RTI Biologics' CEO Discusses Q4 2012 Results - Earnings Call Transcript

Feb. 7.13 | About: RTI Surgical, (RTIX)

RTI Biologics, Inc. (NASDAQ:RTIX)

Q4 2012 Earnings Conference Call

February 7, 2013 08:30 ET

Executives

Wendy Crites Wacker - Director, Corporate Communications

Brian Hutchison - President and Chief Executive Officer

Rob Jordheim - Executive Vice President and Chief Financial officer

Tom Rose - Executive Vice President and Chief Operations Officer

Carrie Hartill - Executive Vice President and Chief Scientific Officer

Analysts

Bill Plovanic - Canaccord

Matt Hewitt - Craig-Hallum

Matt Dolan - ROTH Capital Partners

Dave Turkaly - JMP Securities

Jayson Bedford - Raymond James

Raymond Myers - Benchmark

Bruce Jackson - Northland Capital Markets

Brian Gagnon - Gagnon securities

Operator

Good day, ladies and gentlemen and welcome to the RTIX Fourth Quarter and Year End Earnings Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. (Operator Instructions) As a reminder, this conference is being recorded.

I would now turn the call over to your host Wendy Crites Wacker. Please go ahead.

Wendy Crites Wacker

Good morning and thank you for joining RTI Biologics for our fourth quarter and year end 2012 conference call. Today we will hear from Brian Hutchison, President and Chief Executive Officer, and Rob Jordheim, Executive Vice President and Chief Financial officer. Also joining us this morning for Q&A are Tom Rose, Executive Vice President and Chief Operations Officer, and Carrie Hartill, Executive Vice President and Chief Scientific Officer.

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’ll turn the call over to Brian Hutchison.

Brian Hutchison

Good morning everyone. Thank you for joining us. On our call today, I will discuss our operating highlights and then Rob will review our financial results. I will follow up with financial guidance for 2013.

Let me start by saying that we are pleased with the progress we made on our financial and operational goals in 2012. Our growth in the year was driven primarily by solid performance in our dental, BG/SGO, and sports medicine businesses. We improved our financial position from the beginning of the year and our results met or exceeded expectations each quarter. Beyond that, we continued to position the company for long-term performance.

As detailed in our press release issued this morning, we reported fourth quarter revenues of $44.6 million meeting our fourth quarter guidance of $44 million to $45 million. We achieved record annual revenues of $178.1 million, an increase of 5% from 2011 and meeting our annual guidance of $178 million to $179 million given at the beginning of Q4, 2012. When reviewing each of our lines of businesses, our direct sports medicine business had quarterly revenues of $12.6 million, a decrease of 5% compared to last year. The decline in this business in the fourth quarter was the result of customer reaction to the FDA warning letter received in October of last year.

Unanticipated publicity and aggressive marketing tactics from certain competitors created confusion around the content of the letter for many of our customers. This impacted our revenues at the end of the fourth quarter. We are actively communicating with our customers to keep them informed and provide them with accurate information. We will systematically address each customer’s concerns to ensure they are confident in our implants. Later, I will give more detail on where we are with the warning letters today.

For the full year, sports medicine grew 6% over 2011. This is the seventh consecutive year of growth for our largest business. As we begin 2013, we are seeing continued negative impact on this business related to customer reaction to the warning letter. We expect this will continue in the first half of 2013 and should largely be resolved when we receive a formal close-out letter from the FDA. At this time, we anticipate sports medicine will grow low single-digits for the full year 2013. The majority of this growth will occur in the back half of the year.

Fourth quarter spine revenues increased 19% compared to fourth quarter 2011. The increase was primarily related to growth from most of our large distributors offset by declines from smaller distributors. For the full year, the spine business declined 2% compared to 2011. The decrease for the full year was primarily related to inventory adjustments from certain distributors partially offset by an increase in orders due to product launches and replenishment of stock from our largest distributors in the year. At this time, we anticipate our spine business will mirror the spine market for 2013 which continues to be flat. Fourth quarter surgical specialty revenues decreased 13% compared to fourth quarter of 2011. The decrease in revenues was due to decline in hernia revenue as our commercial distributor is focusing more on xenograft for hernia repair. The decrease was offset by growth in breast reconstruction urology and ophthalmology.

For the full year 2012 surgical specialty revenues increased 2% over 2011. Moving forward in surgical specialties we will be co-exclusive with our distributor in human dermis for the hernia market. Starting in the first quarter of 2013, we will begin direct distribution of these implants through our newly developed distribution force surgical specialties. We have the leadership in place and have been hiring and training new biologics reps, this team will be introducing new biologics portfolio for hernia repair which includes the human dermis implant and our bovine pericardium implant this March at the American Hernia Society meeting in Orlando.

In the second half of the year, we will be filling out the hernia portfolio with the anticipated introduction of our porcine dermis implant. With the introduction of our new direct distribution team and the launch of new products into this market, at this time we anticipate growth in surgical specialties in the mid teens for 2013. Fourth quarter BGS General orthopedic revenues increased 6% compared to fourth quarter of 2011. For the full year of 2012 BGS/GO revenues increased 11% over 2011. The increase in revenues for the quarter and the year were due to the stocking orders from some of our commercial distributors in the second half and strong performance from our international exports as well as domestic directs BGS/GO. Because of a significant portion of the BGS/GO distributed through our direct distribution channel we anticipate that the warning letter will have a negative impact on revenues in this business in the first half of 2013. Additionally we have unfavorable comparables due to one time stocking orders from some of our commercial distributors in 2012. At this time we anticipate that BGS/GO revenues will decline in high-single digits for the full year with growth in the later part o the year.

