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Exactech, Inc. (NASDAQ:EXAC)

Q4 2008 Earnings Call Transcript

February 19, 2009 10:00 am ET

Executives

Bill Petty – Chairman & CEO

Jody Phillips – CFO

David Petty – President

Analysts

Raj Denhoy – Thomas Weisel Partners

Bill Plovanic – Canaccord Adams

Jason Bernard [ph] – Robert W. Baird

Operator

Ladies and gentlemen, thank you for standing by, and welcome to the Exactech, Inc., fourth quarter 2008 earnings conference call. (Operator instructions) I would now like to turn the conference over to, Dr. Bill Petty, CEO. Please go ahead, sir.

Bill Petty

Thank you, Nicole, and good morning to everyone. Thank you for joining us. We are very pleased to have you. Before we get into the meat of the conference, I do want to go through the normal disclosure statement. This release contains various forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, and Section 21E of the Securities Exchange Act of 1934. They represent the company's expectations or beliefs concerning future events of the company's financial performance.

These forward-looking statements are further qualified by important factors that could cause actual results to differ materially from those in the forward-looking statements. These factors include the effect of competitive pricing, the company's dependence on the ability of third-party manufacturers to produce components on a basis which is cost-effective to the company, market acceptance of the company's products, the effects of government regulation. Results actually achieved may differ materially from the expected results included in these statements.

First, I would like to go through some of the information for the full year, and then we will drill down a little further into the fourth quarter. Revenue for the full year 2008 was up 30% to $161.7 million, that’s from $124.2 million in 2007. Diluted earnings per share for the year were $0.87 based on a net income of $11.1 million. This compares with net income of $8.5 million or $0.72 diluted earnings per share in 2007. Net income for 2008 includes legal expenses of $2.6 million related to the ongoing Department of Justice inquiry.

To break it down a little into the product lines. Knee implant revenue for the full year increased 15% to $72.6 million. Hip implant revenue increased 1% to $22.8 million, with apples to apples comparison that means not including the Link sales in 2007, the growth in the hip product line was 23% for 2008 over 2007. Biologic & spine revenues increased 63% to $26.5 million, and this does include revenue of $7.2 million from our spine acquisition. Shoulder revenue increased 77% to $16.8 million. Other revenue of $23 million is an increase of 85% over $12.5 million in 2007 and much of that increase is due to our acquisition of our French distributor.

Now to go to the fourth quarter; the fourth quarter revenue is $40.3 million, that’s an increase of 22% over $33.1 million for the fourth quarter in 2007. Net income for the fourth quarter was up 15% to $3.1 million from $2.7 million in the fourth quarter of ‘07. Diluted earnings per share were $0.24 for the fourth quarter of 2008 compared to $0.23 in the fourth quarter of 2007. That does include the legal expenses. Without those legal expenses of $391,000, the diluted earnings per share for the fourth quarter would have been $0.26.

Also for the fourth quarter, US sales increased 12% to $29 million and international sales were up 59% or $11.1 million. International sales represented 28% of total sales compared with 22% in the fourth quarter of 2007. For 2008, US sales grew 16% to $112.4 million from $96.5 million in 2007, that's for the full year of course. International business for the full year increased 78% to $49.3 million from $27.7 million in ‘07. Now that includes the impact of acquiring our French distributor. Without that impact, international sales were up a strong 39% during 2008.

In summary, before I turn it over to Jody for some more detailed financial comments, I believe this is another strong year for Exactech with solid double-digit growth in our product lines, and overall revenue increase of 30% to almost $162 million. Our assessment, Exactech growth for the full year was well above double industry growth, and for Q4 was at or above double the industry.

Jody, do you want to make some more comments?

Jody Phillips

Sure, thank you. Good morning, everyone. Thanks for joining us for our full year 2008 and fourth quarter results conference call. Initially, I would like to give a little bit of visibility as to the impact of the acquisitions on our reported sales growth.

Our growth in core product sales, excluding the impact of the 2008 acquisitions and the termination of the Link distribution agreement in 2007, was 11% for the fourth quarter and 24% for the full year. The impact of currency on our reported sales growth was minimum, as our only true local currency denominated revenue were we had a 2007 comparative was our UK subsidiary, and this resulted in less than a 1% impact on our reported growth numbers. We will have a more pronounced comparative exposure upon the anniversary of our French distributor acquisition in the second quarter of 2009, when about 10% of revenues will be denominated in European currencies. At this time, we don't feel that state of exchange rates represent a significantly material enough departure from our estimated conversion to adjust our revenue guidance. Furthermore, a large part of our cost structure in those subsidiaries is denominated in the local currency, so we feel like we have manageable exposure at the income line.

