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Teleflex Inc. (NYSE:TFX)

March 12, 2013 3:15 pm ET

Executives

Benson E. Smith - Chairman, Chief Executive Officer, President and Member of Non-Executive Equity Awards Committee

Analysts

Matthew Taylor - Barclays Capital, Research Division

Matthew Taylor - Barclays Capital, Research Division

With this -- and there's going to be a fireside chat session. So Teleflex is a company that's been really spun out of conglomerate to become a pure play medical device company and seen a lot better growth here over the past couple of years. And a lot of that turnaround has been driven by top line growth, partially due to new products, price increases and now the company's focused on driving some operating margin improvement. So all of that adds up to some pretty good growth relative to the rest of the space. And something we're going to talk about here. I'm pleased to have Benson Smith, the CEO. And maybe you want to start off with some of those goals and give us an update on the progress that you're making, starting with the top line and how you're going to drive that to create some value on the operating margin line over the next couple of years.

Benson E. Smith

So the original thought that was -- that we had in really turning the company into a medical device company was that our portfolio should be capable of producing revenue growth in around the 5% constant currency range. I would say that in 2010, when they came up with that, that seemed pretty ambitious because our growth a couple of years before that was 0%, minus 1% and 0%. So -- but there were a couple of short-term things that we were able to do to get the revenue line moving. Some of them pretty simple, making sure we had adequate inventory. We've put about $45 million of inventory into the system. Our service levels went from the mid-70s to the mid-90s in a relatively short period of time. Our back orders went from 5 days to under 0.5 day. That really meant that we weren't losing business out the back door as fast as we're trying to generate in the front door. So that had a really positive effect. Got our constant currency growth rate up in the 4% range in 2011, and 2012 moved up again into the over 5% constant currency range, actually 6.8% was the year -- was the year's number, but that had some benefit from an acquisition in it. So taking that out, it was about 5%. About 3.5% of that came from volume increases, about 1% came from new product introductions and about 1% came from some pricing initiatives. We've been also ratcheting up our R&D expenses in an effort to augment our product pipeline and doing a number of late-stage technology acquisitions. We reported on 4 of those in 2012. They added I think, depending on our business portfolio, they added some really core technologies to us, I think, in order to be able to expand our product line. So at this point, we feel relatively comfortable that, that 5%-plus constant currency range is within our -- certainly within our grasp to continue over the next couple of years. We expect over the next few years that new products will kick in a little bit more heavenly -- heavily, excuse me, than that 1% to 1.5%. And we're -- while we're optimistic on our continuation of pricing certainly over the next several years, we're expecting beyond that point that new product introductions will make up for whatever the difference is in pricing if that starts to decelerate over the next couple of years. So a big part of our improvement is driven by that revenue growth. Our expenses are going growing at about 3% to 3.5% a year. So growing between 5% and 6% makes a big difference in terms of leverage through our expense line. We spent an awful lot of effort in early 2011 rightsizing our sales operations, particularly in the United States. We reduced sales headcount. We trimmed those numbers down as we fit them into strategic business units. And we're generally of the opinion that as we expand our sales revenue per head, we're not going to need to add additional selling headcount to be able to accommodate that revenue. A little bit of a different situation in some markets. China, we are adding sales headcount. Brazil, we're adding sales headcount, but those are rapidly growing markets and deserve that additional investment. From a standpoint of gross margin improvement, pricing was the easiest thing to kind of initiate. Easiest in the sense of, doesn't take a lot of effort, maybe took some risk, but not a lot of effort. You just change your number on a piece of page. It was I think though quite a bit of analysis behind that looking at Asia as a particular market, where we're underpriced, looking at opportunities in Europe, where we could specify unique features into the bidding process and take some of the pricing pressure off and then the United States really looking for areas where there were pretty big gaps between us and our competitors, where we could bridge that gap without risking loss of volume. As I said, that started to contribute some improvement by late 2011 throughout 2012. It was north of 100 basis points, and we expect that same kind of improvement in 2013 and 2014.

Other things affecting our gross margins are consolidation of our footprint, both in the distribution area and in the manufacturing area. We announced turning 3 distribution units in North America into a single location just outside of Memphis, Tennessee. That's pretty well underway at this point, be completed midyear of this year. And starting in the last half of this year will be accretive for us and contribute about $4 million to $5 million in improvement in our gross margins in 2014.

