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Greatbatch, Inc. (NYSE:GB)

Q1 2009 Earnings Call

May 7, 2009 8:00 am ET

Executives

Marco Benedetti - Corporate Controller

Thomas Hook - President & Chief Executive Officer

Thomas Mazza - Senior Vice President & Chief Financial Officer

Analysts

Timothy Lee - Piper Jaffray

Jason Mills - Canaccord Adams

Jeffrey Englander - Standard & Poor's

Keay Nakae - Collins Stewart

Gregory Macosko - Lord Abbett

Stan Mann – Mann Family Investments

Operator

Welcome, everyone, to the first quarter Greatbatch, Inc. 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, Inc.'s current expectations and actual results could differ materially from those stated or implied. The company assumes no obligation to update forward-looking information included in the conference call to reflect changed assumptions, the occurrence of unanticipated events or changes in future operating results, financial conditions or prospects.

I would like to now turn the call over to today's host, Corporate Controller Marco Benedetti. Please proceed, sir.

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 first quarter results and then he will update you on our major strategic initiatives. After that Tom Mazza will provide further comments on our first quarter. We will then open up the floor to Q&A.

As we have done in the past, we are including slide visuals that will go along with this presentation which you can access over our website.

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

Thomas J. Hook

Thank you, Marco. I'd like to thank everyone for joining our earnings call today. We are pleased to be able to share with you our results for the first quarter of 2009.

I'm extremely proud of our accomplishments and feel that the first quarter built upon the positive momentum we started in 2008. Despite the ever-increasing pressure of today's operating environment, we continued to make solid progress towards both our short-term operational and financial goals as well as our long-term strategic objectives. While we certainly are not immune to the impact of the strained economic environment, particularly as evidenced by the pressure on our Electrochem business, our performance reflects the execution we have made on our strategic goals. I believe that our portfolio of intellectual property, operational excellence and diverse revenue base have given us a solid foundation to weather the current economic storm.

During the quarter we delivered solid revenue growth once again, with sales increasing 14% over the prior year period, which correspondingly drove adjusted operating income to increase to $17.6 million or 12.6% of sales. Our operating margin benefited from several factors, including higher volumes, streamlined operation, as well as improved 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 on our first quarter financial results later in the call.

During 2008 we took a close look at the brands we acquired over the last few years in order to strategically align them. This analysis resulted in our recently announced new structure and brand identity, which will unify our existing businesses under a common vision while consolidating our medical entities under a single brand, Greatbatch Medical.

Greatbatch Medical, formerly referred to as implantable medical components or IMC, encompasses our cardiac rhythm management, neuromodulation, vascular access and orthopedic product lines. This business is committed to the design and manufacture of critical technologies that enhance the reliability and performance of medical devices.

We also realigned a portion of our R&D resources under what we refer to as the QIG Group. This group is charged with facilitating the introduction of new and improved technologies in medical device markets by investing in the development of innovations for our customers. Simply said, we will continue to build on 40 years of success to provide cost-effective technologies to our customers that enable them to bring these solutions to market.

Our third brand, Electrochem, is our commercial [break in audio] business that delivers highly customized and reliable battery power and wireless sensing solutions to the energy, security, portable medical and environmental monitoring markets. This business has similarities with and the same operating model as Greatbatch Medical and it further diversifies our business. It has been and will continue to be a critical part of the overall business.

With regard to our logo, the hexagon shapes were chosen because of their ability to connect in the most efficient manner. They are a symbol of how Greatbatch connects with its customers. The symbol is also consistent with the Greatbatch Medical logo. It portrays Greatbatch Medical as what we are, a supportive and critical part of our customers' larger vision.

We feel the new Greatbatch family of companies and the identity system we now have in place will be successful in driving brand awareness, preference and loyalty. The new Greatbatch family of companies is strategically aligned to deliver unprecedented performance, reliability and critical technologies to allow our customers the opportunity to bring solutions to market. Greatbatch now is unified under a global brand based on our reputation of excellence and reliability.