Fourth quarter dental revenues increased 21% to fourth quarter 2011. Strong domestic dental revenues were offset by decline in international dental revenues. Growth in the domestic dental business was primarily due to inventory builds by our distributor for their new distribution facility. The decline in international revenues was primarily due to a reaction to inaccuracies in European media coverage about the company and their tissue industry. We continued to work through these issues and we will bring them to complete resolution.

For the full year 2012 dental revenues increased 17% over 2011. The increase was primarily due to strong orders of new products launched early in the year. Strong orders of xenograft membrane implants and the inventory build in Q4. We anticipate that revenues will decline mid-single digits as we are conservatively projecting that our distributor will only take the contracted minimums in 2013. As we stated in our release our U.S. direct distribution organization accounted for $54.6 million of our revenue for the full year 2012, an increase of 6% over last year. This includes all of our domestic sports medicine revenues as well as certain domestic BGS/GO implant revenue.

We are continuing to focus on expanding our direct distribution efforts to business development opportunities and new product development. As you know we have been actively working on the business development opportunities, we continue to seek the right deal that will fit our long-term strategic plan and being financially attractive. We remain confident that we will find the right fit to grow our business and enhance shareholder value. In 2012 we launched or released for distribution 18 new implants or implant enhancements which come from than $2 million of our 2012 revenue.

Looking forward to 2013, we are continuing to progress down the path of commercialization of our MAP3 cellular allogeneic bone graft. The MAP3 bone graft is natural, safe alternative to autograft and will be available in multiple sizes and configuration. As we mentioned on our last quarterly call we are working on a transition from and R&D initiative to commercialized line of implants. We must optimize the complex operational logistics that will enable us to meet the initial and ongoing demand from surgeons.

This transition has created a few challenges that have put us behind where we hope to be at this point. However, we still anticipate the MAP3 we will launch in 2013. As we have consistently said this is the startup year for MAP3. We are currently in the process of building a facility that will allow us to scale the business to full commercial production. That facility will be complete sometime in early 2014. I must reiterate that we are extremely pleased with the potential for MAP3. However, we will not go to market until we have the quality and consistency that we expect from our implants.

Two other long-term projects, which we are investing over the course of this year, our porcine dermis hernia repair and xenograft tendon for ligament reconstruction, both of which remained on track. For porcine dermis, we completed a successful preclinical study to support our 510(k) application, which was submitted in late October. We have received the first set of questions from FDA, 30 days sooner than anticipated. We have responded and believe we are on track to receive clearance in the second quarter of this year.

As mentioned, we are assembling a Surgical Specialties direct distribution team who will be fully engaged and ready to run out their portfolio with the porcine dermis launch later this. For xenograft tendon, progress continues on our large primate study that will support our progress in the longer PMA regulatory pathway in the U.S. We are pleased with initial results we have seen so far from this study.

As we mentioned in our press release this morning, the FDA warning letter we received last October had unforeseen impact in our business in late fourth quarter and we anticipate that this impact will continue until the first half of the year. As we discussed on our last call, the warning letter was related to environmental monitoring activities in certain areas of our Alachua, Florida processing facility. On January 16, we have received the follow-up letter from FDA that acknowledged receipt of our responses to the warning letter. The letter acknowledges the voluntary corrective actions the company has taken to resolve the issues addressed in the warning letter.

Furthermore, the letter raises no questions or concerns regarding the adequacy or corrective actions we have taken. FDA has indicated in this letter that they will verify implementation of our corrective actions on their next scheduled inspection. The receipt of this letter illustrates that RTI is progressing towards a closeout of the warning letter, which we would expect after FDA conducts a follow-up inspection of our Alachua facility. It also further shows that there is no patient safety nor any withdrawal or recall of any implant required.

As we have stated, we are committed to actively working with FDA to address the concerns. Additionally, and separate from the receipt of the warning letter, the FDA just completed a two-week inspection in our German facility. The inspection covered the scope of all activities performed in Germany such as processing and distribution. The inspection also involved complete review of all records from Bioimplant, the tissue recovery organization in the Ukraine from which we received donated tissue until 2012. The result of this in-depth inspection was positive and resulted in no adverse findings, FDA 483 or even management comments.

The closing meeting was also attended by representatives of German Health Authority. We pride ourselves in operating in the right way, and we are dedicated to providing high quality safe, biologic implants to surgeons and their patients. We are committed to fully resolve any issues as well as address any concerns from our customers.

At this point, Rob will go into more detail on the financial results.

Rob Jordheim

Thank you, Brian. Worldwide revenues of $44.6 million for the fourth quarter of 2012 increased 4% compared to the fourth quarter of 2011. Domestic revenues of $40.1 million for the fourth quarter of 2012 increased 6% compared to the fourth quarter of 2011 primarily based on the strength of the dental, spine, and BGS/GO businesses and were offset by weaknesses in the surgical specialties and sports medicine business.

International revenues, which include exports and distribution from our German and French facilities, were $4.5 million for the fourth quarter of 2012, a decrease of 12% compared to the fourth quarter of 2011. As stated earlier, the decrease was primarily due to inaccuracies in European media coverage about the company and the tissue industry. On a constant currency basis, international revenues decreased 9% as compared to the fourth quarter of 2011.

