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Exactech, Inc. (NASDAQ:EXAC)

Q4 2012 Earnings Call

February 27, 2013, 10:00 am ET

Executives

Bill Petty - Chairman & CEO

Jody Phillips - CFO

David Petty - President

Analysts

Bill Plovanic - Canaccord

James Sidoti - Sidoti & Company

Jason Bednar - Robert W. Baird & Co.

Mark Landy - Summer Street Research

James Terwilliger - Benchmark Company

Operator

Good day ladies and gentleman and thank you for standing by. Welcome to the Exactech, Inc. Fourth Quarter and 2012 Full-Year Results Conference Call. During today’s presentation, all parties will be in a listen-only mode. Following the presentation, the conference will be opened for questions. (Operator Instructions) This conference is being recorded today, Wednesday, February 27, 2013.

And I would now like to turn the conference over to Dr. Bill Petty, Chief Executive Officer. Please go ahead sir.

Bill Petty

Thank you and good morning from at least for today, sunny and warm Gainesville, Florida. As we usually do, I'll start with the disclaimer.

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 our products, compliance costs and the effects of government regulation. The results actually achieved may differ materially from the expected results included in our statements.

Exactech’s revenue increased 9% to $224.3 million for 2012, that's from $205.4 million in 2011. Net income was $12.7 million resulting in earnings per share for the year of $0.96. This is an increase of 44% from the net income of $8.8 million or $0.67 per share in 2011.

I am now going to mention some of the segment performance for the full-year. Our knee implant revenue increased 2% to $81.4 million. Extremity implant revenue was up 30% to $52.1 million. Hip implant revenue rose 21% to $40.8 million. Biologic and spine segment revenues increased 1% to $24.5 million and our other revenues decreased 6% to $25.6 million.

Now to provide a little more information that's typically about the fourth quarter. For the fourth quarter of 2012, revenue was $59.3 million which is an increase of 12% over $53.1 million for the same quarter in 2011. Net income for the fourth quarter of 2012 was $3.9 million or $0.29 per share. This compares to $1.8 million or $0.14 per share for the fourth quarter of 2011 and is an increase of 113%.

For the segment and the fourth quarter knee implant revenue was up 3% to $20.7 million. Extremity implant revenue increased 35% to $14.9 million. Hip implant revenue increased 12% to $10.4 million. Biologic and Spine segment revenues were up 9% to $6.4 million and other revenues increased 3% to $6.9 million.

Now turning to geographic distribution. For the fourth quarter, international sales increased 10% to $21 million while U.S. sales grew 13% to $38.3 million. For the full-year, U.S. sales were $145.6 million and international sales were $78.7 million. This is a 9% increase for each of these geographic segments.

For 2012, our strong results are due to the growth in the U.S. and excellent performance in Latin America and Asia, somewhat offsetting less robust performance in Europe. We were especially pleased with our operating margin improvement and the 44% increase in net income for 2012 compared to 2011. Certainly, this is in part due to lower compliance costs.

I want though to congratulate and thank Exactech people worldwide for producing our robust sales increase and for their focused efforts to control cost and improve efficiency. These improvements had a major positive impact on Exactech’s margin for 2012.

I am now going to turn it over to Jody Phillips to give a little more financial and operations information. Jody?

Jody Phillips

Good morning everyone. Thank you for joining us for the fourth quarter and full-year 2012 conference call. We ended 2012 on a strong note and are pleased to be able to review these results with you today. In order to review our 2012 operating performance and outline our expectations for 2013, I am going to review each of the operating line items from a percent of sales perspective.

First, looking at our gross margin percentage, during 2012 that expanded from 68.4% to 69.4%, which was at the high end of our initial 50 to 100 basis point expectation. This was a result of continued reduction in our manufacturing cost and a higher mix of OUS business through our direct operations which offset modest pricing pressure that we experienced in the U.S. market.

Our 2013 operations will be impacted by the medical device excise tax component of the new healthcare law, which as many of you know is 2.3% of U.S. sales. We expect the cost of this tax to be reported through cost of goods sold and project that the tax could cost as much as $3 million during 2013. In order to offset the impact of this tax, the employees in our organization have been focused since the Supreme Court decision last June in order to improve distribution efficiencies and our cost structure and we are projecting that we will be able to offset roughly two-thirds of the tax and therefore mitigate the impact to our 2013 operating profit percentage.

From a sales and marketing expense perspective, the full-year 2012 increase of 6% was below our sales increase due to operating leverage from our OUS global office operations, where the growth outpaced the increase and expenses. During 2013, we expect sales and marketing cost to increase between 3% to 6% primarily due to variable selling expenses and this will result in a range of 36% to 37% as a percentage of sales.