Through the coming year I think now more than ever it's going to be extremely important that we remain focused on our strategic initiatives. In these uncertain economic times we feel that remaining dedicated to our strategy of diversification, streamlining our operational efficiencies and driving growth through innovation will not only help Greatbatch emerge from this recession as a stronger company but also better suited to meet the unique customized demands of our customers.

Diversification is one of our key long-term strategic initiatives. It has created multiple opportunities and will help drive our revenue growth. At the same time, it reduces our concentration risk and brings us stability during the various economic and customer cycles. We have taken great strides in diversifying Greatbatch and will continue to integrate our businesses and look forward to cross-selling opportunities that will drive both near term and long-term revenue growth.

Driving operating performance is also a critical part of our long-term plan to drive stockholder value. During the quarter we made progress with a number of ongoing consolidation initiatives as we specifically moved our new acquired businesses to the Greatbatch operating model. More specifically, we completed the transition of our Blaine, Minnesota manufacturing facility into our Plymouth, Minnesota operations ahead of schedule and under budget in April. We consolidated production from our Electrochem facility in Canton, Massachusetts into our newly constructed Raynham, Massachusetts facility. This was successfully completed in March.

We continued to transfer operations from our Electrochem facility in Teterboro, New Jersey into Raynham, Massachusetts, which remains on track with our original plans. We also successfully closed our Exton, Pennsylvania administrative offices in April. And finally, we completed the Oracle ERP system implementation at our sixth acquired facility. These initiatives, as well as the consolidations completed last year, will continue to drive improved operating margins throughout the remainder of this year and help us to achieve our goal of improving operating margins by 200 basis points per year.

Looking ahead, we still see numerous opportunities that we plan to tap into. At a high level, we believe we can generate additional sales volume from taking advantage of cross-selling opportunities, creating additional synergies through the implementation of lean manufacturing initiatives and supply chain improvements, and continue to move the company to a common ERP platform, which will allow us to further centralize our back office, finance and IT functions.

Our last key strategic initiative is to drive growth through developing new technologies and innovation. During the quarter we spent approximately 8% of our sales revenue on research and development. We expect this percentage to increase for the remainder of the year as we continue to invest resources in the development of new technologies and solutions for our customers.

This continued investment in research and development will enable us to maintain our leadership position in our core markets and drive further margin improvements once our consolidation initiatives are complete. Ultimately, we believe this investment will facilitate a more diverse product portfolio and multiple future growth platforms. Based on our current portfolio and R&D activities, we feel we are in a strong competitive position for future growth and profitability.

With that I'll turn the call over to Tom Mazza for a review of our first quarter financial results.

Thomas J. Mazza

Thanks, Tom, and good morning.

Sales for the first quarter were in line with our expectations. We reported $139.8 million in revenue, which included $8 million of incremental revenue from our Ortho acquisitions.

Organic constant currency growth for the first quarter of 2009 was 10%, which was principally driven by CRM and neuromodulation revenue. The CRM and neuromodulation product line reported revenues of $77.3 million for the first quarter, a 19% increase over the prior year. Results for the first quarter benefited from strong feed through, coated component and medical battery revenue, partially offset by lower capacitor sales. CRM revenue is significantly impacted each quarter due to the timing of various customer product launches, shifts in customer market share, and customer inventory management initiatives.

First quarter revenues for the vascular assets product line were $10.7 million compared to the prior quarter revenues of $9.6 million. This increase was primarily due to higher sales of [inducer] products, partially offset by lower catheter revenue.

The orthopedic product line reported revenues of $34.1 million for the quarter compared to $27.8 million for the first quarter of 2008. First quarter year-over-year comparisons for orthopedic sales include the benefit of a full quarter of revenues from the acquisitions completed during the first quarter of 2008 of approximately $8 million partially offset by foreign currency exchange rate fluctuations of approximately $3 million. Organic constant currency growth for the first quarter of 2009 was 4% for our orthopedics product line.