Net income for the fourth quarter 2012 was $2.3 million or $0.04 per fully diluted share based on 56.3 million fully diluted shares outstanding. This compares to $2.4 million or $0.04 per share for the fourth quarter of 2011 based on 55.7 million fully diluted shares outstanding. Gross margin for the fourth quarter was 49%, which was an increase of approximately 250 basis points from fourth quarter 2011. The increase was due to higher distributions of tissue in the quarter in conjunction with improved tissue yields and process efficiencies.

During the quarter marketing, general and administrative expenses totaled $15.2 million, an increase of $1.4 million or 10% higher than the fourth quarter of 2011. This was primarily due to higher spending in marketing programs and compensation offset by the strengthening U.S. dollar positively impacting international marketing, general and administrative expenses as compared to the fourth quarter of 2011.

Research and development expenses totaled $3 million, an increase of $553,000 or 23% higher than fourth quarter of 2011. Primarily due to higher research study expenses related to new product initiatives. Lastly, our tax rate for the quarter was 38% compared to 35% in the prior year period. Our effective tax rate increased primarily as a result of a research and experimentation tax credit being recognized in the fourth quarter of 2011 with no comparable credit in the current period.

Turning to the balance sheet, our cash position at the end of the fourth quarter was $49.7 million compared to $46.2 million at the end of 2011. The increase was primarily due to overall strong operating cash inflows in 2012 and the $3 million payment received early last year for distribution rights in connection with our dental agreement with Zimmer. Increases in cash from operations were offset by quarterly federal tax income payments and the payment of prior year variable compensation.

Accounts receivable of $21.7 million compared to $20.7 million at the end of 2011. Day sales outstanding was 44 days at the end of the quarter compared to 45 days at the end of 2011. Inventories of $76.5 million were comparable to 2011 year end, more specifically at the end of the fourth quarter, unprocessed donor tissue increased $1.6 million to $26 million. Tissue in process increased $2.1 million to $28.4 million and implantable donor tissue decreased $4.2 million to $20.1 million.

Working capital at the end of the quarter totaled $129.1 million, an increase of $5 million compared to 2011 year end. At the end of the quarter total debt was $120,000 and we had approximately $16.7 million available under our revolving credit facilities. We are pleased with our liquidity position and confident in our ability to generate cash in 2011, while achieving our operating goals for the year.

With that I will turn the call back over to Brian.

Brian Hutchison

Thanks Rob. In our press release this morning we outlined expectations for revenue and EPS for the first quarter and full year 2013. For the first quarter 2013, we expect revenues to be between $38 million and $39 million. This would result in a 12% decline in revenues compare to Q1 last year at the midpoint of our guidance. We expect EPS in the first quarter to be – for 2013 to be approximately $0.02 per fully diluted share. We expect full year revenues to be between $178 million and $182 million, up slightly from last year. Full year net income is expected to be between $0.17 and $0.19 per fully diluted share based on 56.7 million shares outstanding.

We have taken a conservative approach to our guidance to the first half of this year, due to the impact from the warning letter that I mentioned earlier. While this impact is difficult to predict and quantify, we currently anticipate that revenues in the first half year will be impacted by approximately $4 million to $6 million. We expect that with the close outs of the warning letter from the FDA, we will be able to regain the business that we’ve been impacted by this event with the implant quality and excellent service to which our clinicians have been accustomed.

Additionally, with higher new product revenue in the second half, we believe we will return to growth in the latter part of the year. We estimate that we will have approximately $6 million in new product revenue which will be distributed through our direct distribution organization. The majority of this revenue will be recognized in the second half of 2013. We will continue to focus on a very active business development strategy, which we anticipate will accelerate our future revenue growth. We feel confident our corporate strategy will deliver results for the long-term.

We hope to see some of you this quarter, we will be presenting at the Lazard Capital Markets Medical Technology Snowbird Conference on February 27th and Snowbird, Utah and at Canaccord Genuity Musculoskeletal Conference on March 19th in Chicago. At this time, let’s open it for questions. Stephanie?

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Bill Plovanic from Canaccord. Your line is open.

Bill Plovanic - Canaccord

Great, thanks. Good morning.

Brian Hutchison

Good morning, Bill.

Bill Plovanic - Canaccord

My first question, gentlemen, is as you look at the challenges from the warning letter in the shift of revenues, your delay in revenues, a couple of things. One is that all international. Two, what was that run on a quarterly basis?

Brian Hutchison

Bill, the warning letter impact is predominantly in the United States on a quarterly basis.

Rob Jordheim

Yes, as Brian said, we are looking at the impact being of about $4 million to $6 million, and most of that will come in Q1. I would say probably two-thirds of that in Q1 and one-third in Q2.

Bill Plovanic - Canaccord

Okay and then but if I look at this I mean your international revenues were a bit lower as well. And I am trying to figure out kind of what’s driving that you did – you commented on the warning letter impacting international I believe?

Brian Hutchison

No, we said domestic what’s impacting international us a different, it’s a similar but different issues it’s – we have been under a media attack in all of Europe driven from a zealot reporter if you will in Germany who has had an impact on many of the international markets by getting government reactions. So, we have been dealing country by country by country with France, Spain, UK, Italy and we been impacted pretty much in all of them to some extent by this media. There are strong articles that run in various country papers that are untrue and it requires a considerable amount of time to turn it around and get the governments to back off and for us to be able to continue to grow there.

Bill Plovanic - Canaccord

Okay. And then I’m going to ask on porcine dermis (indiscernible) back in. On the porcine dermis, you mentioned that you are getting ready, you have submitted the 510(k), but then you also mentioned PMA and I…?

