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Greatbatch Inc. (NYSE:GB)

Q4 2008 Earnings Call

March 3, 2009; 05:00 pm ET

Executives

Thomas Hook - President & Chief Executive Officer

Thomas Mazza - Senior Vice President & Chief Financial Officer

Marco Benedetti - Corporate Controller

Analysts

Tim Lee - Piper Jaffray

Jason Mills - Canaccord Adams

Keay Nakae - Collin Stewart

Stan Manne - Manne Family Investments

Operator

Welcome everyone to the fourth quarter Greatbatch Incorporated conference call. Before we begin I would like to read the Safe Harbor statement. This presentation and our press release contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 and involve a number of risks and uncertainties. These risks and uncertainties are described in the company’s annual report on Form 10-K.

The statements are based upon Greatbatch Incorporated’s current expectation and actual results could differ materially from those stated or implied. The company assumes no obligations to update forward-looking information included in this conference call to reflect changed assumptions, the occurrence of unanticipated events or changes in future operating results, financial conditions or prospects.

I would now like to turn the call over to today’s host, Corporate Controller, Marco Benedetti; please proceed.

Marco Benedetti

Thank you. On the call today are Thomas J. Hook, President and Chief Executive Officer, and Thomas J. Mazza, Senior Vice President and Chief Financial Officer.

In terms of today’s agenda, Tom Hook will start by providing a few brief comments regarding our fourth quarter and year end results and then he will provide comments relative to our major strategic initiatives. After that, Tom Mazza will provide further comments on our fourth quarter and year end results, as well as our 2009 guidance release today. We will then open up the floor to Q-and-A. As we have done in the past, we are including slide visuals that will go along with this presentation, which you can access on our website.

Let me now turn the call over to our President and Chief Executive Officer, Tom Hook.

Thomas Hook

Thank you, Marco. I’d like to thank everyone listening for joining our earnings call. We are pleased to able to share with you our results for the fourth quarter and full year. I am proud of our accomplishments in 2008 and the fourth quarter capped off what has been a very successful year for Greatbatch.

Furthermore, this year provides additional evidence of our execution and progress towards achieving our long term strategic initiatives of growing and diversifying our revenue base, delivering innovative solutions to our customers and driving improved operating performance.

2008 was a year of focus, execution and momentum building for Greatbatch. We met both our operational and financial goals set for the year and made solid progress towards our long term strategic initiatives. I believe that our portfolio of intellectual property, great operational capabilities and diverse revenue base has built a strong foundation for the company to carry us into 2009 and beyond.

During 2008, we continued to deliver solid revenue growth with sales increasing 71% over the prior year, which correspondingly drove adjusted operating income to increase from $43.7 million to $58.1 million or 33%. From the first half to the second half of 2008, we saw growth in our operating margin driven by streamlining operations and improving manufacturing and administrative efficiencies.

We remain committed to ongoing improvements in our operating performance through continued facility consolidation and integration, optimizing our production efficiency and product development activities focused on high value added products. Tom Mazza will provide additional detail in our fourth quarter financial results later in the call.

We are particularly proud of our strategic acquisitions and the progress we have made in integrating them. The acquisitions have enhanced the overall diversification of our business and will create additional opportunities to leverage the core operational and product development strengths of the company.

Our diversification strategy is one of our key long term strategic initiatives that has created opportunities within a variety of new markets, including the orthopedic and vascular access markets. Through these acquisitions, we have added proprietary technologies and product lines to our portfolio, as well as strategic manufacturing and product development capabilities. In addition, we have expanded and diversified our global customer relationships.

Although the acquisitions clearly diversified our customer base and reduced our concentration with a few key accounts, it has also created additional opportunities to sell a broader product portfolio across multiple divisions within these key accounts. Instead of selling solely to the Cardiac Rhythm Management sector who have been one of our key customers, we now have the capabilities to sell to the orthopedics, neuromodulation for Vascular Access businesses as well.

We have taken great strides in diversifying Greatbatch and will continue to integrate these new businesses and look for cross selling opportunities that will drive both near term and long term revenue gains.

Another key element for our strategy is focused on streamlining our operational efficiencies and optimizing our production. Over the past four years, we have built a reputation of successfully optimizing and consolidating our operations and we have continued this performance in the past year.

During 2008, Industry will recognize our Alden, New York facility as being one of the top 10 best plants in North America. Additionally, the State of Massachusetts recognized our Raynham facility with an Economic Impact Award.