First quarter sales of our Electrochem business segment was $17.7 million compared to $19.6 million in the first quarter of 2008. This decrease is consistent with the slowdown in the energy markets over the last quarter, which caused customers to reduce inventory levels and push back products. We continue to actively manage our business so that we will be better prepared to meet the needs of our customers once the markets recover. In the meantime, we are taking steps to help mitigate some of the impact this reduced revenue is having on our operating margins.

Turning now to expenses, cost of sales as a percentage of revenue for the quarter was 68.4% compared to 78.1% for the first quarter of 2008. This improvement was driven by higher production volume as well as the impact of consolidation initiatives completed over the past year. Additionally, first quarter 2008 cost of sales included $6.4 million or 5.3% of sales of acquisition-related inventory step up amortization.

Our selling, general and administrative expenses as a percentage of sales decreased to 13.4% compared to 15% for the first quarter of 2008. This improvement reflects the various cost cutting initiatives, the leverage we are seeing due to the increased volume, as well as lower litigation expenses compared to the 2008 period.

Net research, development and engineering costs for the first quarter is $7.9 million, which, as expected, were lower as a percentage of sales versus the first quarter of 2008 due to the realignment of these operations in 2008. Net research, development and engineering costs as a percent of sales were consistent with the fourth quarter of 2008. We expect research, development and engineering costs to increase as a percentage of sales for the remainder of 2009 as we continue to invest resources in the development of new technologies in order to provide technology solutions to our customers.

Our operating expenses incurred in the first quarter of 2009 were $2.8 million and primarily included costs incurred in connection with our various consolidation initiatives and the integrations of our acquired businesses. We anticipate that these costs will remain at current levels for the remainder of 2009 as we continue to integrate and consolidate resources across our entire infrastructure.

As a result of the above GAAP operating income for the first quarter of 2009 increased to $14.8 million compared to a loss of $4.1 million in the first quarter of 2008. Similarly, adjusted operating income was $17.6 million in the first quarter of 2009 compared to $5.6 million for the first quarter of 2008. More meaningful was the expansion in adjusted operating margin to $10.6 million on a GAAP basis and $12.6 million on an adjusted basis. While this expansion in operating margin is indicative of the type of improvements we are trying to achieve, we do not believe the current quarter's results can be extrapolated to a full year run rate given the non-linear nature of our business.

Effective in the first quarter of 2009 the company was required to adopt FASB Staff Position APB 14-1. This FSP requires issuers of convertible debt to recognize interest costs at its non-convertible debt foreign rate. The impact of the adoption of this statement was to increase the company's net cash interest expense by $1.8 million for the first quarter of 2009 or $0.05 per diluted share. Additionally, FSP ABP 14-1 requires the restatement of prior year financial statements when presented. As a result, 2008 interest expense includes $1.6 million related to this FSP or $0.05 per diluted share.

The effective tax rate for the first quarter was 31.5% compared to 39.6% for the same period in 2008. The 2009 first quarter effective rate includes the favorable impact of a Swiss tax holiday and federal research and development tax credits. Additionally, the 2008 first quarter effective rate included the impact of $2.2 million of IT R&D which was not deductible for tax purposes in 2008. The effective tax rate for 2009 is expected to be approximately 32%.

Earnings per diluted share on a GAAP basis were $0.28 per share in the quarter compared to a loss of $0.20 per share in the first quarter of 2008. Adjusted earnings per diluted share were $0.41 in the quarter and increased from $0.16 per share in the first quarter of 2008.

The progress that we have made on our strategic initiatives and our results for the first quarter put us on track to meet our guidance for the year. Therefore, consistent with the guidance provided last quarter, we currently expect revenues for 2009 to be in the range of $550 to $600 million and an 11% to 13% range for adjusted operating margin, which excludes nonrecurring costs associated with plan consideration and the integration of acquisitions of approximately $10 million to $13 million.