That also triggered some opportunities to consolidate some manufacturing in higher cost areas. In New Jersey, for example, we closed down a facility and moved it to Asheboro, North Carolina. We're moving some other product from the United States and Mexico to the Czech Republic. We have in the process of closing down -- excuse me, a distribution facility in France. So there's a variety of activities to compress our footprint and get some more efficiency out of that.

And lastly, we are benefiting from some mix improvement. We divested one of our very low growth, low gross margin OEM businesses in the orthopedic space. We acquired a company called LMA, which is about $120 million in revenue and roughly 60% gross margin contribution. So compared to our average gross margins in the -- now in the high-40s, efforts like that will continue to drive our gross margin up to that mid-50 range I think. That, of course, will contribute to operating margin improvement, operating margin improvement is going to lag gross margin improvement a little bit, things like the medical device tax this year are a bit of a negative on that. But we certainly see continuing to make improvement in the operating margin line corresponding somewhat to the gross margin improvement, but a couple points behind that. We're not going to see a one-for-one improvement there.

Question-and-Answer Session

Matthew Taylor - Barclays Capital, Research Division

Maybe you can just elaborate a little bit on the pricing improvements because it's a little bit rare in this environment to be able to do that. So you've done a good job thus far, can you talk a little bit about the visibility that you have in the different geographies? And you said the High Fives program, but I understand you may exit the year or next year close to 55% in terms of gross margin.

Benson E. Smith

2015.

Matthew Taylor - Barclays Capital, Research Division

2015, I'm sorry. So can you talk about the road to get there through a combination of pricing improvements and the continued cost reductions?

Benson E. Smith

So the -- again, the pricing initiatives are somewhat regionally driven. In Asia, for example, we're primarily doing business through a distributor network. As we build a brand preference with end-users for our brands, we've been compressing the dealer margins a little bit. So it's actually not being translated into end-user price increases as much as our capturing a bigger share of the margin from the distributor. Because there's really good business growth in those markets, the distributor isn't earning less in absolute dollars on a year-to-year basis. Their growth is still going up, but there's a shift in margin, and we see that continuing. And eventually this leads to usually the manufacturer stepping in and going direct in markets, and we see that as a part of what's going to unfold over the next couple of years. So I think we have pretty good visibility and very plausible expectations about what's going to happen with pricing in those markets over the next couple of years. Europe is, I would say, although it's probably the area that we have the most concern about because of the tender situation, there is and continues to be an opportunity to shape tenders that reflect product improvements that you're making and innovative features, and that takes some of the pressure off there. And in the U.S., it's a combination of some products where really we're the only manufacturer of. We have a number of SKUs that we're placing into this harvest/divest category, and the first thing we'll do is try and raise prices in those areas. So at this point in time, we have pretty high level of confidence that we're going to see the same kind of results we've been able to generate over the last 1.5 years or so. The -- I would say the other aspect of that is -- entering more and more of our thoughts is not related entirely to our gross and operating margin improvement, but improving our overall taxation rates. We do have an active toller functions out of Ireland, and it looks now that as we expand the responsibilities in Ireland and expand the decision making to Ireland, there's an opportunity to bring some of those other international manufacturing facilities through the toller organization which will give us a benefit, a tax benefit as well. So the combination of that I think gets us pretty comfortable with the original plans that were kind of put forth as aspirational goals, but we see a pretty clear path to get there at this point.

Matthew Taylor - Barclays Capital, Research Division

Great. Let's stop and let's do an audience question. I want to see what the audience thinks about your pricing. So if you're new to our room today, we have an audience response system in front of you. You can click the button to answer this question. The question is, what's your expectation for Teleflex's pricing expansion this year. Plus 125 to 150 basis points, 100 to 125, 100, 75 to 100 and then down from there?

[Voting]

Matthew Taylor - Barclays Capital, Research Division

So it seems like getting a little credit to do about guidance plus a little bit this year. That may be fair considering last year. That's about what happened as well and seems like you have good visibility there. I wanted to maybe just address this as a longer-term question, can you talk about beyond the horizon, what you see as being a continual opportunity for improvement on the gross margin side in terms of further consolidation or pricing beyond 2015?