In 2008, we also implemented six and initiated another four consolidation projects to enhance the operating performance of our new businesses and move closer to the overall Greatbatch operating model. As evidenced by the improvement in our operating margin from the first half to the second half of 2008, we have already begun to realize several of the benefits. We have approached these initiatives on several different fronts and I want to briefly provide a review of some of the accomplishments during 2008.

During the second quarter of 2008, we streamlined our administrative and research and development functions to better align these efforts with our growth opportunities. We quickly followed this up in the third quarter with the closure of our Columbia, Maryland and Orchard Park, New York facilities and the consolidation of our corporate headquarters and Suzhou, China operations.

Finally, during the fourth quarter, we closed our Saignelegier, Switzerland facility and initiated several other consolidations, which were focused for 2009. These consolidations included the transition of our Blaine, Minnesota manufacturing facility into our Plymouth, Minnesota operations.

Consolidation of production from our Electrochem facilities in Canton, Massachusetts and Teterboro, New Jersey into our newly constructed Raynham, Massachusetts facility and finally the closure of our Exton, Pennsylvania administrative offices. Within our facilities, we have begun to automate some of our manufacturing processes across our business lines, which will make us much more cost effective.

Semi-automation is an important part of our business and gives Greatbatch, the capacity it needs to provide our customers with flexible product solutions. A good example of how we’re using semi-automation can be found in the Electrochem part of our business. Not only did we build a state-of-the-art facility in Raynham, but we also filled it with highly efficient semi-automation equipment that will help us meet customer needs and drive margin improvements.

During 2008, we also made significant progress in moving our newly acquired companies to a common ERP platform, with five of our seven acquisitions already transitioned. This allows us to centralize our back office, finance and IT functions and further streamline operational efficiencies. Our plans are to complete the common ERP implementation across the entire company in 2009.

We see multiple opportunities across the broad product portfolio in the company. At a high level, we can leverage the R&D capabilities acquired to create more growth opportunities, generate additional sales volume from cross selling and implement lean manufacturing and initiatives and supply chain improvements to generate immediate synergies. Additionally, we can leverage opportunities to in source key components.

Finally, during 2008 we began a project to analyze how best to utilize the brands that we had acquired over the last two years. I would like to let everyone know that over the next several weeks and months, we will be introducing you to the new Greatbatch family and identity system that will drive brand awareness, preference and loyalty.

Our last key strategic initiative is to drive growth through the development of new technologies and innovation. During 2008, we spent approximately 8% of our sales revenue on research and development. We intend to maintain our investment at these levels as we continue to develop new offerings for our customers.

This investment in R&D will enable us to maintain our leadership position in our core markets, drive new growth opportunities, and potentially provide additional cost savings across our growing product portfolio. Ultimately, we hope this investment will facilitate a more diverse product platform and position us to emerge out of the recession as a stronger more capable company.

Based on our current portfolio and R&D initiatives, we are in a strong competitive position for future growth and profitability. Given the current state of the markets, I thought it was important to reiterate our belief that Greatbatch is financially sound. Additionally during the fourth quarter the financial market dynamics highlighted an opportunity for us.

As a result the company retired $22 million of long term debt at a 15% discount which would otherwise been due at par in June of 2010. This transaction along with our strong cash flows from operations are access to over $100 million under our existing line of credit and the long term financing we have put in place, clearly illustrates our financial strength.

Based on the current demand for our diversified product portfolio, our ongoing progress with our integration initiatives and our ability to continue to deliver innovative value-added products and solutions to our customers, we believe Greatbatch is positioned well to withstand the turbulent markets and drive long-term shareholder value creation.

With that, I’ll now turn the call over to Tom Mazza for a review of the fourth quarter financial results.

Thomas Mazza

Thanks Tom and good afternoon. Sales for the fourth quarter were ahead of our expectations by approximately $10 million as we reported $146.6 million in revenue. For the full year, sales were $546.6 million, an increase of 71% over last year. The fourth quarter and full year results included $45.4 million and $208.2 million respectively in sales attributable to the acquisitions completed in 2007 and 2008.

Adjusting for the impact for these acquisitions, sales increased by 24% for the quarter and 7% for the year. This includes the benefit of an additional week of operations due to our 2008 year end falling in 2009, which was the closest Friday to December 31.Cardiac rhythm management and neuromodulation product line reported revenues of $77.8 million for the fourth quarter, a 27% over the prior year quarter and 14% over the third quarter 2008.

Fourth quarter revenues for the vascular access product line were $13.2 million compared to the prior year quarter revenues of $8.7 million and $10.9 million in the third quarter of 2008. These increases were primarily due to the Quan Emerteq acquisition in November 2007 which added approximately $2 million of incremental revenue over the prior year fourth quarter.