Our 2012 general and administrative expenses decreased to 8% of sales primarily due to reductions in our compliance spending which was roughly half of the $4.5 million that was spent in 2011. During 2013, we expect G&A expenses to increase modestly and remain in the 8% to 9% of sales range.

2012, R&D expenditures increased 29% to 7.5% sales, and we expect R&D spending to continue to increase at roughly 12% to 16% rate and increase to a range of 7.5% to 8% of total sales.

Our 2012, total operating expenses therefore increased 6%, but decreased to 59.8% of total sales and we project approximately 4% to 7% increase for 2013 and therefore this will result in total operating expenses as a percentage of sales to range from 58% to 59%.

Looking at our tax rate, our 2012 effective tax rate was 36% versus the 34% experienced in 2011. This was partially due to adjustments as a result of an IRS audit ranging from the periods of 2009 to 2011 that we now believe is largely complete. Our current expectations for 2013 for our base effective tax rate of 34% and this excludes the impact of the reinstatement of the R&D credit for 2012.

As a result of these targets for 2013, the midrange of our 2013 earnings guidance roughly equates to an 8% increase in net income remaining at roughly 6% of sales which implies operating expenses leverage and tax reductions to offset the impact of the medical device tax that will be reported through cost of goods sold.

From a balance sheet perspective, we made significant progress during the year by decreasing our total debt by almost $6 million to a total of $41 million. During the year, we also completed a five-year renewal of our credit facility providing us a $100 million in total borrowing capacity that is currently adequate as we project to be modestly cash flow positive during 2013.

Our full-year accounts receivable day sales outstanding remained constant at 75 days for the full-year of 2012 and that was the same that was for 2011 and we are expecting similar numbers for 2013 as well.

Total CapEx during 2012 decreased to $22.4 million as compared to $24.9 million in 2011. And we are projecting approximately $21 million in CapEx spending for 2013. An area of major focus for us has been our inventory management where we are able to increase our inventory returns during 2012 to 1.06 from 0.93. Clearly, we feel like this continues to be an area of significant opportunity for us and supply chain management is one of our key initiatives for 2013.

In summary, and back to our 2013 guidance, we released our full-year revenue guidance of $236 million to $242 million which represents a 5% to 8% top line growth and diluted EPS of a $1.03 to $1.09. Our first quarter revenue guidance of $60 million to $62 million represents a 2% to 6% increase which is expected to result in first quarter diluted GAAP EPS ranging from $0.28 to $0.30 which includes a $0.03 impact of the reinstatement of the R&D tax credit as it related to 2012.

Those are the prepared comments that I have at this time and again thanks for your time this morning.

Bill Petty

Thank you. We are ready to have questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) And our first question comes from the line of Bill Plovanic with Canaccord. Please go ahead.

Bill Plovanic - Canaccord

I have a couple of questions here. Just you talked about the spend in R&D for 2013, you know, it’s going up a little. I'm just curious what are you spending the money on, is it near-term projects, longer term projects, PMA, 510(k) and a little color might be helpful there and then you know that parlays into kind of the new products that you referenced in your comments.

Jody Phillips

It’s definitely a combination of all the things you listed in terms of where we are spending the R&D money, a lot of activity in terms of base product, in terms of base product line and 510(k) approvals.

As you know, we currently have an active project to complete our PMA application for the rotating bearing knee and that is a project that we've invested on a trial basis for a number of years on.

And then we have longer term projects, its typically the cartilage project that is clearly a longer term investment but it is very material part of our spend as well and in terms of characterizing how that is changing compared to the prior year, I'd characterize it as being virtually the same in terms of the mix among the different types of initiatives. And I am not sure I got your second question.

David Petty

So Bill, for the pipeline for the launches for this year, we obviously continue to transition to our logic platform in the new systems and in addition to that, we will be launching the porous coated version of Logic and Logic cruciate retaining knee as well as what we call a CRC or CR constrained to the insert. And then notably, in the second half of the year, we hope to begin to launch a computer assisted surgery system that that’s a big part of the R&D spend as well.

And hip we made reference in the press release to some products that we had intended to launch, some of them last year, which we are launching now in the first half of this year, notably the large heads and liners for our Crown Cup which were held up with the FDA for about six months last year and the InteGrip Porous Metal product, we're expanding the limited launch of that, the revision system with modular acetabular augmentation availability and then the probably in the second quarter, a limited launch of the neck preserving stem.

