Wright Medical Group Management Discusses Q4 2012 Results - Earnings Call Transcript

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 |  About: Wright Medical Group, Inc. (WMGI)
by: SA Transcripts

Operator

Good day, ladies and gentlemen, and welcome to the Fourth Quarter 2012 Wright Medical Group Earnings Conference Call. My name is Derrick, and I'll be your operator for today. [Operator Instructions] As a reminder, this conference is being recorded for replay purposes. I would now like to turn the conference over to Ms. Julie Tracy, Senior Vice President and Chief Communication Officer. Please proceed.

Julie D. Tracy

Thank you, and good afternoon, everybody. We appreciate you joining us. With me on the call today are Bob Palmisano, Wright's President and Chief Executive Officer; and Lance Berry, Wright's Chief Financial Officer.

We issued a press release this afternoon regarding our fourth quarter results and 2013 guidance. A copy of that press release is available on our website at www.wmt.com. The agenda for this call will include a business update from Bob, a review of our fourth quarter financial results from Lance, followed by a question-and-answer session and conclude with closing comments from Bob.

Before we begin, I would like to remind you that this presentation contains forward-looking statements as defined under U.S. federal securities laws. These statements reflect management's current knowledge, assumptions, beliefs, estimates and expectations, and express management's current views of future performance, events, results and trends and may be identified by their use of terms such as anticipate, believe, could, estimate, expect, intend, may, plan, predict, project, will and other similar terms.

Forward-looking statements are subject to a number of risks and uncertainties that could cause our actual results to materially differ from those described in the forward-looking statements. You should not place undue reliance on forward-looking statements. Such statements are made as of the date of this presentation, and we undertake no obligation to update such statements after this date.

Risks and uncertainties that could cause our actual results to materially differ from those described in forward-looking statements are discussed in our publicly available filings with the Securities and Exchange Commission, including, without limitation, our annual report on Form 10-K for the year ended December 31, 2012 as supplemented by our quarterly reports on Form 10-Q. These risks include by way of example and without limitation the risk that we will be unsuccessful in completing our acquisition of BioMimetic Therapeutics and obtaining FDA approval for its augment product.

Our earnings release includes certain non-GAAP financial measures that may be discussed on this call. Please refer to the reconciliations, which appear on the 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 the use of such measures.

And with that introduction, it's now my pleasure to turn the call over to Bob Palmisano. Bob?

Robert J. Palmisano

Thanks, Julie, and welcome to everyone joining us today. Our performance in the fourth quarter reflects continued strong implementation of the transformational changes to our business, as well as the significant progress made throughout 2012 to maximize the foot and ankle opportunity.

For the fourth quarter of 2012, we reported net sales of $123.5 million and adjusted earnings per share, including stock-based expense, of $0.01. Our global Foot and Ankle rate accelerated for the fourth consecutive quarter, resulting in 20% constant currency growth that was far -- that was well ahead of our expectations. This performance underscores the positive progress we are making in our Foot and Ankle business by leveraging our large, direct sales organization, introducing new products, driving productivity gains and increasing our medical education programs.

We also generated strong free cash flow in 2012 of $49.5 million, which was more than triple the amount generated the prior year. Additionally, we officially reached a key milestone for the company with the on-schedule completion of the Deferred Prosecution Agreement. We are now in our Corporate Integrity Agreement period, and compliance will remain a top priority for our company as we continue to execute an effective and efficient compliant system that promotes the highest standards of ethical and legal conduct in all the markets that we serve. I believe these fourth quarter results indicate we are on the right track with strong momentum as we enter 2013.

A year ago, I outlined 3 strategic priorities for our company, which include growing our Foot and Ankle business at well above market growth rates, running a focused and efficient Ortho Recon business and generating cash. I also outlined several important vital few initiatives to transform our business and maximize the opportunities we have. Our solid execution of these vital few initiatives enabled us to exit the year with strong momentum for 2013.

I'd like now to spend a few minutes reviewing the significant progress we have made and discussing our plans for 2013. First, we completed the successful conversion of a major portion of our Foot and Ankle independent distributor territories to direct sales representation in the third quarter of 2012. The conversion was completed ahead of schedule, more reps were converted than originally planned and the revenue dis-synergies to Ortho Recon business were less than anticipated. Additionally, we were able to double our U.S. Foot and Ankle growth rate as compared to Q4 of 2011 while managing the disruption and distraction risks associated with converting that many reps.

Our second key initiative was to significantly increase our Foot and Ankle medical education. Excellent medical education is critical to our goal of driving both adoption and penetration of new technologies in the Foot and Ankle market. We substantially increased our investment in medical education throughout the year. During 2012, we trained approximately 2,000 surgeons, considerably more than the 600 we trained in 2011 and well ahead of our goal of training 1,200 physicians.

Our third initiative was a breakthrough plan to reduce inventory and generate approximately $100 million of cash over 4 years. With the first year of this initiative now complete, I am pleased to report that we are well ahead of our plans, having generated over $30 million of cash benefits by disposing of inactive inventories, optimizing new product builds and identifying opportunities to redeploy underutilized inventory and instrumentation to generate additional growth.

Finally, we began 2012 with a plan to provide better visibility and focus on driving the performance of our 2 businesses. In the first half of the year, we began reporting separate financial results for the Extremities in Ortho Recon businesses. And in the fourth quarter, we separated these businesses operationally. We now have 2 division presidents focused on driving the performance of each of these businesses.

Execution of these vital few initiatives, combined with a robust lineup of new Foot and Ankle products enabled us to significantly exceed our targets for our -- for key measures of Foot and Ankle growth rates and free cash flow. We are very pleased with these results and the progress we have made over the last year. When we put these initiatives in place, we view them much like a transformational acquisition, with dilution in the beginning and accretion thereafter. During 2012, these initiatives produced immediate breakthrough improvements in Foot and Ankle growth and cash flow. More importantly, the greater focus and improved working capital efficiency created by these initiatives will enable to enhance future initiatives.