Turning briefly to the gross margin and operating expenses. Our gross margins during the quarter and full year ended up largely as expected with the experience of a 1% reduction, primarily due to the larger international sales mix. During 2009, we are targeting a 50 basis point to 100 basis point improvement in gross margins under the assumption that we have relatively stable domestic/international sales mix and a stable pricing environment, as we continue to benefit from the internal manufacturing efforts.

Total operating expenses increased 28% for the full year and 25% for the quarter, when you exclude the impact of the DoJ expenses. Our effective tax rate for the quarter was 26%, primarily due to the year-to-date catch up of the R&D credit that was reinstated in the fourth quarter, bringing the full year effective rate to 37%, which is approximately what we expect going forward. The resulting 2008 GAAP net income of $11.1 million represented a 31% increase versus 2007.

From a balance sheet perspective, we ended 2008 with $3.3 million in cash, with $14.8 million outstanding on our $40 million credit line. Our total debt, including facility related term debt was $23.8 million as of year-end. Due to increased working capital needs, most notably inventory builds for new product roll outs, we project the credit line debt to increase to approximately $25 million during the middle of 2009, at which time we are projecting to turn cash flow positive.

Our 2008 capital expenditures were in line with our expectations at $14.6 million, the majority of which was surgical instrumentation that was placed into service with both new and existing products. During 2009, we are projecting $15 million to $18 million in total capital expenditures. From an inventory standpoint, we ended the year with $61.2 million in total inventory, which represented a $17.7 million increase; approximately half of this increase was due to our spine and French distributor acquisitions. Looking forward for ‘09, we expect total inventories to continue to increase modestly through the first half of the year and then level out for the second half of the year.

Our accounts receivable at year-end was $31.8 million, which reflected 61 days of our total days outstanding for the full year as compared to 59 for the full year of 2007, as we did experience slight extending of terms by our customers, particularly in the fourth quarter. We’ve released our first quarter ‘09 revenue guidance at $42 million to $45 million, which ranges from 6% to 13% sales growth, and also we’ve released our first quarter 2009 EPS guidance of $0.24 to $0.26 diluted earnings per share, and this does exclude the impact of our first quarter DoJ expenses.

That's my comments for our now, and thanks again for joining us.

Bill Petty

Nicole, we are ready to open up for the questions now.

Question-and-Answer Session

Operator

(Operator instructions) Our first question comes from the line of Raj Denhoy with Thomas Weisel Partners. Please go ahead.

Raj Denhoy – Thomas Weisel Partners

Hi, good morning guys. I wonder if I could start on the knee line, it was up about 3% in the quarter, which was significantly lower than we’ve seen over the last couple of years, actually. And I'm curious why that number was down so much.

David Petty

Yes, Raj, it's David. A couple of things going on there, and I think maybe the most important one is that domestically we have, I guess like others have reported, we've seen a little bit of an effect of the general economic conditions in terms of impact on the elective procedures. But in our world, we don't think that that should have as great an impact on Exactech because of the smaller market share position we have. And quite simply, for Exactech to increase market share in this environment, we don't think – we think it’s the right strategy. And we are counting on the new products, particularly something called the CR slope version of Optetrak to help drive that market share number domestically. And we had a modest introduction of that in the fourth quarter, though not an appreciable impact on the number of new customers. And we will be increasing the number of sets available for that product in the first quarter to about 50 sets. We think that that is really the answer for us to sort of perceiver under more difficult economic times. I also will point out that we had just timing of some international orders at the end of the third quarter that they came in kind of strong at the end of third quarter. So the fourth quarter internationally was a little bit off of what we would have expected. I think those two things taken together brought that number down in the fourth quarter. But we think that's a temporary thing.

Raj Denhoy – Thomas Weisel Partners

Okay. Just to follow up, you mentioned you’re not seeing slowdown in procedures. So if you look at –

David Petty

No, no, I'm sorry Raj. If you thought I said that I misspoke. What I said is that we are seeing a slowdown like what we think has been reported elsewhere, which is part of the reason for our declining growth domestically in the fourth quarter. But what I'm trying to point out is at a relatively small market share position, it doesn't take very many additional customers added to our customer base for us to overcome any slowdown that might affect the market in general. And we are counting on the CR slope, specifically in the knee for that. We also are relying upon some other new products in the hip line, and other parts of our business to do the same thing.

Raj Denhoy – Thomas Weisel Partners

Okay. So I do appreciate that. So if I'm corrected, the two points you sort of pointing to for the knee slowing is, one I guess some slowdown in procedures, then also I guess some stocking as you saw in the third quarter that sort of eroded some of the growth you might have seen in the fourth quarter. Is that correct?

David Petty

Precisely.

Raj Denhoy – Thomas Weisel Partners

Okay. And so then if we look out into 2009, should we look for knees to come back to this sort of mid-teens growth rate in the first quarter and beyond?