In shoulders, we have actually some improved instrumentation for our proximal humeral fracture plate which has been out on the market now and fully launched. Equinoxe CTA humeral head that we will launch in the first quarter of this year, Cage Glenoid expected to fully launch in the second quarter and subscap preserving TSA instruments that will be in pilot in the second quarter. Longer term a re-servicing project, that go into pilot in the third quarter of this year and of course then there is the ankle project which is really a 2014 watch. And then a number of line extensions and the few launches in the spine space as well.

Bill Plovanic - Canaccord

Okay. And then housekeeping question and I'll jump off, just 2013 D&A, stock comp, and FX impact that you are putting out there?

Jody Phillips

A lot of questions there. Depreciation and amortization, we would expect it to be at a similar percentage of sales. Stock compensation will be at a similar dollar levels that we project or we experienced in 2012. So it shouldn’t go down slightly as the percentage of sales and in terms of the FX that’s anyone's ball game right, certainly where the Japanese yen now is going to be working against us slightly and that somewhat factored into our guidance. But we pretty much pegged our projections based on euro being at a $1.30 and the Japanese yen being at about 85. So that’s the frame of reference of where we modelled things out.

Operator

Thank you. Our next question comes from the line of James Sidoti with the Sidoti & Company. Please go ahead.

James Sidoti - Sidoti & Company

Well, as long as you are going over the assumptions the other two I had were, what your assumption is for pricing in the US and for components costs?

Jody Phillips

The pricing in the US what we are expecting is kind of things to continue as we have been experiencing as that 1% to 3% type reduction depending on the product group. And then the compliance spending, it will now stabilize that the level that we experienced in 2012, so there will not be any leverage in that area that we experienced in 2012, we won't have that benefit in 2013 where we expect it to be stable.

James Sidoti - Sidoti & Company

Okay, and then you talked about the computer assisted surgery system, is that something you are going to charge on a system basis or will you charge on a procedure basis?

David Petty

There are couples of different models but obviously the intention is to sell the systems to the hospital and then there is a disposable kit that goes with it that we would charge for as well.

James Sidoti - Sidoti & Company

And is that primarily for the knee business?

David Petty

There are future versions that will apply to shoulders and also the hips but the first stage is with knee, and that's all that would be available in 2013.

James Sidoti - Sidoti & Company

Okay, and then just can you comment on the trend in the knee business, it was up I think 1% in the first half of the year, just to be picking up a little bit in the back of the year, and do you think that continues to accelerate in 2013?

David Petty

That is certainly our intention, the way that the economies worldwide have been and some uncertainty about healthcare and all those things has been increasingly difficult to be accurately predictive about, how the patients are going to show up, but in spite of that we are certainly projecting the momentum that we saw in the second half of the year to continue into 2013.

James Sidoti - Sidoti & Company

All right, and then my last question is on the sales force, just comment on are you happy with where you are right now, you think you will be adding a few more this year any other changes there?

David Petty

We actually had and I have talked about not in a lot of detail perhaps for obvious reasons but over the last 12 to 15 months, we’ve had really quite a lot of change in our domestic sales organization, and I mean change for the good. I mean hiring experienced sales professional who are starting to show results in delivering new business, and so we expect to continue that approach to managing the sales organization, identifying high quality people that bring into the fold and as with any sales organization where we have non-performers we will move on. So we are going to continue that.

Operator

Our next question comes from the line of Jason Bednar with Robert W. Baird & Co.

Jason Bednar - Robert W. Baird & Co.

First for David or Jody, I just want to start with your revenue guidance. The midpoint of your guidance obviously suggests another year of above market growth despite being a bit slow in what we've seen in recent year from you guys. The thing we are trying to understand is how to think about the product mix within your 5% to 8% growth guidance.

Even if we assume that growth in your shoulder business moderates to maybe the mid-20% range. Your guidance would then imply your other businesses are relatively flattish or maybe up a little bit in 2013. Is that the right way to think about hip, knee and spine franchise? I know you just commented that knee probably continuing a little bit of that momentum in 2013, but maybe we are a bit ahead of ourselves in the extremity side.

Jody Phillips

No, I think maybe the missing element there Jason is our other segment. As you know there are some products that we are distributing of other companies outside the US; and for a long time we've been projecting that that element we expect to transition or loose some of that business and I think you will continue to see that happen. So one of the things you may want to factor into your model is having a sales reduction in the other segment and then given your assumptions there on the shoulder that still would imply probably some growth in hips and knees.

Jason Bednar - Robert W. Baird & Co.