As we move into 2013, we will build on the momentum with 3 new vital few projects. They are to increase sales productivity, improve gross margins and build a growing global Ortho Recon business. First, we have turned our attention to further increasing our U.S. Foot and Ankle productivity to reinforce our leadership position. You will recall at the end of the fourth quarter of 2011, our annual U.S. Foot and Ankle sales productivity was approximately $600,000 per rep. Our productivity significantly improved during 2012 and, as of the end of the fourth quarter, now stands at approximately $700,000 per rep.

To increase sales productivity through 2013, we have a clear plan to increase selling effectiveness through improved rep training, disciplined sales management and aligned compensation plans. Additionally, we will decrease the amount of time spent on non-revenue-generating activities like managing inventory. We have often stated that our goal is to increase annual productivity to over $1 million per rep over time. At this point, we believe we can reach that level in 2014. And over time, we believe we can reach our level meaningfully above the current goal of $1 million per rep.

Second, we can now begin efforts to improve our gross margins as the positive impact of the inventory project improves our demand visibility. We are in the early stages of developing our plan, but we believe by improving our processes, we can reduce manufacturing costs and improve pricing that will improve gross margins by 100 to 150 basis points per year for 3 to 4 years.

Our third vital few initiative for 2013 relates to building a growing global Ortho Recon business. We are also in the early stages of developing this plan, but we will have excellent opportunities to drive growth in certain international markets and to stabilize our U.S. business with our new divisional focus and organizational structure.

We are very enthusiastic about these new vital few initiatives for 2013. Our team's past performance has proven that we can execute very difficult and meaningful strategies. We are a much different company than we were a year ago, and we have an opportunity to drive significant improvement again this year.

As we exit 2013, we expect that the initiatives that we put into place last year will be moving into the accretive phase, and our new 2013 initiatives will already be providing some benefits. We believe this should drive accelerating revenue growth, continued strong cash flow and create an inflection point in earnings. This outlook, combined with the potential impact on the BioMimetic transaction, makes us very optimistic about our ability to drive significant revenue and earnings growth 2014 and beyond.

Lastly, BioMimetic will be holding their shareholder meeting next week on February 26. We expect their shareholders to approve the transaction. Once approved, we expect to close the transaction promptly.

As BioMimetic previously announced, they have answered the additional questions that they received from the FDA and are now awaiting a response. Assuming Augment receives FDA approval, which we anticipate between April 2013 and January 2014, it will be the first clinically proven protein therapeutic to come to the orthopedic market in a decade. We are looking forward to adding BioMimetic's Augment Bone Graft to our biologic product portfolio and capitalizing on the significant unmet market opportunity that exists for use in hindfoot and ankle fusions.

I would now like to turn this call over to Lance for a discussion of our fourth quarter financial results and 2013 guidance.

Lance A. Berry

Thanks, Bob. As we get started, please note that unless otherwise stated, all of today's discussions regarding our sales growth rates refer to our constant currency growth rates, and our results of operations refer to our as adjusted results as described by Julie during the introduction of our call.

Net sales for the fourth quarter of 2012 totaled $123.5 million, a decrease of 3% as reported and 2% on a constant currency basis. Adjusted net income for the quarter, including stock-based expense, totaled $0.4 million or $0.01 per diluted share compared to $0.13 per diluted share for the quarter ended December 31, 2011.

Note that our Q4 adjusted earnings per share does not include the impact from the R&D tax credit. The credit was reinstated retroactive to the beginning of 2012 but was not signed into law until after the end of the year. Therefore, we are unable to record the benefit in 2012 results and will instead record the impact of the credit for 2012 in the first quarter of 2013.

Looking now at our sales results in detail. I'll start with the Extremities segment. The global Extremities segment, which includes Foot and Ankle, Upper Extremities and Biologics, increased 11% on a constant currency basis during the fourth quarter, driven by 20% global Foot and Ankle growth. Both the U.S. and international Foot and Ankle businesses are ahead of schedule with their plans for accelerating growth, and we are very pleased with their performance as we exit the year.

Our global Biologics business declined 2% on a constant currency basis in the fourth quarter, primarily driven by declines in our U.S. Biologics business. This business is still declining but at a much lower rate than we experienced earlier in the year.

The strong Foot and Ankle performance, combined with the smaller declines in the Bio business, resulted in a sharp acceleration in the total Extremities segment, which completes the year as a roughly $215 million global business, growing in double digits and with expectations for growth rate acceleration in 2013.

In Ortho Recon, Q4 sales for the global Ortho Recon segment declined 11% on a constant currency basis. Our U.S. Ortho Recon business declined 17% this quarter, primarily driven by anticipated customer losses and modest impact from the anticipated sales dis-synergies related to our U.S. Foot and Ankle sales force conversion initiative.

With regard to customer losses, we exited the year with the U.S. Ortho Recon business generally in line with the expectations that we outlined at the beginning of 2012, which was a combined loss of approximately $25 million from Ortho Recon customer losses and revenue dis-synergies from our sales force conversion.

Note that some of the customer losses occurred late in the fourth quarter and some have also occurred in the first quarter of 2013. At this point, we believe that the customer losses from our previous issues have run their course. And in Q2 2013 and beyond, these issues will no longer impact our business other than the drag they will create on our growth rates until they are fully annualized.

Our international Ortho Recon business declined 7% in constant currency due in large part to previously reported price decreases in Japan that went into effect in the second quarter of 2012 and a negative top line impact of converting our Belgian subsidiary to a stocking distributor earlier this year.