The orthopedic product line reported revenues of $35.7 million for the quarter compared to $37.9 million for the third quarter 2008. Orthopedic sales during the first three quarters of 2008 benefited from the release of excess backlog that was on-hand at the time of the Precimed acquisition, which has since been fulfilled. Additionally the fourth quarter results include the impact of an overall uncertain market conditions, including foreign currency exchange fluctuations.

Switching to our Electrochem business, fourth quarter sales for this business segment were $19.8 million compared to $14.4 million in the fourth quarter 2007 and $18.9 million in the third quarter 2008. The increase in sales compared with the prior year is a result of the acquisition of EAC in November 2007, which added $4 million to revenue.

As intended, our acquisition strategy has enabled us to successfully diversify our revenue mix from a combined concentration of approximately 80% in 2007 to approximately 50% for 2008. Given the normalized growth level currently being experienced by the CRM market, our revenue growth and diversification has validated our strategic investments in the vascular, commercial and orthopedics markets.

Turning, now to expenses; our selling, general and administrative expenses as a percentage of sales decreased to 13.6% versus 14.9% for the fourth quarter 2007, which reflects the various cost cutting initiatives implemented in 2008. This percentage increase compared to the third quarter 2008 of 11.5% primarily due to the timing of expenditures.

Net research, development and engineering costs for the fourth quarter were $7.7 million, which as expected were lower as a percentage of sales versus the fourth quarter 2007 due to the realignment of these operations in 2008. Net research, development and engineering costs as a percentage of sales were consistent with the third quarter 2008.

Other operating expenses incurred in the fourth quarter of 2008 were $7.1 million and primarily included costs incurred in connection with our various consolidation initiatives and the integration of our acquired businesses. We anticipate that they will continue to incur these types of costs for the foreseeable future as we continue to integrate and consolidate resources across our entire infrastructure.

As a result of the above, GAAP operating income for the quarter increased to $12 million from $5.4 million in 2007, but decreased from the sequential quarter of $15.7 million. Similarly, adjusted operating income was $19.1 million in the fourth quarter 2008, compared to $6.9 million for the fourth quarter 2007 and $19.3 million for the third quarter 2008.

More meaningful, was the expansion on adjusted operating margin to 13% from 8.2% in the fourth quarter of 2007; while this expansion in operating margin is indicative of the type of improvements, we are trying to achieve. We do not believe the quarter’s current results can be extrapolated to a full-year run rate given the non-linear nature of our business.

As a result of the enactment of the research and development tax credit in October 2008, effective tax rate for the fourth quarter 2008, was 29.3% compared to 45.4% for the same period of 2007 and 40.5% for the sequential quarter. We expect our effective tax rate in 2009, to be more inline with the 35% U.S. statutory rate.

Ultimately, our strong adjusted operating income, translate to adjusted earnings per diluted share of $0.50 per share in the quarter, compared to $0.20 per share in the fourth quarter 2007 and $0.44 per share in the third quarter 2008. Earnings per diluted share on a GAAP basis were $0.36 per share in the quarter, compared to $0.12 per share in the fourth quarter 2007 and $0.33 per share in the third quarter 2008. GAAP earnings per share for the fourth quarter include the impact of a gain on extinguishment of debt of $3.2 million or $0.09 a share.

The progress made on our strategic initiatives and our results for 2008 give us confidence that we will be able to continue our progress in 2009. As such, we are guiding in the range of $550 million to $600 million for revenues for 2009 and an adjusted operating margin of 11% to 13%. Although, we are confident in our guidance, we continually monitor our business due to the current state of the markets.

As Tom mentioned earlier, we are in a solid financial position as our strong cash flows from operation, access to $100 million under our existing line of credit and long term financing we have in place make us confident we will weather the current storm. However, factors we see potentially impacting this guidance include a potential softening in the orthopedic and commercial energy markets, potential delays in elective surgeries, foreign currency volatility, changes to the insurance reimbursement policies, as well as customer inventory adjustments.

We have worked hard to implement an efficient operating model, while making the necessary investments insure growth across our various product lines. Overall cost reduction initiatives are on track and along with our revenue growth enabled us to improve our operating margins in 2008. In addition, we believe our strong cash generation, diverse revenue base, financial discipline and effective cost structure will enable us to strengthen our platform for future growth and increase shareholder value.

Let me now turn the call back over to the moderator to take questions.

