Inc

Fair enough, but no plans at this point, but maybe AOS in '09 we could see some data or anything like that?

Gary D. Henley

We' are collecting our own data as we always do on every product, I mean, we want to know before anybody else does the efficacy of our products.

Jeff Johnson – Robert W. Baird & Co., Inc

Nothing you'd share now, I take it?

Gary D. Henley

No, not now.

Jeff Johnson – Robert W. Baird & Co., Inc

Yes, fair enough. Gary, how shall we think about Adcon as we get into the fourth quarter now we've lapped the divestiture? Obviously your international biologics businesses have been down a couple of quarters here because of the divestiture, but should we expect that to go back to positive in the international markets?

Gary D. Henley

Yes, I think it will. We've got a pretty good product line in total with our ALLOMATRIX, our DVM products, our GRAFTJACKET, now BIOTAPE, PRO-DENSE, CANCELLO-PURE products, I think that you'll see that turn around and get into positive numbers going forward.

Jeff Johnson – Robert W. Baird & Co., Inc

Great, and the last two questions, John, I think one for you. I think the answer is no here, but do you have any exposure at all to variable rates? Obviously with your convert I know you don't, but is there a revolver or a credit line anywhere that we need to think about interest rate exposure there going up?

And then just last question just M&A pipeline in this market if you could address?

John K. Bakewell

No, we have a $100 million committed facility but we don't have anything drawn down in it, Jeff.

Jeff Johnson – Robert W. Baird & Co., Inc

Yes, that's what I thought. Okay.

John K. Bakewell.

So there's no exposure on the, I guess on the interest expense liability side. Of course our cash balance is subject to variability on the investment deal side of the world.

Gary D. Henley

And as far as the M&A I think I've been pretty consistent. We'll stay with the philosophy of looking, finding properties that fit our plans, our long-term strategic plans, be very opportunistic, so am I still buying plane tickets for Ted Davis? Absolutely.

Operator

Your next question comes from Bill Plovanic – Canaccord Adams.

William Plovanic – Canaccord Adams

Just one point of clarity, if you look at the hip business and you make the statement that we'll continue to see growth at somewhere near the current rate, I mean what is really driving that? Is this change in distribution, change in mix? Is it volumes that are growing? What's really caused this change?

Gary D. Henley

Well, Bill, I think it's a little bit of all of those things. I mean I think it's, as I said earlier, just execution by the team, working hard to get our products in front of physicians. It's training physicians on our new technique with [TABS] and [SUPER TABS] techniques for example. I think it's, if I sounded a quarter ago confident that it was going to turn around – I was. And then we had a kind of a couple slower quarters, but I didn't feel like it was anything that was wrong. It just – gives us a little bit of time to get it back on track and I think that's what we're seeing now.

William Plovanic – Canaccord Adams

Would you say you're picking up accounts from any of the other larger players?

Gary D. Henley

I'm sure we've gained some accounts. I mean with this growth we've had to. I know we've gotten some new ones. I probably could say we've lost a couple so it's a continuing process. We're always up looking to find new accounts and take our product and introduce it to them and then train them. And then hopefully retain them as customers for the long term.

William Plovanic – Canaccord Adams

And then a follow-up question for John if I may? Just John, I think in the past we've talked about leverage in the domestic business is somewhere in the high single digits, maybe low double digits. You continually see leverage. Is there a point in which you get more leverage or does that, you take that and reinvest it in the businesses at certain point? So the question is how do we look at that going forward?

John K. Bakewell

Yes, the higher your revenue growth rate, Bill, certainly the greater your opportunity to leverage. There always is that question do you reinvest it back into the business, but as you can see we now have had three quarters of 20% plus top line growth and we've been able to put up some pretty impressive leverage, I mean, leverage beyond our 100 to 150 basis point expectations.

It cuts the other way as well. It would be challenging to produce a meaningful amount of leverage if your accounts and currency growth rate were to get into the single digits. And that just makes it harder, so but if we can produce that low to mid-teen top line which is and it has been our long-term stated corporate objective, off of that we should be able to deliver 100 to 150 basis points of operating leverage.

Operator

Your last question will come from [Anin Alva] with [Buoyant Advisors].

[Anin Alva] – [Buoyant Advisors]

I was just wondering if you have the cash flow from operations for the quarter?

John K. Bakewell

Cash flow from operations was approximately $3 million.

[Anin Alva] – [Buoyant Advisors]

$3 million, and with regards to inventory I noticed that it's been ramping up for the last few quarters. Just, could you give us some color on what's causing the significant inventory build?

John K. Bakewell

Sure. If you really step back and look at our cash flow, all together we've deployed a considerable of what I would call growth capital throughout the year here and it's been to support some very specific planned activities that really have positioned us for growth down the line and adds metrics to align us to, to be sure that we can compete successfully as we go forward.

To break it down, those activities include number one, the facilities expansion initiative that we've undertaken this year. And in total that's about $18 million or so of investment this year. Secondly, we've had to support the transition of our Toulon manufacturing facility and its closure and its relocation. We've had to relocate both the manufacturing and logistical operations and to do that we've had to build some safety stock in inventory. So that's one of the components that has driven inventory up here in 2008.

And then the third item, which I'm going to say is the most significant is a very aggressive build out and expansion of our extremities foot and ankle initiative. And that has required capital both for, not only for the acquisition and partnering arrangements, as well as the instrumentation and the inventory working capital that you need to support not only the launch of a significant number of new foot and ankle products in a very tight condensed timeframe, but also you have to equip those new reps that are in the field with both inventory and instrumentation so that they can go about their business.

So fortunately even after those activities have been funded we have a lot of liquidity available to us and you can see progressively Q3 free cash flow was considerably better than Q2's. So we have summated; we've crested the hill on our cash flow. We'd expect Q4 is going to be even better. And if you exclude some of the cash flow that's going to be related to the call outs and the remaining facilities expansion payments, we should see a free cash flow that approaches positive territory in Q4. We certainly expect positive free cash flow in 2009 going forward.

Gary D. Henley

That's our intent. Yes.

Operator

That concludes the question and answer session. I would now like to turn the call back to Gary Henley for closing remarks.

Gary D. Henley

Thank you, [Ed]. We'd like to thank all the participants for joining us today. As I said earlier, I'm quite pleased with the progress we've made in our business to date and our prospects going forward. As we move into this final quarter and '09 and beyond, we think we're well poised to deliver on our long-term stated objectives.

So again, appreciate you taking the time and next we'll talk to you on the December modeling call. Thank you.

Operator

As explained at the beginning, this conference call may have included some forward-looking statements as defined in the federal securities laws. We refer you to our earlier explanation for more detailed description of forward-looking statements. We again caution you that actual results might differ materially from those described in the forward-looking statements.

We also direct your attention to the risks and uncertainties discussed in our SEC filings, including our 10-K for 2007 and our subsequent 10-Qs during 2008. These factors could cause our actual results to materially differ from those described in the forward-looking statements. In addition, you should not view a forward-looking statement as a representation by us that the described results will be achieved. We again caution you not to place undue reliance on any forward-looking statements.

Finally, all forward-looking statements are made as of today's date and we assume no obligation to update any such statement after this date. Thank you for your participation in today's conference. This concludes the presentation and you may now disconnect.

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Source: Wright Medical Group Inc. Q3 2008 Earnings Call Transcript
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