Next one is for Dr. Petty, Tornier is launching a revision friendly stem, a move that addresses 30% of the market which they really didn't have a good product and a move that may help stem some of the share loss they have seen in recent years of which we assume Exactech has probably benefited. So first question is there any way to quantify how much exact shoulder spine care in recent years may have been coming from Tornier and second does Tornier coming into this market put Exactech at any risk of surgeon trialing or share losses over the coming quarters.

Bill Petty

Most certainly we see Tornier as a strong competitor. They have been in shoulder business for a long time and been very successful with it. We have certainly not targeted any specific brand or company in our shoulder launch and our continuing revenue growth.

As you know the DePuy Global Shoulder has kind of been the market leader just a little ahead of Tornier for a long time. So we expect our competitor to introduce new products. Our goal and our extremities business is to take the great platforms that we have and continue to improve those and stay ahead of our competitors, and we believe that our group is doing a good job of doing that and our intent is to continue to do so.

Jason Bednar - Robert W. Baird & Co.

And then Jody coming back to you for the last couple of questions, 2012 was a nice bounce back for operating margin against what we were relatively easy comps in 2011, but it sounds like you continue to expect some incremental leverage in 2013. We are wondering how much of this margin expansion is coming simply and continuing to recapture loss margin when you went through your European selling transition and then thinking of longer term view how sustainable is this market expansion over the coming years.

Jody Phillips

Yeah, I think you are on to something there. There is continued operating profit improvement in our direct operations outside the US; that certainly was the benefit in 2012, implied in our guidance for 2013, is very modest continued improvement in operating margins and our direct operations outside the US and I don't think 2013 will be the last year of that. It really will be dependent on how the economies perform. I mean if we get the top line expectations that we're thinking over the next couple of years that margin expansion in those markets certainly can continue for two or three more years.

Jason Bednar - Robert W. Baird & Co.

Is there any kind of number you would quantify there beyond 2013 about 100 bps?

Jody Phillips

You know, we certainly said publicly before that we expect to expand operating margin about 50 to 150 basis points per year. It was obviously going to be, we're challenge with that for 2013 as you know due to the introduction of the medical device tax but thinking about an annual expansion of 50 to 150 basis points, the 100 basis points per year company wide I think is where we would target.

Operator

Our next question comes from the line of Mark Landy with Summer Street Research. Please go ahead.

Mark Landy - Summer Street Research

Jody, you mentioned where are you going to put the medical device taxes. It's going to be absorbed in cost ing cost or is it a line item in expenses?

Jody Phillips

It won't be an inventoriable cost that will effectively be reported through COG.

Mark Landy - Summer Street Research

Did you give any guidance as what you feel there the impact would be in 2012?

Jody Phillips

We're projecting to incur about $3 million in cost related to the medical device tax in 2013.

Mark Landy - Summer Street Research

And then as an (inaudible) is more towards Dr. Petty. In terms of the clinical trials being Biologics that you kind of discussed early on last year. How should we think about that in terms of the R&D budget is that still a little bit of a variable cost depending on how the product does early on in the studies or should we see some form of a pick up in R&D as those [pick] and how does that impact on R&D budgeted spend here?

Bill Petty

I think the cost this is Bill Petty speaking. I think the cost we are seeing related to the cartilage project are going to be going forward with in a relatively stable fashion not with substantial increases. So I don’t think you will see a major impact in the overall results from changes there.

Mark Landy - Summer Street Research

Okay. And Jodi you said you (inaudible) we did see a couple of other companies’ report the price orders coming out of Spain and nobody was really to call that these are going to be consistent. They were “surprising”, how do we think about the gross margin impact from that and what is your expectation suppose to be or specific before this, not for Spain given that it is a big focus for you guys, and could this be a (inaudible) in December or anything at the end of last year that perhaps contributed some of the margin improvement?

Jody Phillips

We are not aware of any surprise type business in Spain. I will remind you that we are on a consigned model where we recognize revenue once it's implanted in patients, though. It is not a stocking model, there are no stocking orders in the Spanish market. In our revenues the only blip we had in 2012 is there was major payment of existing accounting receivable in June, but we discussed on the third quarter call. So I am not sure if you are referencing supply business or something different, but we did not experience any spike in the orders anytime during 2012 in the Spanish market.

Mark Landy - Summer Street Research

Okay, and then just steady as it goes in Europe kind of maybe just trying to reach the bottom but certainly not expecting any fireworks.

Jody Phillips

Yeah, I think that probably the clear way to characterize this. Day today as you know I think maybe the bottom is reached. It’s not been going backward at least for Exactech which was different then it was a year and year half ago.