Questions-and-Answers Session

Operator

(Operator Instructions) Your first question comes from Tim Lee - Piper Jaffray.

Tim Lee - Piper Jaffray

Hi, good afternoon and thanks for taking the question. First, if I could just start with your ‘09 sales outlook, it’s down a little bit from kind of your preliminary number that you gave on the third quarter conference call. I guess what’s really changed in the past 90 days that made you recalibrate your numbers? Did we see, given the out performance we saw here in the fourth quarter from a top line basis, did we see some sales that we thought we’d see here at ‘09 kind of come in 2008?

Thomas Hook

I think really it’s just as simple as, we have the 53rd week in 2008. It was a variable whether we’d see a lot of sales in that week given the holiday period. We ended up seeing about $10 million worth of sales, which made us make a small adjustment really to guidance for the year.

We’ve been fairly pragmatic and I guess you could call a pessimistic on the dynamics and turbulence in not only medical markets, but financial markets. So, we’ve tried to plan effectively for the year as a lower growth year given some uncertainties about what’s going to happen broadly in healthcare is to plan some risk factors in there and we felt it was prudent to make that adjustment and effectively stick with where we planned through the end of 2008.

Tim Lee - Piper Jaffray

Just following upon the CRM side, a very strong or the CRM and neuro segment very strong numbers up 27%, outside of the additional week, was there anything specific that led to that out performance?

Thomas Hook

I think really what we had effectively that was differentiated was some product launches with some customers that were nice revenue pick ups. We’ve worked on winning business with our customers for years now and as some of those products are reaching kind of the stage where they should go into clinical launch, that’s dragging through some sales for us.

So, there are hard fought victories of a few years ago that are showing up in the revenue line now. As I said, all the time we don’t bid a 100% on every opportunity we’re bidding on, but we’re trying to be very competitive and maintain not only the growth rate with the market, but also win new business in terms of selling new technologies into new applications for customers to grow faster than the market growth rate.

Tim Lee - Piper Jaffray

Just one last one before I jump back in line here. On the ortho side, you talked about, some of the backlog being flushed out in the last two quarters. So, this current Q4 number, should we think about this is the kind of that run rate basis on a going forward basis? Thank you.

Thomas Hook

I think the best way to think about it is that, when we acquired the orthopedics businesses in 2008 at the beginning in Q1. We had backlog that we needed to burn-off. We decided to look at burning that off over the course of 2008. So, we leave the year into 2009 on more of a clean basis. So, we did do probably the last third of the backlog burn-off in the fourth quarter and really in the first quarter of 2009 is going to be more, I would say the normalized run rate of the orthopedics business, not affected by that backlog burn-off.

Operator

Your next question comes from Jason Mills - Canaccord Adams.

Jason Mills - Canaccord Adams

I wanted to follow-up on Tim’s question on the CRM side. I’m wondering how much that business specifically benefited from the extra week and if we could get access to sort of what the organic growth excluding that incremental revenue may have been year-over-year?

It seems like you certainly grew faster than the market in that area and I’m wondering if that continuation of sort of that organic growth excluding the extra week help, can be continued in 2009 and what you’re hearing from your OEMs with respect to what they’re modeling in terms of growth in both neuro and CRM?

Thomas Mazza

I mean without the extra week, we were probably around 10% organic growth, a little bit north of 10% organic growth.

Jason Mills - Canacorrd Adams

In the entire division?

Thomas Mazza

Entire division. I’ll let Tom answer the second piece of that.

Thomas Hook

I think the best way to think about it’s we’re going to continue to plan pretty pessimistically. We’re obviously very tightly linked with the cardiac rhythm management customers across all of the product lines. We’re not counting on any stellar market growth.

I think we’re going be inline with what expectations are. Obviously, different customers have different views as do, different analysts tracking the, particularly the parody and the defibrillation side of the market here, but we’re taking a fairly conservative viewpoint. We don’t want to overstate. We certainly don’t want to build product inventories. We want to stay tightly coordinated with our customers and driving their programs.

I think the big reason, really the only appreciable reason why we’re going to continue to pickup business and grow faster than the market is, because we will win product designs and customers for projects that we historically have not and although we won’t win 100% of those. Net-net our focus is to continue to be very competitive and drive value for the customers, so we can grow those product lines.

We have a lot of room for growth in the product line areas and do more work for our current customers given that the markets aren’t going to give us a lot of natural growth. So, I expect low single digits in terms of natural market growth in the Cardiac Rhythm Management, higher than that of neuromodulation, but given that’s a relatively small number for us; it’s going to be dominated by the growth rate in the Cardiac Rhythm Management side for that business.