With regard to Japan, excluding the impact of the price declines, this business underperformed as compared to our expectations for 2012. That performance is largely attributed to product factors that have already been addressed with the launch of both the EVOLUTION Medial-Pivot Knee and the DYNASTY BIOFOAM Cup in Japan in early Q4 of 2012. We do anticipate these launches will return our Japan business to performance levels in 2013 that are in line with our long-term expectations, and we are already seeing early success from these launches, particularly the EVOLUTION Knee.

Moving on to some details below the sales lines, beginning with our Q4 gross margin. Overall, we achieved 68.2% for the quarter, a 20-basis-point decrease over prior year. Q4 operating expenses totaled 65.1% of sales compared to 58.3% of sales in the prior year.

As for the line items making up our Q4 operating expenses, selling, general and administrative expenses totaled 58.7% of sales for the fourth quarter compared to 52.8% in the prior year period.

The increase as a percent of sales was driven primarily by the impact of lower sales on non-variable costs, higher costs associated with our sales force initiatives and lower levels of cash-based incentive compensation in the prior year.

R&D expense totaled $7.3 million in Q4 2012 and $6.2 million in Q4 of 2011. The Q4 spending level was more in line with our expected future spending levels before consideration of the BioMimetic transaction.

And finally, amortization expense of approximately $700,000 was down slightly as compared to approximately $800,000 in the prior year. Below the operating income line, net interest expense and other expense totaled $1.7 million for Q4.

Our Q4 effective tax rate as adjusted was approximately 10.5% for the quarter as compared to 39.8% in the prior year period. For the full year 2012, our effective tax rate as adjusted was 34.4%, excluding stock-based compensation. This effective tax rate was better than anticipated despite not having the R&D credit and drove some of the upside to our Q4 earnings results.

Finally, for share count, our Q4 per share results as adjusted are based on an as adjusted diluted share number of 39.3 million for Q4 of this year and average diluted shares of 39.6 million for Q4 2011.

All together, our overall earnings results came in above our expectations as the sales performance and tax rate improvement drove bottom line overachievement.

Moving on to the balance sheet and cash flow. Following the completion of our convertible debt offering in August, we now carry a combined cash and marketable securities balance totaling $333 million as of December 31, 2012. We generated $5 million of free cash flow in the fourth quarter and $49.5 million of free cash flow in 2012, significantly ahead of our expectations and prior year, primarily due to lower levels of CapEx spending and improved inventory management.

Previously, Bob mentioned the progress on our inventory initiative and provided some color on the specific actions and results associated with the plan. In 2012, we decreased gross inventory by approximately $20 million while adding approximately $8 million of inventory to support growth in new products. We have disposed of over $14 million of fully reserved inventory and isolated 7,400 SKUs, which has been virtually invisible at the customer level.

The next phase of improvement will be driven by -- to a large extent by the rollout of our regional inventory hubs across the U.S. We successfully completed the pilot phase of this project, with the initial location producing a 40% decrease in inventory days on hand, while Foot and Ankle sales growth in the territory supported by this hub accelerated from a level that was below the overall company average to being some of the fastest-growing territories in the U.S.

Additionally, the time that sales reps in that area spend managing inventory has gone down from approximately 40% to approximately 20%. We are ahead of schedule with our rollout as we launched 4 additional hubs at the end of 2012 and plan to be complete with the rollout by the end of Q3 2013.

I will now provide some detail on our current sales and earnings per share outlook for full year 2013, including providing some color on the line items of our income statement to assist you with your modeling and provide some insight into the key drivers of the business in 2013.

Consistent with past practice, please note that our guidance ranges and assumptions for 2013 exclude any consideration for the effect of potential future acquisitions or any other possible material business developments.

Additionally, it is important to note that we'll be using a number of non-GAAP financial measures to describe our outlook for the business. In particular, unless stated otherwise, all of today's discussions regarding results of operations refer to our as adjusted results. Our press release filed today notes those items that are excluded from our as adjusted results.

Turning now with sales. Excluding the impact of BioMimetic, we expect full year 2013 revenues to be in the range of $485 million to $495 million. This range includes a negative impact from currency of approximately $11 million or 2% as compared to 2012. Our currency assumptions are slightly conservative to current levels, and if rates were to remain constant at their current levels, it would positively impact our as reported results by less than 1 percentage point as compared to our current guidance range.

Before moving into a more detailed discussion of individual line items, I would first like to provide you with the primary assumptions that are driving our top line guidance.

First, we anticipate accelerating global Foot and Ankle growth, growth in our Japanese Ortho Recon business and Ortho Recon growth in certain distributor markets. Additionally, we will benefit from approximately $4 million of acquired revenue associated with a small international Foot and Ankle acquisition that closed in early 2013. These growth areas will be partially offset by some significant headwinds we carry into 2013 as we face a full year of U.S. Ortho Recon customer losses and dis-synergies associated with our sales force conversion, $11 million of currency headwind at our current planning rates and the approximate $4 million onetime benefit in 2012 of converting our Belgian subsidiary to a distributor. All together, these key assumptions drive the results to $490 million midpoint of our guidance range.

Keeping those comments in mind from an overall perspective, here are some details on those expectations. We anticipate our global Extremities business to grow in the low to mid double digits on a constant currency basis with higher growth rates internationally.

Foot and Ankle growth is anticipated to accelerate in the U.S. and internationally. Additionally, the international growth rate will benefit from the approximate $4 million of acquired revenue. Bio and Upper Extremities will continue to have modest declines.

The Ortho Recon business is anticipated to range from the low to mid single-digit constant currency declines globally as low single-digit international growth is offset by low double-digit declines in the U.S.