Benson E. Smith

So I think one of the more important things that we've put in place at Teleflex is actually really good pricing discipline. And by that I mean, every year it is now our habit to go through the entire product catalog by product line, by region and look at where we think we can make some adjustments to pricing based on the response to the product, based on a variety of different factors, the competitive situation, et cetera. So I think that discipline is going to extend well beyond just the next couple of years. Even in terms of pricing our new products. Coming out of an industrial, a strongly industrial basis, where 50% of the revenue was supplying the auto industry, they would walk into General Motors with their boots quaking about $0.0025 increase in the price of a component. And often, we'll lose business or gain business on relatively small increments. So the medical device industry is quite different and historically has accommodated pricing increases and has accommodated paying more for products that are innovative that solve clinical problems. I think the other dimension of that is, products need to be able to help reduce the overall cost of care as well. So our innovation has shifted to that. But the last thing I would say is, and I've been in this industry for 40 years now, pricing does get cyclical. I mean, after DRGs it was 3 or 4 years where manufacturers were kind of intimidated to raise prices at all. After a while, you can only stand so much as an industry, and you have to start raising prices. And so I expect that we'll see somewhat of an industry thaw over the next couple of years as groups and hospitals have extracted about as much as there is to get out of manufacturers. So we're somewhat optimistic that as we look a couple of years ahead that the industry as a whole is going to work its way out of this somewhat, a little self-induced pricing drama that's been created.

Matthew Taylor - Barclays Capital, Research Division

Let's deal with another question on this topic. The next question here, and then we'll move on to some other topics. This is just around gross margins. We already talked about this. But the question is, when do you expect Teleflex to achieve a gross margin level of 55%?

[Voting]

Matthew Taylor - Barclays Capital, Research Division

So if you're talking about exiting in '15 and '16, it would kind of make sense in terms of your targets. It seems like, you're getting some credit for those initiatives that you have.

Benson E. Smith

Yes. We've been -- certainly, over the last couple of earnings calls trying to point to the fact that we have what I think is a reasonable line of sight to that improvement. That again, not for the full year 2015, but exiting the year certainly going into 2016 in that range, close proximity to it.

Matthew Taylor - Barclays Capital, Research Division

And so I want to talk a little bit about LMA and deals because that's been also something that is evolved here. You've done some late-stage deals and then LMA was a little bit of a bigger deal that you did, but it seems like you’re going to be able to extract a lot of synergies out of that. Can you talk about the synergies that you expect this year and further years and then your overall kind of M&A strategy?

Benson E. Smith

So we really like the looks of LMA as we even began our early discussions with them. To us, it rang a lot of important bells. It was use of overseas cash. It was a company that had a global leadership position in that laryngeal mask segment, in fact, invented it. And was a very nice complement to our existing anesthesia business. And so we felt that there was quite a bit of room for synergies as part of that process. And surely after we made acquisition, we put out numbers that we expected to get somewhere between $0.35 and $0.40 of accretion in 2013. That's primarily from 2 areas. It's coming from the elimination of their corporate overhead structure and then the combination largely of their domestic sales and marketing organization and collapsing that into our own anesthesia and respiratory sales force. That part of it -- and that's probably the lion's share of it. That was largely completed in mid-December, that one sales force is out operating now. We retained about 50% of LMA's sales force, so it wasn't just getting rid of them and just having Teleflex sell it. We used this as an opportunity actually to prune our own sales force and keep what we thought was the best of both groups. I was just at their sales meeting a couple of weeks ago, and they're, I would say, very enthusiastic about the prospects of being part of Teleflex. But largely, that's pretty much I would say done. And we actually haven't seen anything that -- any hiccups at all that would stop us from also capitalizing on the elimination of their corporate overhead. That's just a question of timing at this point. In 2014, we expect to get another $0.15 of accretion largely from taking over some distributors where we have direct operations. Those are a little bit longer to engineer. We're in discussion with most of those major distributors now and have a high level of confidence that we'll have a relatively smooth transition from that process. LMA also had relied heavily on a third-party manufacturer to supply its product, and we had projected that by 2015 we would be able to move away from that and essentially be in a complete mode of self manufacturing and expected another $0.15 of improvement or synergies coming from that area. That's probably moving a little faster than we thought it was going. So we are largely confident that all of those synergy goals will be met as part of the process. And we've owned them for about 4 months now. And usually things start to come out of the closet if they're going to come out of the closet by this point. And we really haven't seen any real negative surprises.

Matthew Taylor - Barclays Capital, Research Division

And how often could you do an LMA-like deal? Is that what you're looking for now? Or are you looking more back at those kind of late-stage acquisitions that you've done?