Jason Mills - Canaccord Adams

One other top line question and then a middle of a P&L type question. As it relates to winning new product designs, Tom, could you update us on some important new product initiatives that you have on the horizon, whether they be near-term, long-term and perhaps give us some semblance of timing as it relates to some of these product initiatives?

Thomas Hook

Well, I think one of the nice things we’ve done is we’ve taken a very holistic look over the past several years at each of the fundamental component technologies we have; for what our customers are looking for in next generation technologies. Whether it’s what I’d call technical parameters performance, cost performance, it links up with what their strategies are driving.

Below each one of those, are the some fundamental technologies. Obviously, around EMI filtering is a hardy area, cost effective EMI filtering is a very hot area. We have technologies in each one of those baskets that we’re commercializing out through. Our battery and capacitor performance, improved energy density; obviously our Q series batteries, our higher voltage, tantalum capacitor technology, both of those have been very interesting to customers.

When we go over to the acquired product lines, we’ve been commercializing more products in the acquisitions of both Enpath and Quan Emerteq that have rolled up into our Vascular Access business segment and then on into cardiac and neurology. Although, those revenue lines are smaller for us; we picked up significant business in the various products of leadwires, the catheters, the steerable sheaths, etcetera that have given us opportunities where we historically had 0% revenue to have some nice growth opportunities there outside of CRM and within CRM and neuromodulation.

I think going onto the orthopedic side we’ve largely been learning in orthopedics, driving operational excellence to deliver the very good operating performance for our customers. As we deliver better operating performance for our customers, just the basics, reliable, timely, on cost, being able to quote packages etcetera, timely, we’re going to continue to pick up business there just on favorable operating performance.

We have a lot of work to do to gain and improve our self on the technical competence side in orthopedics. We still have investments to make there and improvements to make before I can pull brag about the technical prowess we have in orthopedics. We have some additional improvements to drive there.

Electrochem side of the business doing very well commercially; obviously the oil and gas industry with the price of oil is struggling, hence oil service is down. We have a lot of nice product technologies that have come out around batteries. We’ve also added the rechargeable battery technology, in particular for military and external medical that has worked very nicely.

We’re going to continue to commercialize that technology and a new technology we’ve highlighted before in the commercial side, probably the sensing technologies that is more applicable on the capital equipment side of the business rather than the down hold services side of the business, and as that product line which has been qualified as kind of in prototype and test market phase will continue to see that become more significant in the commercial business as we go forward in the next couple of years.

Jason Mills - Canacorrd Adams

Last question on the P&L for Tom Mazza; the operating margin guidance for 2009 is quite a large range and it certainly, the lower end is not reflective of the second half of 2008. Perhaps you could walk us through sort of what some of the dynamics that could get you to the higher end versus the lower end, as well on the P&L, below the operating line anything that we should be aware of to help us model your earnings, which you didn’t give a range like you did last year.

I am wondering if you could help us out so that we’re thinking about below the operating line consistent with what actually should happen, so that we should have some visibility into that part of the P&L.

Thomas Mazza

On the operating margin line, as Tom Hook and I have been stating consistently we’re going to start. We’re going to save money before we start spending money. Clearly, over we’ve given out a prediction for the next three years that we can increase basically our adjusted operating margin by 2% per annum for each of the next three years getting up to 16%.

To get the growth above the 16% rate, we’re going to have to reinvest in the business and really that’s where we see it coming back into line, where we’re going to spend more money in development of R&D and projects to drive the longer term run of the business. So, we’re comfortable, there is a little bit of timing issues there. So, what we don’t want people to doing is, extrapolating off of the last two quarters, because we really are going to take out the costs before we go forward on it.

Thomas Hook

I think a good way, this is Tom Hook talking. Jason to really just get at this is that we have to show the productivity to justify increasing our R&D spends. So we’re going to drive productivity, even continue to reinvest in the business. We think operating income is something that is directly within our control based on although broad range of revenue guidance onto across that range we feel confident we can drive the 11% to 13% through the fundamental initiatives we have and still allow us room to do more R&D investment.

Some of the revenue is beyond our control were obviously the currency markets are dynamic right now. Clinical markets are dynamic. Obviously, we’re very tightly linked with our customers and as their business has variables in it that are somewhat unusual, it forces us obviously to comprehend that there is going to be a little bit more variability in the business than we would historically like to see or like to have.