The declines in the U.S. will be driven by the full year impact of Ortho Recon customer losses and dis-synergies associated with our U.S. Foot and Ankle sales force conversion in 2012, in Ortho Recon, customer losses in the first quarter of 2013.

Based on how we exited 2012, the impact of these customer losses and dis-synergies is a year-over-year decline in the $10 million to $15 million range. The international Ortho Recon business will be negatively impacted by the previously discussed Japan price declines that annualized in Q2 and the Belgian conversion to a stock distributor. Excluding these headwinds, the U.S. and our direct European businesses are anticipated to be relatively flat, while new products are expected to drive growth in Japan.

Additionally, we expect to grow certain distributor markets as a result of our inventory initiative and enable us to pursue growth opportunities more aggressively in these areas. This completes my prepared comments on revenue.

Turning now to the P&L. Our outlook for the full year 2013 adjusted EPS, including stock-based comp, is $0 to $0.06 per diluted share. Similar to the revenue discussion, I'll provide you with the key assumptions driving our EPS guidance.

Please note that this commentary includes stock-based expense. We will continue to provide you visibility to the impact of stock-based expense, but in 2013, we will no longer exclude it from our guidance and our as adjusted results. Reporting in this manner will be more consistent with Street consensus models and hopefully will make modeling our business simpler.

The key revenue headwinds discussed earlier, primarily Ortho Recon customer losses and currency, combined with a full year of increased spending levels in medical education and R&D and the medical device tax, combined for a negative EPS impact in the $0.25 range as compared to 2012. These headwinds are partially offset by revenue growth in global Foot and Ankle, Japan and distributor markets. The total of these factors is the midpoint of our adjusted EPS guidance range.

Now for some specifics on the individual line items on the P&L. First, on gross margin. For 2013, we are expecting gross margins to improve in the range of 50 basis points, as favorable mix from faster-growing Foot and Ankle business is partially offset by negative geographic mix within the Ortho Recon business. We expect to generate benefits from our vital few initiative to improve gross margins. However, due to the way these benefits roll through across the sales, they will not meaningfully impact the P&L until 2014.

In total, we expect operating expenses to increase as a percent of sales for the full year 2013 as compared to full year 2012 due to the full year effective increased investments in medical education, R&D and the costs associated with our sales force initiative, as well as the medical device tax. In total, SG&A as a percent of sales is expected to increase in the range of 300 basis points, and R&D as a percentage of sales is expected to increase in the range of 100 basis points. Excluding any future acquisitions, you can expect amortization expense to continue at the rate of approximately $750,000 per quarter.

Before we move to line items below the operating income line, to assist you with modeling EBITDA, I do want to provide you with our outlook for depreciation expense, which for the full year 2013 is in the range of approximately $38 million to $40 million as compared to $38.3 million in 2012. Stock-based expense is anticipated to be in the range of $12 million or an EPS impact of approximately $0.19 in 2013.

Now let's touch briefly on the items below the operating income line. Our expectation for interest and other is approximately $2 million per quarter. Our effective tax rate expectation is in the range of 32%, including stock-based expense, compared to 34% in 2012.

With the R&D tax credit signed into law in 2013 but retroactive at the beginning of 2012, we will actually report 2 years worth of their credit in 2013. This will favorably impact our tax provision by approximately $500,000.

For diluted shares, we start the year with a diluted share count of 39.8 million. We are assuming that we would exit the year with diluted shares of 40.2 million, resulting in an average diluted share count of 40 million. So all together, these considerations are the basis for our $0 to $0.06 guidance range for adjusted EPS, including stock-based compensation.

From a cash flow perspective, we produced $49.5 million of free cash flow in 2012, which is well ahead of our original free cash flow expectations for the year. Excluding the impact of BioMimetic, our current expectation is for continued strong free cash flow of approximately $35 million to $40 million in 2013. Given the headwinds from decreased profitability and some of the inventory benefits being accelerated into 2012, this is a good target for cash flow this year.

As it relates to quarterly guidance, as with the case in 2012, for 2013, we will update our annual guidance each quarter, but we'll not be giving guidance expectations for the current quarter. We do want to provide you with information on seasonal fluctuations of our business to assist you in modeling our quarterly performance.

We expect both the U.S. and international Ortho Recon businesses to begin the year with revenue declines in line with what we saw as we exited 2012 and improve sequentially as we move through the year and annualize the various headwinds we discussed.

We expect to exit 2013 with the global Ortho Recon business growing generally in line with market rates of constant currency growth. For the Extremities segment, we expect continued steady acceleration in the growth rates throughout the year.

One item of note for Foot and Ankle growth. We have 2 less selling days in the U.S. in Q1. Additionally, our international distributor business for Foot and Ankle exceeded our expectations in the fourth quarter. And although we are very optimistic about our international Foot and Ankle prospects, you should not expect to see the same level of sales in that portion of our business in the first quarter.

From an earnings perspective, we expect EPS in the first half of the year to be generally in line with the EPS levels in the second half of 2012, plus the negative impact of the med device tax of approximately $0.02 per quarter.

EPS in the second half of the year is anticipated to be significantly better than the first half as our 2012 vital few initiatives begin to move out of their dilutive phase and we begin to see early benefits from our 2013 vital few initiatives. Note that due to Q3 being our seasonally lowest quarter and Q4 being our seasonally highest quarter, it is likely that the actual sequential improvement in EPS from Q2 to Q3 is fairly modest and the improvement from Q3 to Q4 is significant.

This quarterly pacing may appear to result in a somewhat back-end-loaded plan. However, that is not really the case. On revenue growth, a significant portion of the improvement throughout the year is driven by easier comparable throughout the year in the Ortho Recon business.

For EPS, the Q3 to Q4 seasonality somewhat magnifies what is more of a steady improvement from the first half of the year to the second.