Brian Hutchison

PMA is for bovine tendon for ligament reconstruction. The porcine dermis is the 510(k). We submitted it last year in October. We got questions. They came in 30 days earlier than we expected, we responded, we sent them back. The next 90-day clock is running, which means if nothing else changes, we would expect approval in Q2.

Bill Plovanic - Canaccord

Okay and then on that same thread, you saw the impact from the distributor as you go to kind of a co-marketing agreement how much more impact would you expect in that surgical specialties is that distributor kind of scales that or is that baked into the current guidance?

Rob Jordheim

Bill this is Rob, that’s baked into the current guidance I mean we expect a decline on of orders from Davol, but offsetting that in the second half of the year we expect revenue from our direct operation to certainly more than replace that.

Bill Plovanic - Canaccord

And you’re building it – is that a separate direct force than which you have now for Sports Med, GO/BGS?

Brian Hutchison

It is. We’ve already hired 16 reps for that group.

Bill Plovanic - Canaccord

And was that been baked into Q4 your SG&A expenses?

Brian Hutchison

From a guidance perspective, no. What we did as we have accelerated our spend in that area in anticipation of going co-exclusive with Davol for human dermis. The fact is that came up in Q4 we are excited to get the products and we started hiring a bit earlier than planned.

Bill Plovanic - Canaccord

So, it wasn’t in Q4, but we will see the impact in Q1?

Brian Hutchison

That’s right, that’s correct.

Bill Plovanic - Canaccord

Okay, I’ll jump back and thanks.

Operator

Our next question comes from Matt Hewitt from Craig-Hallum. Your line is open.

Matt Hewitt - Craig-Hallum

Good morning gentlemen.

Brian Hutchison

Good morning, Craig.

Matt Hewitt - Craig-Hallum

Few different questions, first of all regarding the FDA warning letter, if I recall correctly a number of your peers also went through the inspection process also received 483 letters, has the impact that you felt sounds like later in the fourth quarter and so far in the first quarter, is that impacting them as well, I mean, has there been a market shift towards completely other products or how are they dealing with the impact?

Brian Hutchison

Well, Matt, we don’t necessarily know how they are dealing with it, we do know that some of them have warning letters. We also know that some of them have posted Class I recalls. So we do know that our – that some of our competitors are dealing with this. We don’t know exactly how they are dealing with it or what the impact is because they’re not public so, they don’t really have to disclose anything. So – we will learn that as this year unfolds, but we fully expect that the playing field will be level during this year.

Matt Hewitt - Craig-Hallum

Alright, shifting gears a little bit – on the new products with MAP3 entering last year the expectation was it would be later in Q3, likely Q4, you would have it available. Now it sounds like you’re hopeful or anticipate that product being launched this year. Is it safe to assume that it will launch this year. It’s just a question of timing whether it’s first half or second half or help me understand how much that has really slipped.

Brian Hutchison

I’m going to let Carrie address that question.

Carrie Hartill

Good morning, Matt. So, I think the answer is yes, it’s safe to assume that we’ll be ready with product on the shelf to support sales and marketing efforts this year. What we are dealing with this the logistics of shifting from R&D to a scaled up commercialized production and what we don’t want to do is be able to put a small amount of product on the shelf and not be able to do that consistently and then have outages immediately. So, we need to refine the process in all of the logistics in the process to make sure that is not going to happen and that is potentially what we are working to right now.

Matt Hewitt - Craig-Hallum

And how long do you think that that process is going to take? Is that a quarter or two to get adequate inventory on the shelves?

Carrie Hartill

I’d like to project, I think 2013 is a safe assumption.

Matt Hewitt - Craig-Hallum

Okay. And then one last one and I’ll jump back into queue, you have a pretty strong balance sheet as it sits today almost $50 million in cash. I know that you continue to look for M&A opportunities, but is there any chance that you possibly institute a repurchase program for your shares?

Rob Jordheim

Matt, this is Rob. We talked about that with our board regularly, but the position of the board at this point in time is that we can execute better on our strategy by using that cash for M&A activities. So, it’s been talked about but, at this point, we don’t plan to do that.

Matt Hewitt - Craig-Hallum

Alright on the M&A front, is something that you anticipate relatively soon as something that could occur here in the first half of the year.

Rob Jordheim

Yeah, I think it could, I think right now the business development pipeline is – as robust as it’s ever been, it’s just a matter of finding the right deal and pretty confident we will this year.

Matt Hewitt - Craig-Hallum

Alright, thank you. I’ll jump back in queue.

Operator

Our next question comes from Matt Dolan from ROTH Capital Partners. Your line is open.

Matt Dolan - ROTH Capital Partners

Hey guys, good morning. The first question is following up on the warning letter. Brian, maybe you could just give us a little more detail on where exactly within your product category, is that just in sports in terms of the U.S. business. And then secondly what gives you confidence that this – what seems to be a perception in the market, will improve in the second half of the year, at least confident enough to embed that into your guidance?

Brian Hutchison

Well, Matt, I’ll start and then Carrie will finish so, what we are dealing with this a wide, wide range of customer questions. In certain cases, it’s really sitting down and talking with doctors and in other cases, talking to risk managers or other people. Unfortunately, our timing of – this timing of our warning letter followed a pretty dramatic case where patients contracted meningitis and diet. The risk – attention to risk and level of risk at many institutions has risen dramatically and some institutions across the country actually have what they tell us is a policy with any vendor is under any warning letter of any kind, they won’t work with them until the warning letter is lifted, irregardless of what it’s for so, we’ve been put on hold in certain institutions that, but we have good relationships, but we have cleared the warning letter for that to occur. The letter that we just received from FDA actually is already been helping. We’ve already cleared the couple of those accounts by using that letter to give them confidence that the company is fine. So, at this stage it’s a wide variety of questions and I’ll let Carrie add to that.