So we broadened out to try to bracket what we think that they are. Obviously, our intentions are to continue to drive upside performance in terms of winning and launching technology seamlessly to customers and I think provided there is not any major pertivations in the overall healthcare markets that we see good visibility into the year. If there is an unforeseen pertivation, we’re planning conservatively to be able to buffet that and be able to ride it out, so produce good profitability for the year.

Jason Mills - Canacorrd Adams

Okay, below the operating line? I mean convertible, is there anything?

Thomas Mazza

We’re still going through the counting on the convertibles. We’ll give specific guidance on the convertible, the impact of the converts at a later time, but yes, we’re still going through the final calculation on that, but as we all know that’s a non-cash item anyway to the balance sheet.

Operator

Your next question comes from Keay Nakae - Collin Stewart.

Keay Nakae - Collin Stewart

I wanted to go back to the revenue and talk about some of the forward gains you were hoping to see, Tom. In EMI filtering and high voltage tantalum, you had projects in the past you were working on integrated filtered feed through, two cap system and where specifically are those projects are?

Thomas Hook

I think I’ll touch, obviously the conversion on the EMI filter feed through stuff continues from unfiltered product to filtered product and I’d say there are multiple factors. One, just the straight up filtering of unfiltered product a is transition that’s in our favor and also as higher levels of filtering capability are needed, higher power levels, broader frequency ranges and particularly as the standards become more tougher for new product introduction. We’re trying to stay in the forefront of that and we have successfully won multiple new products to filter unfiltered devices as well as to provide next generation filtering.

I think the third thing ends up being is that, we continue to need to drive cost effectiveness for our customers. Now we have the technical ability to achieve the technical specifications for filtering. We need to be able to drive cost efficiency for our customers by being able to do it with some level of productivity, leverage the volume we have, drive some cost reductions, which will allow them to be more competitive and in turn drive more volume for us, so there is a careful balance there.

So, a lot of factors in our favor, a lot of technology over the past couple of years as come to fruition in this area. It’s clearly going to continue to move towards filtering capability based on broader frequency ranges and higher power levels and then the whole filtering concepts around being able to image active implantable medical devices in MRI environments are becoming critical.

So, a lot of investments in terms of technology development, which we’ve been obviously granted a key foundation patent and have been filing actively for other technology; we feel as pivotal in this area and kind of a suite of products as we described before around EMI effects, lead wire heating effects, as well as image artifact effects.

There is a series of technologies we’ve been actively developing internally and also in co-operation with our customers to be able to deliver on those capabilities, so that clinically the device customers can move those into their product development streams and markets; and we have a lot of active negotiations and co-design initiatives to be able to do that. That’s really week-by-week as we’re talking continuing to develop and we’ll continue to develop for the next several years.

As we look at the capacitor technology, in terms of two cap system and also higher voltage and higher energy dense three cap systems. We kind of bifurcated the original two capacitor solution, which resulted in lower energy density, but higher voltage; and we bifurcated that into a program that proved to be much more popular with customers, which was the use of three capacitor technology; that had extraordinarily high energy density. So, energy density definitely became more of a primary driver than number of capacitors.

So we’ve been able to make an overall capacitor stack much more compact and in turn kind of mute some of the gains of having a two capacitor system actually, have made it smaller using three smaller more dense capacitors; and that’s we’ve been moving onto product qualifications with several key customers and I see that still reaching commercialization.

It’s fair to say that we have some technical hurdles; we still need to cross in terms of making a high voltage two capacitor system at a comparable energy density. As we continue to do those developments particularly on the tantalum side of the equation, the anode side; we will put more emphasis behind that project, but right now we are very focused on delivering on the customer needs on the high energy density system.

We’ve been making good strides with that, I can’t say to my satisfaction. I’m not sure that I’m satisfied with the rate of technology introduction there for complicated and risky projects. There is a lot of aspects to them from both the process and product design and qualification aspects.

We’ve navigated a lot of those well with multiple customers, but there is a lot more work to be done to be able to press the advantage of density and in terms obviously, smaller device sizes for our customers; and as we’re more successful with that we’re going to continue to see business pick up in those categories.

Keay Nakae - Collins Stewart

On the vascular side, we seen the revenue there come down sequentially in each of the quarters. I’m sure part of that is due to the enjoined products, but it sounded like from your comments that you’ve got some new things coming down the pipe that could stabilize that business if not reverse the growth?

Thomas Hook

Yes, well I mean actually, sequentially the revenue growth has been up, but so I’m not 100%. I’m sure what you’re referring to, but in the general the vascular product lines, we think are an opportunity for a lot more growth. We’re very low percentage in the overall market share, these types of products.