With regard to cash flows, due to timing of CapEx and certain annual payments, we expect free cash flow to be negative in Q1 and positive thereafter. You should expect some variability between quarters on cash flow due to the timing of CapEx and certain other items.

All of my previous comments exclude the impact of the proposed transaction with BioMimetic. If the transaction closes as anticipated by the end of the first quarter of 2013, the company anticipates no change to its full year 2013 net sales range of $485 million to $495 million.

Excluding transaction and transition costs, this transaction is anticipated to negatively impact earnings per share in the range of $0.32 to $0.34 per diluted share, resulting in anticipated full year 2013 loss per share, including stock-based compensation for the combined company of $0.26 to $0.34 per diluted share based on approximately 45.8 million shares outstanding and free cash flow in the range of $0 million to $5 million.

We anticipate issuing approximately 7 million shares for this transaction. However, these shares will be outstanding for only a portion of the year. Therefore, the impact on full year diluted shares is approximately 5.8 million. The incremental 7 million shares will fully impact each quarter beginning in Q2.

These impacts reflect our plans to leave the BioMimetic business generally intact as is, plus some additional costs associated with preparing for the commercial launch of Augment Bone Graft.

For purposes of this guidance, we have assumed approval of Augment in January 2014. If we were to receive approval of Augment during 2013, we would update our guidance at that time.

In closing, we're very pleased with the overall results for 2012 and expect the continuation of the growth and momentum into 2013. A year ago, we launched the plan to transform our business. We executed well in 2012 and are right on track with that plan.

Additionally, we have enhanced that plan with new biofuel initiatives and a potential breakthrough transaction for our Biologics business. As we exit 2013, we expect to have an Extremities segment that is growing in the mid to high teens and a global OrthoRecon segment growing in line with market.

Additionally, we expect to have returned profitability to the business and be positioned well for significant earnings improvement in 2014 and beyond.

Operator, we would now like to open the call up to take questions.

Question-and-Answer Session

Operator

[Operator Instructions] And our first question is from the line of Matthew O'Brien, William Blair.

Kaila Krum

This is Kaila Krum in for Matt O'Brien. Given the strong Foot and Ankle performance we've seen in recent quarters, we were just hoping you could provide a little bit more color as to the competitive dynamics for the market. What's your comfort level that you will be able to continue to deliver above-market growth? And then, which products specifically do you expect to really drive that growth going forward?

Robert J. Palmisano

Yes, I take it from a competitive situation, the -- although there are several companies involved in Foot and Ankle and that number seems to be growing, the real competition, I always say, comes from the underpenetrated market. There's a large market out there that are still doing procedures that are decades old, and that the growth will come more from penetrating that opportunity and not trading market share between companies, in my opinion. I think that the markets that we're in were probably recognized as the leading company. We have the largest product portfolio. We think that the market will be led by total ankle replacements and new hammertoe products. I think those are the leading ones that will have the biggest impact. And also, I think when we're able to market an FDA-approved Biologic for total ankle -- for ankle fusions and hind foot, those will all be very -- lay it to the growth and really drive the market.

Kaila Krum

Okay, that makes sense. And then just from an expense perspective, with respect to the core business, should we see SG&A and R&D trend at similar levels for the year with a potential tickup with the approval of BioMimetic?

Lance A. Berry

Well, we didn't give a line item guidance including BioMimetic. We had some commentary that we expect, excluding the BioMimetic transaction, that SG&A will be up about 300 basis points in 2013 compared to 2012 and R&D would be up about 100 basis points. And then we did give some guidance on what we thought the EPS impact of the BioMimetic transaction would be. And that would be in a combination of R&D and SG&A. But -- and that's really keeping their expenses somewhat as is and continue to run that business how it's been run.

Operator

The next question is from the line of Joanne Wuensch, BMO Capital Markets.

Joanne K. Wuensch - BMO Capital Markets U.S.

Gross margins look like they're going to start to improve next year, more in the second half than the first half. How do we think about the drivers for those gross margins? And if you can indulge us, what do you think that run rate will look like as we head into 2014?

Robert J. Palmisano

The drivers, as we execute the -- our plan on gross margins are decreasing cost of goods. And that's the majority of the 100 to 150 basis points per year that we mentioned, which we think we have good opportunities there. And I'd also add is that we're able to pick up some volume increases in the future that could potentially be better. The -- there's also some opportunity in pricing. As you know, particularly the OrthoRecon businesses discounting is fairly prevalent. And we're trying to make sure that we're not overly discounting and putting processes in places, as I think that will help us control that and be able to have a net effect of increasing our margins.

Joanne K. Wuensch - BMO Capital Markets U.S.

And then if you can indulge me, what do you think your exit run rate will look like?

Robert J. Palmisano

From 2014?

Joanne K. Wuensch - BMO Capital Markets U.S.

Going into 2014, yes?

Lance A. Berry

Yes, Joanne, I would be careful about exit rates just because our margin can bounce around quarter-to-quarter. I think I would just think about it as you think about -- we've given you some guidance around where we think '13 can be and said that we think we can drive beyond that 100 to 150 basis points a year of improvement in the out years.

Joanne K. Wuensch - BMO Capital Markets U.S.

Okay. And investors that I speak to are somewhat concerned, confused why you're closing or buying BioMimetic before you have the FDA data. I understand the story behind it. But is there anything incremental that has happened since the last time we've been on a public conference call that you could give us that has increased your confidence in going forward?

Robert J. Palmisano

I would think that we're pretty confident before. We remain pretty confident. We -- they did get a list of 6 of what we would classify as clarifying questions. We've seen the responses. They were done very well and very thoroughly. And I don't know -- I saw -- I would think that there's nothing that is substantive. But they're certainly seems to be headed in the right direction. So we're understanding that the nothing's done until it's done, and there are always risks. But we're fairly confident that this product will be approved.