Carrie Hartill

Matt, to elaborate just a little bit on that the letter that we’ve received from FDA in the middle of January has been incredibly helpful. But it is not a formal closeout. So, there are as Brian mentioned there are some institutions with policies that pretty black and white they will not work with any company that has an opened warning letter. The letter that we received from FDA is somewhat remarkable, it’s fairly unusual to receive a letter acknowledging and accepting the adequacy of corrective actions prior to an inspection. So, we were – we are able to successfully work with certain institutions and this is – that appears to be getting momentum literally in the last several days as our sales folks are approaching hospitals with this information. So, we do believe that it’s we’re making headway. This is not a closeout letter, but its pretty down close to a closeout letter and as Brian mentioned earlier in the call one thing that we were contending with was speculation by competitors that the warning letter would lead to a recall and the letter we would now receive from a FDA pretty much closed it out that – that prediction. So, I think it is helpful. We are looking forward to FDA’s revisit, so that we can get the formal closeout. But we’re confident that we’ve addressed their concerns, they appeared to be accepting our level of confidence and all of our corrective actions. They are requiring anything else of us. And we are sharing that with our customers as quickly as we can.

Brian Hutchison

I want to add to clarify to make sure you understand that meningitis case I mentioned is not RTI nor RTI related whatsoever, it’s related to steroid injection.

Carrie Hartill

A compounding pharmacy.

Brian Hutchison

A compounding pharmacy, but that particular case has been mentioned to us on calls by risk managers that they are just concerned about any warning letter because the news media made it sound as if you get the warning letter first and then the recall follows which as Carrie just clearly told you is not the case.

Matt Dolan - ROTH Capital Partners

So what have you assumed in terms of market share? Do you think, in the meantime, there is some competitive share lost or what have you baked into the projection?

Brian Hutchison

We believe that is exactly the case, which is why we are projecting the decline specifically in sports in the first half of the year is because we see that is a basically temporary shift in the market.

Matt Dolan - ROTH Capital Partners

Okay, and then under the same line of thinking for the international business, what have you assumed with the – again what seems to be a perception rather than something that’s very predictable with your media issue there within your guidance?

Brian Hutchison

We’ve taken a conservative position on guidance I can’t tell you that many of you know that we go to Germany frequently I’ve been there a lot Tom Rose will be there next week. The momentum does feel as if it’s turning, but it’s a long way to go. It’s country by country rumor by rumor essentially. And we’re still dealing with the couple of them in France and Spain. But for the most part things are turning around positively now, so we’re hoping that this year continues to build momentum. And we expect to get to the second half of this with some strong positive momentum. I can’t tell you that we now have the German authorities clearly, clearly supporting our positions because of the work that myself and Carrie and many, many others have done by visiting in Germany and visiting at the EU level. And then inviting them to our facility which they did their own inspection and they came for the FDA closeout. So, they feel a lot better about the situation there. So, factually now, the media will lose some of its ability to impact some of these things because the government officials have seen it face-to-face.

Matt Dolan - ROTH Capital Partners

Okay. And then on this $6 million in new product, can you break that out a little, is any of that next generation of your core business or is that all MAP3 related or maybe a combination of the two?

Rob Jordheim

Matt, it’s Rob. It’s actually a combination of the two with the majority of it at this point being the porcine dermis product.

Matt Dolan - ROTH Capital Partners

Okay. Thanks very much.

Operator

Our next question comes from Dave Turkaly from JMP Securities. Your line is open.

Dave Turkaly - JMP Securities

Thanks. Can you remind us, have you received 483 or warning letters like this in the past?

Brian Hutchison

Dave, this is Brian, this is my first warning letter in running manufacturing plants and medical devices in 20 plus years. I would say it’s going to be my last if I could guarantee that I can’t guarantee that but it’s certainly something I’ve always tried to avoid 483s are quite common, 483s typically come at the end of the inspection. But normally there is a process where you work through the 483 with FDA and resolve the issue and you never get to warning letter stage. In this particular case, when we got the 483 in July and we attempted to create a dialogue with them multiple times through that from that period until we got the warning letter and they refused each time. So, they did acknowledge to us since that they received all of those communications, why we didn’t get process the way it normally working, normally works I don’t know. But we expect to do the very best we can to continue work with any government agencies that audits us. People are going to find things. Humans make mistake, so you can find things, but we would expect to avoid any future warning letter any kind in the future.

Dave Turkaly - JMP Securities

Okay, my recollection was, after the last call, that we thought this was kind of maybe more immaterial or kind of a non-event given that the FDA has not yet given you a date for this re-inspection. But it sounds like you have comfort that a closeout is coming soon. Is there anything you can point to – anyone on your team that’s dealt with this in the past, or is it really a letter that you got in January that gives you that comfort?

Carrie Hartill

Yes, this is Carrie. The answer is yes, the letter that we got in January was – as I mentioned earlier pretty remarkable. And in all that a couple of words mimics exactly closeout letters that FDA posts. They do not advise us of when they’re going to re-inspect under tissue regulation, there is no pre-announcement of inspections. So, we have no way of projecting when they will re-inspect. It is not a formal closeout letter, so we cannot position it as such or present it as such. But what it does clearly indicate to us is that there are FDA has no additional questions or concerns about any of the actions that we’ve taken neither do they believe that we need to take further actions prior to their inspection. So, we derived a great deal of comfort and promise from the letter that we have received, we are looking forward to re-inspection as much as anyone else is, so that we can put this not behind us. Once the re-inspection takes place FDA has 65 days to actually post the closeout letter on their website. And we would receive that letter simultaneous with the posting. So, that’s pretty much the timeline what we can’t predict is when they’re going show up. But it could be as early as tomorrow.