Although we are confident in our guidance, we continually monitor our business due to the current state of the markets. We are in a solid financial position, with strong cash flow from operations, access to over $100 million under our existing line of credit, and long-term financing in place, which makes 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 potential customer inventory adjustments. We have worked hard to implement an efficient operating model while making the necessary investments to ensure growth across our various product lines. Despite a difficult operating environment, our strong financial position, the resiliency of our core markets, as well as the benefits of a more-diverse revenue stream, make us confident in our ability to deliver solid operating performance for the remainder of 2009.

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

Question-and-Answer Session

Operator

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

Timothy Lee - Piper Jaffray

On the CRM/neuro side, at least relative to our thinking, another strong quarter. Was there anything specific, I mean, is this kind of like a new run rate that we should be thinking of, something in the upper 70s or were there any one-time impacts that made this quarter particularly strong?

Thomas J. Hook

I think obviously our business - a couple of factors here - first of all, our business is a little lumpy in terms of the overall flow of the business, especially in Cardiac Rhythm Management. We tend to get large pulls from bit OEMs. I think it's also fair especially over the year end point there's a lot of adjusting that's done to customer's product lines in terms of what they're going to pull on and plan for their plans for the year. As you know, obviously, one of our customers doesn't have a calendar year end, so there tends to be a separate set of dynamics around that fiscal year.

So it was a strong quarter. Obviously when we look back, we're happy with it, but the landscape still looks a little uncertain. We've picked up a lot of product wins over the last several years with our key customers that kind of underpin it, but we haven't seen a market or systemic change across Cardiac Rhythm Management that is different from before. We've just been doing a decent job of picking up some wins, especially with some key customers and key product lines.

But we always obviously plan very conservatively, but execute very aggressively for that. Because of that, we're not going to change the guidance; we're going to leave it right where it's at because we think we're going to come in right where we had planned on for the year.

Timothy Lee - Piper Jaffray

Just two P&L questions, if I may. On the tax rate, now you're saying a full year rate of 32%. Has that changed from last quarter? I think last quarter you had said the U.S. corporate rate. Is it changed from last quarter and if it isn't changed, what transpired in the last 90 days to take it down to 32%?

Thomas J. Mazza

We do believe we're going to have a rate. Our current estimate based on our current forecast is 32%. Part of it is our tax planning with overseas as well and being able to firm up on some of the items that we had questions on previous to this time and really just firm up our estimates.

Timothy Lee - Piper Jaffray

On the R&D side, you'd talked about R&D ticking up the balance of the year. I appreciate that to be in the gross R&D number, but should we think about net R&D ticking up for the balance of the year as well?

Thomas J. Mazza

Yes. Assume the net is running about 2% less than the gross more or less on a total basis of sales.

Operator

Your next question comes from Jason Mills - Canaccord Adams.

Jason Mills - Canaccord Adams

Tom, I'll start with just a housekeeping question on CapEx spending for the year. What are your current expectations there and what does that translate to in terms of free cash flow expectations for the year? It looks like to us perhaps it could be a pretty good year for free cash flow generation.

Thomas J. Mazza

We're estimating EBITDA to be in excess of $100 million this year and we're expecting capital investment to be in the $30 to $40 million range.

Jason Mills - Canaccord Adams

And remind me where that relates to last year.

Thomas J. Mazza

Last year was about $45 million. It should be less. We still have the consolidation efforts we're going through and the final buildouts of the corporate center here as well.

Jason Mills - Canaccord Adams

And, Tom, you held your operating expenses very well in check notwithstanding a better top line result than we were modeling. Is the middle of the P&L an area that you can continue to leverage going forward pending solid top line performance? Is that the area perhaps even more than gross margin percentage where you see the most leverage in your model?

Thomas J. Mazza

I think it's one of the leverage points. You know, driving efficiencies is critical. I think philosophically the operating teams in this area are doing a very good job. We have a lot of consolidation projects, both at the manufacturing and the administrative levels, that are occurring simultaneously. They've done a very good job of squeezing out the efficiencies and the functional groups have been very good at squeezing out the back office.