Operator

Your next question is from the line of Kim Gailun, JPMorgan.

Kimberly Weeks Gailun - JP Morgan Chase & Co, Research Division

So I guess, first question is on the Foot and Ankle performance in the quarter and just focusing on the U.S. business. So you grew 16%, and you're basically indicating that you expect to accelerate off of that 16% level and kind of improve it on a sequential basis as we move through '13, is that right?

Robert J. Palmisano

Yes. I would say other than Q1, which I think Lance mentioned is our 2 last selling days. And so that will have some effect -- I'm not sure about -- generally speaking, you're right. I -- we expect that that will accelerate throughout the year, and by the end of the year will surpass what we did in terms of rate of growth this year.

Kimberly Weeks Gailun - JP Morgan Chase & Co, Research Division

Okay. And how much of that do you think is purely -- I mean, I guess a better way to ask it is how much disruption do you think you're seeing right now? So despite the great performance you've put up, how much disruption do you think that you're seeing from the Foot and Ankle sales force change over -- even here in the fourth quarter?

Robert J. Palmisano

Well, I mean I think that the -- we couldn't have gotten there without converting the sales force, I don't think. And I think this is a big asset of our company, and we're just getting better at it. We're very happy to see the productivity gains that we had just in the second half of the year when we actually started to get this thing organized. We anticipate that going up quite nicely to over $1 million per rep in the next couple of years. So I think that we laid our proper groundwork by biting the bullet and getting this direct sales force. Now we're making sure that they're well trained, well motivated, compensated correctly, having the right products and spending a lot of time and energy around medical education that we can continue to drive this business. So we think that all that stuff is working. There's nothing that I could look at and say, "Gee whiz, that was not something we should have done." And I think we're all headed in the right direction here.

Kimberly Weeks Gailun - JP Morgan Chase & Co, Research Division

Yes, okay. Just as a quick one on BMTI. Assume that you're working pretty closely with the company at this point, to your knowledge, have they had any communication with FDA since they got the questions back in, in early February?

Robert J. Palmisano

They've answered the questions, and we haven't heard anything back.

Operator

Your next question is from the line of Matt Miksic, Piper Jaffray.

Matthew S. Miksic - Piper Jaffray Companies, Research Division

Wright Medical, you -- last year, I think the big story was, Bob, and one of the big stories at least that I noticed in hearing you talk about the company was that you had really refocused investors and thinking around cash flows, driving inventory improvement in about the operating changes that you made to the distribution field force. This year, you are highlighting some nominal improvements in margin, which is a little bit of a different animal. Wanted to just get your sense as to maybe how the different gives and takes factor into those improvements, especially given your comments on investments you're making in training, all pointing towards improving productivities? You talked about maybe other investments in distribution. How do we get -- what are the gives and takes to get you that 100 to 150 basis points improvement? And then I have one follow-up.

Robert J. Palmisano

Yes, Matt, primarily, it's the whole range of activities involved in making our products, everything from purchasing through manufacturing to distribution. We had this process in place, I think that we talked at some length of times, high-performance management in which we'll identify what we call a vital few. And we put a team together, a cross-functional team, and they developed a plan, a current state and then a desire state and then a transition plan. And they take apart every aspect of it and there are no sacred cows. And they came up with this plan that -- and we have had just in the last year, I would say is that we have a history of executing well against these types of strategies that we list as vital few. So I think that when we say that we can get to 100, 150 basis points over -- per year over the next couple of years, we think that is pretty -- that's pretty solid, and we're very confident about that. There's also an area of pricing and -- that I mentioned before in that we don't think there's going to be any price increases but we do think that having much more solid and disciplined pricing policies around discounting can also provide some upside to our margins. So it's those 2 areas, Matt. Just previously, my last CEO job at ev3, we actually had -- we had a goal of increasing gross margins by 5 points, and we actually did 10. Now I'm not thinking we can do 10 here, so don't take that to the bank. But we do know how to execute against these kinds of things. So I feel really good about it.

Matthew S. Miksic - Piper Jaffray Companies, Research Division

Okay. And then I guess maybe a similar question on cash flows. This year -- last year, you talked about, I guess, there was a number of sort of field actions, if you will. They sounded a little bit more one-time in terms of tightening up the use of inventory in the field. And this year, it's a little bit more of a structured system. If you could talk a little bit about what this hub system actually means. I think it's -- we've all heard of distribution hubs, but I'd love to understand this is something you've implemented before, if this is something you think should have implemented in the past to Wright Medical? And maybe, I don't know if you can narrow this down, but how big of an issue is that for this year? Or is, again, the implementation of that going to be something where we see cash flow benefits in '14 and beyond?

Robert J. Palmisano

I'm going to turn you over to the inventory guru, Lance. And he has all the answers here.

Lance A. Berry

Matt, so I guess, first of all, we started off with a pilot of this in 2012. And so we've had a pilot in place really since the middle of '12 and making sure that we understood how we need to go about that. So -- and then now, right at the end of the year, we put some additional hubs in place. I think it works really well for getting control of the inventory, getting good visibility to the inventory and getting the right demand signals back to the plant for inventory, which helps us a whole lot with the supply chain. Additionally, it does help us get the inventory in the field down, like we saw with the pilot territory. We're able to get inventory days on hand down 40%. So we would expect to get benefits from that in 2013. And then the big benefit as we go forward and regrow in this Foot and Ankle business is that our reps have -- get to spend considerably less time managing inventory and they can focus on selling. But then in addition, it should take us considerably less inventory and instruments to be able to meet those growth rates.

Operator

Your next question is from the line of Michael Matson, Mizuho Securities.