Dave Turkaly - JMP Securities

Okay. And then given the – it appears to us that reading that pseudomonas was something that they found some of but – maybe 70 instances. Even in some of the communication it mentions you sold 30,000 plus implants. Is this – just to be clear has that a bacteria – that or any other ever been found in a patient that got implanted with one of your sports med or bone graft products, had it led to a failure any complication with the patient?

Carrie Hartill

Okay, can I take this Brian? Alright just so again just to be clear understanding that warning letter is written in FDA speak and someone non-technical is somewhat difficult to interpret. Pseudomonas was found in certain parts of the facility, pseudomonas is a very common water-borne organism that we would expect to see periodically in the facility FDA did not find it. We actually – what FDA discovered was based on our own internal data. We have masses of data related to environmental monitoring. Every time that we identify pseudomonas we put into place appropriate correct of that just to protect the tissue. What FDA with dissatisfied with was our overall high-level environmental monitoring program that would have allowed us to detect what appear to be a trend.

And we don’t dispute that and we’ve take extraordinary measures within the state-of-the-art environmental monitoring system to assure that we don’t miss the opportunity to identify potential trends in the future. But at no point was effective tissue brought into question. So, the answer is no. There is no safety issue related to tissue. No we have not reported pseudomonas. Every tissue that is not terminally sterilized is cultured for untested for a variety of microorganism before it leaves the facility and that is essentially of safeguard. And just put into perspective the numbers that FDA were reporting in the warning letter – 70 – this is not to downplay it, but over the period of 15 months, 70 incidences of pseudomonas was seen in the facility across a sample size of just environmental cultures of about 10,000 cultures a month. That’s just environmental cultures. That’s not tissue cultures, there are any number of other types of cultures and samples taken across the facility during the course of the month. So, I think a lot of this is driven by a misunderstanding – a genuine misunderstanding of what is tissue, what is environment and then the number looked extraordinary until we put them into perspective.

Dave Turkaly - JMP Securities

And importantly, like you mentioned, nothing is – or, at least, Brian, I believe mentioned up front, no product recall and no instance where anything ever happened to a patient that was implanted.

Carrie Hartill

That’s exactly right. And I think that the key there and the key to FDA action – FDA is clearly has an area of focus currently, which is why you are seeing a proliferation of attention and warning letters in the industry. We are not surprised by that. It’s not good to be first, but we are not surprised by what we are seeing. What I think is critically important is to understand that is a recall were to be required as part of the response to an inspection. It would have been conducted way before the warning letter would have been – would have been issued. If the FDA expects you – disagrees with your actions and expected to perform a recall than that is one of the first thing to happen after an inspection, nor the thing that happened after warning letter. If the FDA disagrees with you to the extent that they are prepared to issue a warning letter four months after an inspection than what you get is a is a cease and desist letter not a warning letter. You’d be basically shutdown. That is not what happened to us…

Dave Turkaly - JMP Securities

Thank you.

Carrie Hartill

So, FDA has agreed at any point with the corrective actions we took.

Dave Turkaly - JMP Securities

Last one from me and thank you for all the detail. So, given that you have gotten this letter on January 16th, you would have to find it incredibly, I guess, minuscule chance that anything with real teeth like a recall would be coming in the future given that – that letter that’s in your hand.

Carrie Hartill

Correct. There is no indication if any issue with tissue safety associated with anything that the FDA found and now is there anything ongoing that we believe FDA would take exception to when they do their re-inspection.

Brian Hutchison

And just help you guys be clear, any time, any customer complains about anything and there were some media report that said were 700 “complaints” filed, that again is over a substantial period of time, but bulk of the complaints we see from anybody has to do with a tissue implant cracking upon implantation which they don’t remove or the color or an implant or the size of a tendon. We rarely if ever get any significant complaints, however, our complaint monitoring system forces us to spent time with each and every one to closeout which we do. That gives me confidence every night when I lay down that we do not have an issue with any patients because if we did we would know quickly.

Dave Turkaly - JMP Securities

Thank you so much.

Operator

Our next question comes from Jayson Bedford from Raymond James. Your line is open.

Jayson Bedford - Raymond James

Good morning, thanks for taking the question, just a couple. Do you think it will take the actual closeout or listing of the warning letter before the pressure on your Sports Medicine business subsides?

Brian Hutchison

Unfortunately, I think that will help our sales force a great deal. We had our national sales meeting and myself from the executive team spent several days with our entire sales force and they are dealing with a real-time and one particular rep, who is a very, very, very successful rep has been forced out of his top four hospitals until the warning letter is cleared. The hospitals – he has good relationships with each one, they have told him comeback when it’s clear. Until then, our policy is we don’t do anything.

Jayson Bedford - Raymond James

Okay. And then embedded in the guidance, it looks like the assumption is that the letter is closed out mid-yearish, is that fair?

Brian Hutchison

Well, we can’t as Carrie said we can’t predict when they will come. We would love for them to come now and if they came, they would spend a few days here, possibly a week and at that end, it’s – we’re confident that they would close out this warning letter. Now as Carrie said, it takes 60 to 65 days for them to issue that letter to us, but that’s we would love to see happen. We just can’t predict when they will come back.