David Petty

Raj, you know we don't tend to breakout our guidance by segments, but I guess what I'm saying is we've always been comfortable that Exactech should be growing at roughly twice the market growth rate, is the general statement. And we feel like we have the product launches in the pipeline to sustain those kinds of growth rate.

Raj Denhoy – Thomas Weisel Partners

Okay. Fair enough. I will ask one more and get back in line. The Department of Justice expenses continue to be somewhat lumpy. They were quite a bit lower here in the fourth quarter than they were last quarter. What should we expect for those lines now as you move to 2009?

Jody Phillips

They were lumpy on the low side in the fourth quarter. That means they might be lumpy on the higher side in current quarter.

Bill Petty

Raj, this is Bill speaking. It depends on the legal activity, and when the legal activity steps up, then the expenses go up.

Raj Denhoy – Thomas Weisel Partners

How should we think it, in the sort of $0.5 million to $1 million range, is that kind of –?

Bill Petty

I can't predict. That's one of the reasons when we give our guidance we just don't know how to put that number in because if you remember back in the summer it was way more than we thought it would be. So we just do not know how to predict because, frankly it is not in our control.

Raj Denhoy – Thomas Weisel Partners

Okay, fair enough. And I'm just going to ask one more and jump back. This idea of some slowing in procedures, you guys did reiterate your guidance for 2009 on the top line, have you incorporated into that some potential slowing in procedures in 2009?

Jody Phillips

We have, based on the knowledge that we had at the time we formulated that guidance, and at that time we have seen a little bit of slowing, I’m talking about back in October. And so to the extent that things stay as they are, we are comfortable. If we see any further change, obviously we would modify that guidance. But as of right now, we are comfortable with it.

Raj Denhoy – Thomas Weisel Partners

Okay, great. Thank you a much.

Bill Petty

Thank you, Raj.

Operator

Thank you. Our next question comes from the line of Bill Plovanic with Canaccord Adams. Please go ahead.

Bill Plovanic – Canaccord Adams

Thank you. Good morning.

Bill Petty

Good morning, Bill.

Bill Plovanic – Canaccord Adams

Can you give us a little preview for your first and second quarter in terms of the product launches, you already mentioned CR slope with the increased instrument sets. And then, with regards to give us a little preview of AAOS (inaudible) product. So, can you just please share that with us?

David Petty

Absolutely. Bill, it's David again. CR slope I did mention, we’ve put – and often times in the past, follow the number of sets that we deploy. We put about 20 sets this past product holiday at the end of the fourth quarter, and there will be an additional 30 sets rolled out during the first quarter. Sticking with the knee line and moving to the summer time, we will be putting out 25 sets of the PS logic knee system for what I would call early evaluation with the designers and clinicians. We're going to be launching 50 sets of what we call the LPI instrumentation to allow for so-called minimally invasive procedures on the tibial and patellar side of the knee instrumentation system, and that will be 50 sets this summer. Moving to the hip, we have launched a modest 10 sets of our Novation Element and we will add an additional 25 sets in the first quarter, which will include options for direct anterior approach for a number of those sets. We also have a fracture system under Novation, a medic [ph] facture system that will be launched in the second quarter, as well as a line extension to our Standard Cemented Novation Hip. We are throughout this year going to be launching a new version of the InterSpace Antibiotic Spacer that allows for a higher release rate of the antibiotic. And in Biologics, this summer will be launching a bone marrow aspirate concentrate system. And in the spine, we will continue to rollout our First Ion [ph] pedicle screw and Rocheware [ph] surgical plating system.

Bill Plovanic – Canaccord Adams

Okay. That's helpful. Can you give us some color on the cartilage deal that you’ve signed?

Bill Petty

Sure. We signed an agreement with Research Institute in Taiwan. And they had taken this project to the stage of what we felt was a pretty impressive animal studies. We have a team working on it from Exactech combined with a team in Taiwan. We are not in a pharmaceutical industry but soon we will begin what would typically be called a Phase 1 clinical study. And though, we recognize it is a little aggressive, we look forward to doing a – those are – that’s in Taiwan and we are looking forward to a more extensive study and hopefully beginning in the fourth quarter of this year. And we are going to be meeting with the FDA to determine if that study might even give us the capability to apply for a PMA in the United States. We don't know about that. So we are working on the full strategy from a regulatory standpoint, but that product is getting very close to its first clinical use.

Bill Plovanic – Canaccord Adams

Okay. Interesting. And then is there anything in the scientific community that we can find on this, or is this pretty much been underwrapped at the research at Taiwan at this point?

Bill Petty

There are some papers published in scientific journals. Other than that, it’s I guess underwrapped from the standpoint of our actually development at this time, because we don't – it's not that we are trying to be secret, it's we just don't have anything to report other than what I've said and what's in the scientific journals.