Michael Matson - Mizuho Securities USA Inc., Research Division

Just looking at the free cash flow guidance that you gave, both without BMTI and with BMTI. It seems to imply a pretty significant cash burn from BMTI of about $30 million to $40 million, roughly speaking. And it seems to be significantly above of, if I'm recalling correctly, where they were at for 2012. So -- and I guess there's not a lot of clinical studies and stuff going on there right now. So I'm just wondering, is there -- is that a really conservative number, or is there some reason that they're burning a lot more cash in 2013?

Lance A. Berry

Yes, Mike, this is Lance. There is actually a little bit of a disconnect between the cash and the earnings guidance. The -- because in the cash flow, we also have to deal with all the transaction and transition costs that was only be in this year, so that eventually is part of your reconciliation.

Michael Matson - Mizuho Securities USA Inc., Research Division

All right, I got it. And I guess just on the OrthoRecon business, I know that this has been a topic that's been discussed quite a bit in the past. But I just wanted to check on -- in on the modular necks and wonder -- I'm just curious where you're at in terms of what portion of your total hips are still being sold with modular necks, if you can disclose that. And then what is your availability -- or how many products do you have that are not modular? Because I think you've said in the past you're trying to develop some more single-piece stums [ph].

Robert J. Palmisano

Yes, I think that the vast majority, particularly in the U.S., of the necks are modular. We have in the past and then continued to develop fixed stem necks. And I think that as the market goes that way, we'll be well prepared to have a full line of fixed stem necks. But right now, there's still a big demand for things for modularity. Doctors like it. And -- but we're constantly evaluating that, making sure that we're up to speed on the whole -- what's going on. But right now, it's still for us -- it's basically a modular neck product line.

Michael Matson - Mizuho Securities USA Inc., Research Division

Okay. And then I was just curious if -- I know there's been some increased marketing efforts around the hammertoe product, some increased direct-to-consumer at least over the web and so forth. So just wondering if that's had any benefit to that product line?

Robert J. Palmisano

Yes, I mean it's -- it really is starting to pick up. I think that in 2012, we didn't get it -- we didn't launch all that until late in the year, and I -- so we didn't get much when we're effective in 2012. But in 2013, I think that we anticipate that that will -- well, additionally we have some new products in hammertoe that will hit the market in 2013.

Operator

Your next question is from the line of Jason Wittes, Brean Capital.

Jason Wittes - Brean Capital LLC, Research Division

Just a couple of questions here. First, I think, Bob, you had mentioned that other than some lost accounts this -- or starting beginning this quarter, you feel pretty comfortable that the physician losses have pretty much stabilized here. Did I hear you correctly?

Robert J. Palmisano

Yes, that is true, yes.

Jason Wittes - Brean Capital LLC, Research Division

So if I look at this year's growth, we're losing about $10 million to $15 million just from the comparisons because of the way the losses occurred. But otherwise, you should start to see some modest growth from here?

Robert J. Palmisano

Yes, we think that by the end of the year. But certainly, by the -- in the fourth quarter, we will be at -- back into an upswing. It's not going to be dramatic. It's going to be like market rates, whether that's 1% to 3% or something like that. But it's -- certainly is better than the way it has been going for us

Jason Wittes - Brean Capital LLC, Research Division

Okay. And then in terms of the outlook for growth, it sounds like you're looking to actually eke out some growth from outside the U.S. I assume some of that is from building out distributorships, or how do we think about where that growth is going to be coming from?

Robert J. Palmisano

Yes, we brought on recently a real seasoned, well-respected VP for our international -- and he's located in Singapore, a guy I've known for years who has been a great performer. And we anticipate gaining into more of the emerging markets pretty solid growth through distributorships, particularly in China and Asia and some other areas.

Jason Wittes - Brean Capital LLC, Research Division

Okay, that's very helpful. And also I wanted to ask about BMTI. I think you mentioned the cash burn is going to be more than what the P&L impact. I guess my math says somewhere under $20 million is the impact that's going to go flow through the P&L. Is that correct, Lance? Is that, is my math --?

Lance A. Berry

It's right. It's a little bit north of that, yes, a little north of $20 million.

Jason Wittes - Brean Capital LLC, Research Division

And in terms of how it's divvied up between SG&A and R&D, how do we think about that?

Lance A. Berry

We didn't give any specifics on that. Really just kind of pointing to the bottom line, play it better if we can get the transaction closed and be able to do all of our purchase accounting and really have applied better visibility on the first call post the close of the transaction.

Jason Wittes - Brean Capital LLC, Research Division

And I -- just to follow up, and I don't know if again you might have to wait till the deal closes, but in terms of the projects going forward, I assume you anticipate still continuing clinical trials once they've started and perhaps additional ones going forward?

Robert J. Palmisano

Yes, we are definitely continuing the tennis elbow trial. And after that, we'll evaluate. But that's the one that's started, and we're in support of that and we'll continue that one.

Operator

Your next question is from the line of Richard Newitter, Leerink Swann.

Richard Newitter - Leerink Swann LLC, Research Division

Just wanted to ask you, can you maybe -- I know you said it before, can you just remind us kind of the rough time frame for Augment approval and commercialization if that could happen? I know you said right now you're kind of thinking about January of 2014. Realistically, I mean if you were to get approval, let's just say by May or early June, I mean, will commercialization begin immediately? How quickly can that ramp up?

Robert J. Palmisano

I wouldn't say it will be immediately. But we have, again, one of these vital few teams starting at BioMimetic to develop all the materials necessary to commercialize. We would love it approved in May, Rich, but we don't anticipate that. So that would be a nice problem to have. But I think that anything in the second half of the year, we would be ready for if that were to happen.