Jayson Bedford - Raymond James

Your international business baked into your guidance, do you expect it grows in 2013?

Rob Jordheim

Jayson, this is Rob. I think the international business will probably end up flat for 2013. I think you are going to see a decline in first half and you are going to see some growth in the second half, but overall for the year it will be flat, but growth in the second half leading into 2014.

Jayson Bedford - Raymond James

And then just on surgical specialties, do you have – now that you will be direct, do you have visibility into end user usage meaning a good grasp of who is actually using the product?

Rob Jordheim

Well, at this point we’ve got certain market data that we are planning around as we build our sales force, but for sure once the sales force gets up and these are mostly experienced rep by the way we will definitely be able to generate more of that kind of data.

Jayson Bedford - Raymond James

Okay. And you have 16 reps now, how big do you want to get that?

Rob Jordheim

I think over time when it’s fully built out, it will be somewhere between 80 and 90, but this is going to be probably three years down the road. We would expect to double the number we have right now by the end of this year.

Jayson Bedford - Raymond James

Okay that’s helpful. And then when you look at the mid-teens growth, how much of that roughly is porcine? How much of that is volume versus kind of a step-up in price and going direct?

Brian Hutchison

The majority when you look at surgical specialties as a whole, you noticed we have the hernia declining with our partner Davol, but that’s going to be more than offset by the direct side of the business we expect abreast through our partner hernia to grow also. So, that’s where you are getting that mid-teens result.

Jayson Bedford - Raymond James

Okay. And then just lastly from me, on MAPC have you conducted first in man?

Brian Hutchison

We have not.

Jayson Bedford - Raymond James

Okay, thank you.

Operator

Our next question comes from Raymond Myers from Benchmark. Your line is open.

Raymond Myers - Benchmark

First, you had said last quarter what the percent of direct sales of revenue was? Can you repeat that again this quarter?

Brian Hutchison

You mean repeat in terms of what we have said last quarter and now, I mean it’s going to a drop a bit, because of the impact of the warning letter. But in the back half of the year, once we launched the new products which we’re all going to be direct by the way it will increase.

Raymond Myers - Benchmark

What was the percentage of direct sales in fourth quarter?

Brian Hutchison

About 35% domestic.

Raymond Myers - Benchmark

Great. Can you compare the RTI warning letter to the nature of other warning letters that have been issued to other tissue processors recently, are they similar or are there differences?

Brian Hutchison

Well, this is Brian and if Carrie wants to tag on, she certainly can. I think each one is unique. I think the common thread that we are seeing is there is a focus on environmental monitoring that’s – while the regulations are not new, the practice is new of concentrating on that. And the other thing that’s new is when the FDA shows up, there is one or two or three microbiologists in tow. These are not tissue people they tend to be people with pharma backgrounds. So, then there is an extra long education process, because they don’t necessarily understand tissue. So, it’s a new – that’s a new issue in with what we are seeing and I know others are seeing it, but I can’t – I couldn’t compare the end result of warning letters, because I think they are all unique.

Raymond Myers - Benchmark

Okay. And does this create a backlog of demands for allograft tissue or are your customers getting their allograft tissue from other sources that are not turning into warning letters?

Brian Hutchison

Currently, they are getting it from other sources and I do believe there are certain facilities, who are using more autograft right now.

Raymond Myers - Benchmark

Good, good that was my next question. Is there enough supply to the facilities that are – where demand is being diverted to other facilities, is there enough supply of tissue to continue to supply those facilities or will there be a further supply constraint?

Brian Hutchison

There is not enough supply to permanently impact us. I mean, there just is not. This is still on the sports side particularly it’s still a supply constrained group.

Raymond Myers - Benchmark

So, pretty rapidly, the customers’ choices will be autograft or don’t do the procedure?

Brian Hutchison

No, I don’t think rapidly, I think it will play out as this quarter goes on, but I do think there will be some tightening. Hopefully we can clear our warning letter and get back into some of those cases or use the letter we got on January 16th to get into some of those cases. We are certainly trying to because we – RRI has plenty of tissue available right now and we expect that. And the good news here is that one other difference I will draw it for you in the past when these issues have occurred or media issues have occurred with RTI they have impacted us on the donor side. As you can see our unprocessed donor inventory has been going up consistently through this year. We are in the best tissue supply situation we have ever been in, ever. So, I am not worried about that side at all. And I do believe we will be well positioned to meet demands as the year unfolds once we start to see the demand come.

Raymond Myers - Benchmark

Great. Thank you, Brian.

Operator

Our next question comes from Bruce Jackson from Northland Capital Markets. You line is open.

Bruce Jackson - Northland Capital Markets

Thank you for taking the question. So, there have been a couple of general articles recently calling for improved tissue tracking applying the ISBT-128 blood banking standard. I was hoping I could get your views on that topic and talk about how you are positioning the company relative to those new standards and if there is going to be any additional expense because of it?

Carrie Hartill

It’s Carrie Hartill, we are supposed to be tracking the developments of ISBT-128 as well as the FDA on the device side, it’s got the device identifier guidance and will ultimately become a requirement. We are evaluating which systems will work best for us. We are also challenged with our – if you like given the opportunity of working in advance of this in Europe. So, ISBT-128 because the Europe already has standards well underway in development and particularly in Germany where we currently operate. So, the answer is we are closely evaluating ISBT-128. We have people within RTI on the working group that to take a look at tissue identification through that systems, but there are also other systems in play that are equally valid and may indeed be more acceptable to the device side of FDA and to the device side of other parties in Europe. So, we are down the path of being able to accommodate whichever system ultimately becomes the norm. We are not currently selecting an individual, a specific system, we will be driven primarily by the FDA UDI guidance and requirements which does not currently include ISBT 128, but we are on top of it. And in terms of additional costs that will remain to be same. We expect it’s the tissue industry collectively select a particular system then the tissue industry will collectively negotiate any fees. So, we are actually working actively within AATB to achieve that goal as well. If there is any impact in terms of cost, it’s going to be minimal absolutely minimal not materially in anyway.