Bill Plovanic – Canaccord Adams

And, change gears here. Considering that you are already, you're more than a month and a half through the first quarter. You can see kind of what the surgery calendar looks like for the next 30 years, 60 days. And the guidance you've given us, you have strong confidence that that $42 million to $44 million you took that all in account upon giving the guidance, correct?

Bill Petty

Well, Bill, you know that we can't talk about the first quarter, but you said what we know and we wouldn’t be very smart if things have totally fallen apart to stay with those numbers, would we?

Bill Plovanic – Canaccord Adams

Okay. And then lastly, the distribution at this point is typical, and if it had any direct number as we exited the year?

Jody Phillips

The numbers as we exited the year was 41 agencies and 222 sales reps in our orthopedic, traditional core product business meaning hip, knee, shoulder and arm; and Biologics salespeople as you know we have a separate sales force with the spine. And I’ll just point out, we closed 2007 with 205 reps as we reported. So that's an additional 8% throughout the year.

Bill Plovanic – Canaccord Adams

Okay. Fantastic. And then just, last is spine. That was a nice jump back up to the 2 million-ish level. Is that new customers? Is that more procedures with your existing customer base? Is that more product in per procedure? What would you attribute that to?

Jody Phillips

I think it's both. Additional sales with existing customers and some new customers recognizing, we have a very, very small customer base, and it doesn't take very much of either to see an impact in the number at this stage.

Bill Plovanic – Canaccord Adams

Okay. Great. Thank you, that's all I had.

Bill Petty

Thank you, Bill.

Operator

Thank you. (Operator instructions) Our next question cops from the line of Jason Bernard [ph] with Robert W. Baird. Please go ahead.

Jason Bernard – Robert W. Baird

Good morning guys.

Bill Petty

Good morning, Jason.

Jason Bernard – Robert W. Baird

The first question was wondering – you know you mentioned that FX had about a 1% impact in the quarter. We wonder if that’s isolated to knees at this point or shoulder and biologics revenue outside the US big enough to being impacted as well.

Bill Petty

The exposure there was primarily in the knee in the UK subsidiary, it’s primarily need business.

Jason Bernard – Robert W. Baird

Okay, wonderful. And then as we think about FX for '09, I'm sorry if I missed this, but you can help us break out your exposure, and FX assumptions have you included in the ’09 guidance?

Bill Petty

Of the 10% of our total revenues that I said was at European currency exposure, about 80% of is exposed to the Euro. And the other 20% is to the pound. And our – we are probably between at today's conversion rates, we are about 5% to 10% lower than where we had originally pegged. So at this point, we didn't feel it was significant enough to adjust anything. But obviously it stains [ph] as the dollar continues to strengthen significantly as it has over the last quarter. Then there could be some adjustments.

Jason Bernard – Robert W. Baird

Okay, sure. Fair enough. And most of the continuing education courses you have scheduled for 2009 cover three products, the CR slope you mentioned, the knee, Novation Element, hip, anterior approach and the Equinoxe shoulder. It would seem these then represent the greatest growth opportunities in 2009. But can you (inaudible) ranking order, or at least qualitatively how do you think about the opportunities these products provide in ’09?

Bill Petty

That's a great question. And you're right on the money in terms of what we expect will help us gain market share by bringing new customers, and the idea here is with the technology, particularly with the reverse shoulder and also with the CR slope we think we've got a better mouse trap so to speak, something that will appeal to surgeons and help them do a better job taking care of their patients. And we are seeing based on the surgeons who are signing up for these labs, in fact we are drawing new surgeons to the Exactech world through these products, to this technology. And then with the Novation Element, hips damage, really I think the attraction is the direct anterior approach or instrumentation that we have to allow through a slightly different surgical approach, which is appealing to patients because in theory it is a less invasive procedure that patients can recover from more easily. And so I would hesitate to place a relative importance on any one of the that, I think each of them within their respective business segments are equally important and have the potential to make a meaningful impact on the growth of our business this year.

Jason Bernard – Robert W. Baird

Okay. That makes sense. And then last question, any update on your Japanese opportunities for new product approvals, especially with regards to products?

Bill Petty

I’m sorry, you said Japanese approval registrations. We do have registration for our knee product line, and a very limited registration for our hips. And we are in process to have the registration for our hips in Japan. But I will hesitate to give a date as to when we expect that at this time.

Jason Bernard – Robert W. Baird

All right, great. That's all I got, thanks guys.

Bill Petty

Thank you, Jason.

Operator

(Operator instructions) And there are no further questions at this time. I would like to turn the conference back over to Dr. Petty for any closing remarks.

Bill Petty

Thank you, Nicole, and thanks to everyone for joining us. Thank you for your confidence in Exactech, and have a great day. Bye-bye.

Operator

Ladies and gentlemen, this concludes the Exactech, Inc., fourth quarter 2008 earnings conference call. Thank you so much for your participation. You may now disconnect.

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