We’ve had to make significant investments in engineering to be able to design and effectively drive manufacturing capability at an efficient price point. So, it’s going to be an area of continued investment.

One of the central initiatives we have is to consolidate the Vascular Access business into a single facility in Plymouth, Minnesota. Right now we have multiple facilities. That will drive a central team, more unified engineering and allow us to pursue customer opportunities in a more focused basis.

Today we don’t have that it’s kind of bifurcated strategy and we’re letting not so much opportunity slip through the cracks as we’re slow to capitalize on opportunities in terms of finishing product developments and getting them into the revenue line; and we just have to reverse that trend and be much more aggressive to be successful, because it’s such an important area of growth for us. We have low market shares and a lot of opportunity we could pick up with some big customers.

Keay Nakae - Collins Stewart

Okay and for Tom Mazza, how should we think about improvement in gross margin going forward? You seem to be getting a little bit more mix from CRM, maybe going forward at least for ‘09, a little less from orthopedic. If we think about the mix combined with your improvements in efficiency, what types of improvements might we see in gross margin?

Thomas Mazza

I think, over the long term, I mean a substantial portion of the 2% improvement in operating margin on average over the next three years will come from the gross margin line. Clearly, we have the infrastructure in place to handle the larger volumes and it’s heavily volume dependent will certainly cause the margins to go up as well as all the initiatives that we have going on to take cost out there. So, I would think you would see the lion’s share of the 2% gains in operating margin coming from the volume and the reductions in cost of goods sold.

Keay Nakae - Collins Stewart

Okay and is that more or less true for ‘09 versus the other years?

Thomas Hook

I think it’s really consistent across the three year long range planning period we have, it’s the cost reductions, consolidations, overhead, etc., in which we drive efficiencies and effectiveness. We’ve got spread out a balanced load plan over the course of three years. So, with that progression that is really going to deliver the results and it also is really the basis of the discipline.

So, we don’t end up with a reliability or quality issue, when we try to horse the projects too fast or press a customer, it’s easier to make a mistake or result in redo of qualification that offsets a big chunk of cost savings and in that a lot of these cost savings initiatives we do pass savings onto customers as well. We want to make sure that, we’re doing this in a very disciplined zero defect mechanism. So, we don’t end up having any issues.

So, by spreading it out over the three year period, it’s a lot more prudent thing to do and I don’t see that changing as it will be a lumpy quarter-to-quarter, but year-to-year will be on a fairly predictable track and we’ll save money before we put it back into cost, the cost save back into research and development expenditures. So, we’ll make sure ahead of the curve before we just start spending money.

Thomas Mazza

Going along with that too as well, I mean clearly, the two initiatives we have currently underway, the two major consolidation initiatives we have, the Canton to Raynham as well as EAC to Raynham facility and the combination of Blaine and Plymouth facilities, those two will have an impact towards the end of 2009 going into 2010.

Because obviously, we’re disrupting the production levels as we’re moving and closing the facilities. So, on those two particular initiatives, Tom is 100% correct that, we do have it planned, so we try to levelize the cost savings as much as possible, but the big up ticks on the gross margin side related to those two will be towards the end of this year until early 2010.

Operator

Your next question comes from Stan Manne - Manne Family Investments.

Stan Manne - Manne Family Investments

I have three questions. One, is there more of a move towards the producer, the customers outsourcing? We’ve seen some of that where the large ortho sold some plants back to outsourcers. Are you seeing any movement in that direction over the year or coming years?

Thomas Hook

I’d say the trend towards outsourcing is favorable, but I would also say that it’s absolutely gated by proven capable performance from Greatbatch. If we can earn the business by showing we can meet timelines, cost targets, reliability, quality, and have a strategic alignment with our key customers. We’ll be eligible and I emphasize eligible to be able to pickup these opportunities. So, we have to do all of those things right even entertain the conversation, then one of two ways it could happen.

One could be by literally a sale off of an asset similar to how we did the Shamond deal, the other way which would be, I think more typical, which would be as we then bid on a new product development for an existing project to do manufacturing, get qualified, have the customer come in and audit our facility as well as products we produce, do the necessary submissions for regulatory approval and then we win a percentage of that business and then it believes over to us.

So, I think there is a myriad of opportunities ortho in particular, obviously a different landscape and cardiac rhythm management and neuromodulation, but nonetheless, still plenty of opportunities, still plenty of new product developments in which we can bid on and each of the individual teams and Product Line Managers are very focused on this because, if we can’t do this successfully, we just will not grow faster than the generic market growth rate.