Bruce Jackson - Northland Capital Markets

Okay that’s very helpful. Thank you. And then do you have any update on the litigation that’s currently underway in New York?

Brian Hutchison

Well the only thing we can say on that is that that is ongoing and there is nothing really to report at this stage. There are no trial dates set. There is really – everything that’s pending right now in front of us is what I would call administrative in nature and there is nothing we can do to accelerate it other than work through the issues with the court systems that we are. And at the end of the day we think that we will get the right outcome for our company and our shareholders and move forward.

Bruce Jackson - Northland Capital Markets

Okay. Thank you very much.

Operator

Our final question comes from Brian Gagnon from Gagnon Securities. Your line is open.

Brian Gagnon - Gagnon Securities

Good morning. I have three questions for you. How big an opportunity is the surgical specialties business with the taking over co-marketing and then being able to launch with these new products?

Rob Jordheim

Brian, this is Rob. Well, right now, the biologics hernia market is about $350 million, somewhere at $350 million to $400 million. As we said, we are going to be co-exclusive. We are building our sales force now. In fact, we accelerated that effort. Our view is if we can get a good percentage of this market somewhere in, let’s say, 10 to 20. That’s all incremental for us at a much higher margin. So, you know, the benefits to the company here are pretty substantial.

Brian Gagnon - Gagnon Securities

And these reps that are bringing on, where are they coming from?

Brian Hutchison

I have looked at a lot of the background here. And most of them are coming from big medical device companies and some of them are actually competitive type reps that have experience in the marketplace. So, we feel good about the group that we are hiring.

Brian Gagnon - Gagnon Securities

Okay. So, have they actually hit the ground running or do you have this product now able to give them? When did the exclusivity end with Davol?

Brian Hutchison

That’s going to start on February – well this month, but right now we are getting them up and trained. I think training is scheduled for the next couple of weeks, and once we get them up and trained and then they are going to get out there.

Brian Gagnon - Gagnon Securities

Alright. So, let me ask a kind of different question, are these guys going to have quotas?

Brian Hutchison

Yeah.

Rob Jordheim

Yes, they do.

Brian Gagnon - Gagnon Securities

Alright, so they should have big quotas, so going from 16 reps to 32 reps, we should expect they should have maybe a $1 million quota per year at some point?

Rob Jordheim

At some point, we are starting from scratch.

Brian Gagnon - Gagnon Securities

We'll give them a few months.

Rob Jordheim

We'll give a few months, that's good.

Brian Gagnon - Gagnon Securities

Okay, alright. So it's a big opportunity. Alright, so on MAP3 when you launch with this product and I understand you want to have enough product because hopefully it will be important for you, will you launch with data as well?

Carrie Hartill

Brian, we’ll be launching with animal data and bench data, a substantial amount of both. We will not be launching the clinical data, but we do have a clinical study teed up as soon as we feel that it’s appropriate to begin implantation. Again, we are trying to triage what do we make product available for use or do we make it available and sequester it for clinical studies. And we do have a clinical study teed up ready to go that will provide some relatively early stage results because of the specific surgical indication that's involved.

Brian Gagnon - Gagnon Securities

And then you talked yet about which indications you are going after to start with?

Carrie Hartill

Well, the first clinical study is going to be foot and ankle. It gives pretty early stage results, three to six months, but primarily we are focusing on foot and ankle and thigh, and then trauma behind that.

Brian Gagnon - Gagnon Securities

Okay. And then last question, with the decrease in Q1’s revenues, I am a little surprised you are going to be able to stay profitable, well how are you doing that? Is that from improvements in gross margins on existing products, is it mix, or is it cutback in expenses or all three?

Rob Jordheim

Brian, this is Rob again. What we are going to see is we should see some improvement in gross margin. We are going to keep our spending level roughly the same because of the investments we got to make to grow the business in the back half of the year. What you are seeing in Q1 on the EPS line is also we are getting a penny of benefit or almost a penny of benefit on the tax line related to the research and experimentation credit in Q1. So, that's the actual 2012 credit being taken in 2013 Q1, because we couldn't take until the government approved it. So to answer your question, we will be profitable, but not to the extent we were last year in Q1.

Brian Gagnon - Gagnon Securities

Okay. And then cash flow generation for 2013, what’s your thought at this point? How much cash did you generate in 2012 and what do you think you could do in 2013?

Brian Hutchison

Well, in 2012 we did about $20 million. And I think in 2013 on an operating cash basis, we should come close to that number also.

Brian Gagnon - Gagnon Securities

Okay, alright good, looking forward to getting this warning letter behind you and moving forward to these new products.

Brian Hutchison

We are too.

Operator

I will now turn the call back over to Brian Hutchison for closing remarks.

Brian Hutchison

Thank you everyone for the call today. We look forward to speaking with many of you as the day unfolds and in the upcoming conferences. And then we will talk to you again at about 90 days. Bye-bye.

Operator

Ladies and gentlemen, that does conclude today's conference. You may all disconnect and have a wonderful day.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!