Benson E. Smith

So financially and integration-wise, we certainly would be in a position to do one every other year. It's going to take us most of this year to swallow LMA and make sure everything's performing as we expected it. The -- I would say the trick or the difficulty is really finding one. We've got a pretty tight algorithm in terms of what we're looking for. We do think it's a good time right now because there is a lot of consolidation going on within the medical device industry, and we expect more. And so we expect to be able to do one, but not in 2013. We will continue to do late-stage technology acquisitions. There's a lot more of them to be done there, much smaller in size, but that's going to be part of our capital allocation strategy as well.

Matthew Taylor - Barclays Capital, Research Division

Okay. Let's ask one on that. So I think our next question is on capital allocation. So question is, what do you believe Teleflex should be doing with excess cash? And choices are M&A, buybacks, dividends, internal investment or debt pay-down?

[Voting]

Matthew Taylor - Barclays Capital, Research Division

So we get M&A and dividends are the winners. Do you want to talk a little bit about capital allocation more broadly in addition to M&A?

Benson E. Smith

So I would say, every -- I mean, we've had a long history of being a consistent dividend payer. The yield now has dropped below 2% as our stock price has increased considerably. One of the issues for us with dividends is that the combination of interest and dividends uses up most of the cash we're generating in the United States. So to actually raise our dividends isn't -- we'd have to bring back cash from outside the U.S. to be able to do that. And as we look at that, as we look at -- the same thing with buybacks and the same thing with paying down debt, there's a pretty healthy penalty for using cash for that versus what we see as a relatively short term good opportunity to add some technologies to our portfolio. We look at that every year in terms of, is that the right strategy moving forward? I can't say that we feel the same way about it a couple of years down the road. We think this opportunity for some of these late-stage acquisitions is likely to dissipate over the next couple of years simply because there's not a lot of start-up ventures being formed right now. So I can appreciate that there's always an interest in a surety of a dividend. And I wouldn't say that in a couple of years down the road, we wouldn't have had a different thought about that. But I think what I've articulated now is what's kind of on the drawing table for us at least until we get to 2014 and revisit the issue.

Matthew Taylor - Barclays Capital, Research Division

And then, do you want to highlight a couple of the bigger drivers in your portfolio over the next 12 to 18 months that you would call out as being really incremental to growth?

Benson E. Smith

So we're -- one of the things that we really like is within every one of our major business segments, and I'll define those as vascular access; surgical; anesthesia, with the combined business for us anesthesia and respiratory; urology. Every one of those business segments has actually had pretty good organic growth over the last couple of years. And in every one of those, we see some different opportunities to actually increase our growth and participation in that segment. In the vascular space, it has -- it's really a strategy of being more effective in penetrating the Japanese market. Our product line in that area in the Rest of the World has a chlorhexidine coating, which doesn't sell well in Japan at all. A company we acquired, Semprus, will allow us to put a surface modification on that, that we think will be a good seller in Japan. There's also an effort to get CVC as a version of a CVC catheter, excuse me, that can be placed by a nurse team as opposed to a physician, which we think will sell well outside the United States and perhaps in the United States. And then we're making pretty good inroads in the PICC space with VasoNova targeting system and improvements in our PICC line. In surgery, our sort of niche market is in that laparoscopic space with ligation and instrumentation. We've added a couple of new product features this year. Have actually a pretty aggressive rollout of instrumentation over the next several years. And part of that really is to follow that laparoscopic trend as it moves around the world. We think we're well-positioned there. It's not the biggest segment in the surgical space, and so it's not an area of particular interest for Johnson & Johnson and Covidien, so we found nice opportunity to operate within that area. In the area of anesthesia, one of the things that LMA did for us was give us a strong global position in the airway management segment. The other piece of that is ET tubes. Again, one of the acquisitions we made, Semprus, gives us an opportunity to do some modifications to that product line that we think will give us a much stronger position in the airway management position. Basically, our strategy is try and find a segment of a market that we feel we can have a very strong position in on a global basis that we can kind of keep competitors out through largely through intellectual property and a constant stream of improved products. So we see that opportunity in all of these business segments that we're in. That's one of the reasons why I'm enthusiastic about them.

Matthew Taylor - Barclays Capital, Research Division

Great. Thanks for your time. I think we have to end there. But really appreciate you taking the time.

Benson E. Smith

Thanks, Matt.

Matthew Taylor - Barclays Capital, Research Division

Thank you.

Benson E. Smith

Thank you.

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