Stan Manne - Manne Family Investments

Second question, we’ve always talked about operating margin goals looking out. You said 2011 without investment you’re moving theoretically 15 to 17. What will it take to move toward that 20% operating goal in 2012, ‘13? You’ve obviously examined the…

Thomas Hook

I think it’s kind of straightforward to think of it in two tranches as Tom Mazza explained. Where we are kind of in ’08, which was starting out, around 10% and then next year obviously moving towards the 12% range and then beyond that 14% and then 16%, a lot of that is due driven by the core operating consolidations and running the business that Greatbatch has today more efficiently.

However, to get it above 16% really requires us to have more product technologies and more revenue streams come on, so that we can pick up volume and leverage the overall operating base of the company, which means we have to make investments in research and development and product launches, to be able to start kind of the 2011 in 2000 timeframe to add to that incremental revenue on the overall size of the company to drive continued margin expansion.

So the R&D investments are absolutely critical to be able to pick up new lines of businesses with our key customers and also pick up new lines of business with customers we just have not satisfied historically and that’s very much applicable in orthopedics as well as the Vascular Access market.

Clearly, our strategy is to do that leading with technology to drive value for the customer to be able to pick up that business and be able to drive incremental margins for us that are going to be accretive in nature to the overall company and leverage that volume across the whole corporation to continue to drive cost reductions as well.

Stan Manne – Manne Family Investments

So it’s like the Q series batteries and the MRI?

Thomas Hook

That’s correct and many other things.

Stan Manne – Manne Family Investments

Not semi or more automation that you’re talking about, which seems to be a newer approach that you’ve thrown into the mix?

Thomas Hook

I think, semi automation is going to fit in with the consolidation efficiency programs that are going to get us from 10% to 16% along that curve. That also provides us the capacity to be able to do manufacturing in the out years and keep up with the overall growth of the business and to capitalize on that as well.

Stan Manne – Manne Family Investments

The capacity we have now we could grow 10% to 15% a year and not require new facilities, is that correct for the next three years?

Thomas Hook

That’s correct in terms of capacity, in terms of unit volume, but we also have to remember that capability is equally important in the Greatbatch business model. So, to launch new product technologies is absolutely critical for us and some of that will require investment to improve manufacturing capability.

Also remember that the mix of products across Greatbatch, some have very low levels of capacity and the utilization is high, where others we have more than enough capacity to absorb any market growth rate. So, there is some incremental investment needs, but nothing beyond what would be maintenance capital.

Stan Manne – Manne Family Investments

Alright, two more questions. One, you’ve not talked about debt pay down in the next several years. Can we get a little color on debt pay down plans?

Thomas Hook

I think the color would be directionally given that we don’t pay a dividend, that directionally as we continue to produce free cash flows and we don’t have plans for additional acquisitions from a strategic standpoint as we’re going consolidate, drive the business organically and pay down debt.

Stan Manne – Manne Family Investments

Well it looks like you could do quite a bit of that in the next three years according to my calculations.

Thomas Hook

Directionally that’s the plan.

Stan Manne – Manne Family Investments

Okay, last question is D&A in ‘09, depreciation and amortization, what should we use?

Thomas Mazza

$30 million to $40 million.

Stan Manne – Manne Family Investments

$30 million to $40 million?

Thomas Mazza

Correct.

Stan Manne – Manne Family Investments

Okay it was $40 million was the last number I got on the last conference call, so we’re moving down or is it close to the 40s than 30?

Thomas Mazza

It’s in that range.

Stan Manne – Manne Family Investments

Okay, just one last comment. Just making some quick numbers on the high side on the 600 and the number metrics you’ve thrown out I get an over $2 adjusted earnings per share. Is that something my calculation in the right ballpark?

Thomas Hook

Thank you for your confidence Stan.

Stan Manne – Manne Family Investments

On the top side; that’s just using your metrics by the way.

Thomas Hook

Obviously we’re just going to stick with the revenue range and the operating income range.

Operator

(Operator Instructions) And I show no further questions at this time. I’d like to turn the call back over to management for any closing remarks; please proceed gentlemen.

Marco Benedetti

Thanks, I’d like to remind you that both the audio portion of this call and the slide visuals will be archived at our website at www.greatbatch.com and will be accessible for 30 days. Thanks, everyone for joining us.

Operator

Ladies and gentlemen, thank you for your participation in today’s conference. That does conclude the presentation. You may disconnect. Have a wonderful day.

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Source: Greatbatch Inc. Q4 2008 Earnings Call Transcript
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