Mark Landy - Summer Street Research

All right, and I want just lastly, I know that you are a small part of the business but perhaps maybe you can give some color on, some of the largest spine competitors perhaps a little bit more optimistic as they seem less rebound interest (inaudible) last month I think (inaudible) just a lot of cold water on that. Anecdotally how are you guys thinking about spine just specifics maybe procedure volume and then also insurance claims are expecting that to get more difficult or stay the same?

David Petty

Procedure volume is not the issue and it’s hard to use our experience to make sense out of the market. I say that only to point out that our spine business is very small and for us its all about getting a reasonable bag of good products that solve problems for surgeons, and one customer at a time building a business. And as we get a more comprehensive range of product we’ll have the capability of the attracting more qualified, experienced sales people. So we are sort of in a guerilla warfare game in the spine business and whether procedure volumes are up or down, we are counting on one customer at a time and we are happy to report that that business for us has stabilized and has begun to grow and we are proud of the work that our development teams and sales and marketing teams have done and expect them to make contributions to our top line growth in 2013.

Operator

(Operator Instructions) Our next question comes from the line of James Terwilliger with Benchmark Company. Please go ahead.

James Terwilliger - Benchmark Company

First of all, thanks for taking my question, second of all great fourth quarter, most of my questions have been answered but I've got two quick questions. When I look at the extremities business in the fourth quarter is up 35%. I know this has been a great growth driver for you guys, very attractive product line for your company but the 35% was a tremendous number; can you talk a little bit more about what drove that 35% growth in extremities in the fourth quarter?

Jody Phillips

More of the same, as there were no major new product launches, it really was predominantly driven by new customer acquisition in the US and continued growth in a couple of markets outside the US notably in Latin America. I think that's the main driver.

Bill Petty

This is Bill speaking, maybe partly as a surgeon and partly as a CEO, for many years and especially when I was more active in practice frankly our shoulder results were not all that good. We were able to provide pretty good pain relief to patients but the function that we are able and by we I'm now using a broader term for the industry, we are able to provide much improved function for the patient. Now because in the past there were not a whole lot of shoulders replaced, most surgeons were were not trained to do so and our program in training I think has been very good and has provided the expertise that surgeons needed to provide the care that their patients really deserve to have and wanted to have, and I think that has been a strong reason for our growth and I believe that we are, I won't say we are in the early stages of that but I'd say we are still very much in the middle part of that process. It should be good not only for Exactech shoulder business but I think for the industry in general.

James Terwilliger - Benchmark Company

Well, you've done a great job with that product line. It’s just been a great growth driver even during the down orthopedic market over the last couple of years. Switching to a different question and you mentioned a little bit maybe some of the extremities business going international, it seems like you've done a very nice job in growing your international business with growth coming out of Latin America and Asia. Is there anyway you can quantify. I know you want to be sensitive here, but could you quantify maybe the downturn as a growth rate of what you are seeing with your business units over in Europe. I'm trying to calculate how much pressure Europe is, maybe it’s not getting worse but how much pressure looking backwards has it put on the international growth rate.

David Petty

So for 2012 let's just say Europe was essentially flat with actually impressive growth in a couple of markets and depressing news in a couple of others.

James Terwilliger - Benchmark Company

And then lastly and maybe this is for Jody, Jody when I'm looking at the CapEx for next year, how is the transition going from maybe outsourced manufacturing to bringing some of those components in-house. Could you update me in terms of the capacity that you are bringing in-house from a manufacturing standpoint?

Jody Phillips

Sure. Our percentage that we're manufacturing internally is remaining relatively stable on implant. So we're picking up total volume there as we're keeping up with the pace of the business growth. We continue to target implant lines to bring in-house where we can make a meaningful cost impact.

We have increased our percentage of production significantly in terms of the instruments that it's a very low number. I don’t have an exact figure for you but in our Sarasota operations, we continue to manufacture more and more of our instruments internally; still a very low percentage. And the bulk of that CapEx for next year, again is surgical instruments specifically with the roll out of our logic knee system and the shoulder more Equinoxe shoulder system and it's still a pretty low percentage that we manufacturer in-house of these instruments.

Operator

(Operator Instructions) And Dr. Petty, I am showing no further questions at this time. Please continue with closing remarks.

Bill Petty

Thank you, [Katie] and thanks to all of you for joining us. Thank you for your interest in Exactech. Our goal as always is to reward the interest and confidence you have in us and hope you have a great rest of the week. Bye, bye.

Operator

Ladies and gentlemen, this does conclude our conference for today. You may now disconnect. Thank you for your participation.

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