Richard Newitter - Leerink Swann LLC, Research Division

Okay, that's helpful. And then just again, I think you -- I think, Lance, you said that you expect to be exiting 2013 with a mid to high teens Extremities growth rate. I just want to make sure, that was for your overall worldwide Extremities, not Foot and Ankle, correct?

Lance A. Berry

That's correct.

Richard Newitter - Leerink Swann LLC, Research Division

Okay. And just -- can you help us think about, obviously, 36% growth for the international Foot and Ankle segment. You said, "Don't expect that -- look at that as a run rate." Can you give us any kind of indication, order of magnitude of what that should look like going forward? Are we thinking about a mid-teens growth business from here? Or is this something 20% plus?

Robert J. Palmisano

I think in 2013, the growth rate would be substantial, but it's a small base. It's often a very small base. Additionally, that we got some benefit from the small acquisition that we did in the U.K. of about $4 million of revenue. So you would -- I think you're going to see some pretty solid growth rates, but it's off a small base.

Lance A. Berry

Yes. And, Rich, I just wanted everybody to be careful about Q1 in particular. We got a really, really good Q4 for international, and we expect to have a really good year for international. But with the selling days and just early on in our initiatives for international, you may not quite see Q1 as strong as some of the other quarters.

Richard Newitter - Leerink Swann LLC, Research Division

Okay. And did you say that the -- that acquisition, that international acquisition actually benefited 4Q?

Lance A. Berry

No.

Robert J. Palmisano

No, it didn't close until January.

Richard Newitter - Leerink Swann LLC, Research Division

Okay. And were there any extra selling days in the fourth quarter?

Lance A. Berry

There was one extra selling day in the U.S. in the fourth quarter.

Richard Newitter - Leerink Swann LLC, Research Division

Negligible impact or...

Lance A. Berry

I mean, one day is about 1, 1.5 percentage points.

Operator

Your next question is from the line of Mark Landy, Summer Research.

Mark Landy - Summer Street Research Partners

Lance, just quickly, the cash flow assumptions and the impact with BMTI, that, I'm assuming, excludes the favorable resolution of the LOCON [ph] dispute? Or how should we think about that?

Lance A. Berry

Yes, that's correct.

Mark Landy - Summer Street Research Partners

Okay. And when you closed the deal, they do have the international approval. I think they've already started marketing in Australia, some European countries, Canada. How do we think about the international ramp-up as you transition over to your representatives? And then also how do we think about your ramp-up in revenues as with the costs?

Robert J. Palmisano

The -- those are the 2 markets that you mentioned, Australia and Canada, that they actually are in the market and it's in the early days. There -- don't anticipate right now, although, and maybe we could be nicely surprised, a big market for these products in Europe. But so I think that we're looking mostly in the U.S. for the next couple of years to drive the growth in -- of this acquisition. It's just probably not a product that would -- they just look at things differently in Europe. And so I don't think that that is going to be a big market. Australia and Canada could grow, but they're relatively small markets.

Mark Landy - Summer Street Research Partners

Bob, second point. As you kind of look at the cost that you might incur there versus the potential for the revenues, should we think about that as offsetting kind of small losses, obviously not large opportunities, you're not going to spend a lot of cash there?

Robert J. Palmisano

Yes, we're not going to spend a lot of cash there. And these are distributor markets mostly. So it's -- you kind of have to look at it more in the contribution margin basis than anything.

Mark Landy - Summer Street Research Partners

Okay, fair enough. And then just kind of looking at the Extremities growth, you can probably point to 4, 5 drivers there in the market expansion among maybe some new geographies, product line expansion, share taking and I suppose some form of price and mix. How do we think about those as contributors to growth to 2013, maybe 2014 versus 2012?

Robert J. Palmisano

Well, I think that the real opportunities are in penetration. And that it's taking -- doing procedures in a new way. And that's why -- so you have a lot of procedures out there, and there's various ways of traditions can do them. And we feel that in appropriate cases, using a Total Ankle Replacement, for example, rather than the Fusion is a better procedure. So that's really a conversion is making that case, that clinical case to that position and getting them trained and motivated to make that move. So the big area of growth is really in increased penetration. So that's why we think a direct sales force was key, and that's why medical education is so important in an area that we spent a lot of money on and will continue to spend a lot of money on because you're teaching somebody something new and it takes a lot of repetition, a lot of training. So I really think that the growth is going to come from penetration more than anything.

Mark Landy - Summer Street Research Partners

Okay. So that obviously is a multiyear benefit, right? That's something we should think about for the next couple of years?

Robert J. Palmisano

Well, I think it's multiyear, but there's a big market, and it's -- and so there's a big opportunity.

Operator

At this time, there are no more further questions in queue. I would like to turn the call back over to Mr. Bob Palmisano for any closing remarks.

Robert J. Palmisano

Thanks, operator. As you have heard, Wright's transformation is well underway and is working. We are in the early stages of repositioning our company for improved growth and performance. We started this process in earnest at the beginning of 2012, and I believe that we will see continued improvement as we progress through 2013 and beyond by continuing to focus on areas where we can win.

And there is a reason for great optimism as we continue with this transformation. We are building out 2 strong platforms. We have innovative products, we have the right team and elements in place, and we believe that, we believe, will enable us to become a high-growth, high-margin company.

We have both a clear goal and clear ability to improve our performance as our strategy and vital few initiatives continue to gain traction.

In closing, I would like to thank our dedicated employees and distributor partners around the world that made 2012 performance possible. Their talents, capabilities and commitment are the drivers of our success and will continue to be vitally important as we move towards realizing our vision of becoming #1 in customer satisfaction.

Thank you all for being with us today and for your interest in Wright Medical. We look forward to updating you on our progress throughout the year. Thank you.

Operator

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

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