We had another, you know, solid year on back office compression that still needed to get done. productivity is a word that just doesn't apply to manufacturing; it applies to all the administrative functions from sales and marketing and finance, IT, human resources, so we're going to leverage those resources quite a bit to hold those expense items. And absolutely the expectation is to grow revenue and the only line item expense that we want to see is the area of investments in research and development that feeds innovation that brings us the higher-value products.

But we're going to keep a lid on expenses by forcing the consolidation and to keep them growing, if growing at all, by just compressing into the back office and streamlining efficiencies. And there's more room to go there. I mean, we've picked a lot of low-hanging fruit and we've gotten into the meatier things now, but we've still got a hard year of work left to finish up in 2010.

Jason Mills - Canaccord Adams

So that sounds fairly positive. If I'm hearing you right, Tom, you're saying that - well, you didn't say this but I should expect that as sales grow perhaps sales and marketing expenses grow, but that should be at least offset by the compression you could have on the G&A side of SG&A?

Thomas J. Mazza

Yes, that's a fair way to look at it. As I say all the time, we're committing to increase operating margins by 200 basis points. To be able to do that, we have to increase more than 200 basis points because we have to take and fund more research and development, so that productivity has to come from somewhere. And your statement's correct; we have to manage all those expense line items, you know, the SG&A line items, to deliver some of that, and we have to get a lot of it from manufacturing. The combination of the two lets us fund R&D at an increasing level.

Jason Mills - Canaccord Adams

And I know that you expect that, given you posted an operating margin in the quarter of towards the high end of your range, you expected folks to push you a bit on why not raise it as to expectation; having covered the company for awhile, I'm not surprised. But with that being said, perhaps you could sort of, Tom, talk to us a little bit about the quarterly progression of your operating margins in 2009. And following on Tim's question, was there anything in the first quarter that drove the strong operating margin that perhaps may not recur in the balance of the year?

What I'm hearing from you is we expect R&D to tick up; however, there's some [inaudible] left on the SG&A side and you're continuing to consolidate in cost of goods sold in one area ahead of schedule, so it seems to me like at least at this point in the year, given the strength in the first quarter, that you may be comfortable with more of the top end of your range as opposed to the bottom end of your range, and so far as you're willing to go that far, we'd love to hear it.

Thomas J. Mazza

Jason, I always love it when you are aggressive. Obviously, we're going to stick to the guidance that we have out there. I'm very comfortable with that.

And as you know, we put a lot of pressure on the back office consolidation and manufacturing efficiencies and they can be lumpy because of mix and volume, but we make sure we have locked in our ability for profitability before we unleash the research and development spending. When we met those objectives in 2008 at the end of the year we started more concentrated work in the QIG group and more in R&D. That spending takes a little time to ramp up. So we're making some concentrated investments here.

I don't want to get ahead of myself. We've thought long and hard last year planning out 2009. We feel we're right in the sweet spot. Clearly, we're going to always force the operating teams to over perform, not under deliver, so it's critical for us that they maintain momentum in the year and ahead of the game, but we're actively taking some of our windage and we're pushing it down into the investments and key initiatives because that's what's going to get us the higher value products and more key projects with our core customers in the out years is by winning them right now.

So it's absolutely pivotal that we're not going to get ahead of ourselves by over committing to things and then quenching the R&D effort. We want to maintain a balance; it can get jumpy quarter to quarter. And we feel very confident in the 11% to 13% range, where we're targeting, and that's how we're going to manage the business.

Jason Mills - Canaccord Adams

Could you give us an update, you spoke of your R&D pipeline and your plans to add resources there. You've clearly done that in the past and we have some products upcoming that could be really positive for the company, one of those being your MRI technology. Could you also update us on where customers may be in the evaluation cycle of what [inaudible] capacitors - you mentioned capacitors was a little light this quarter; I'm wondering if that could change in the next couple of years. You've got some customers out there, large customers, that don't use your capacitor technology and then obviously your high-rate Q series batteries, maybe where folks are in the evaluation there, and update us.

Thomas J. Hook

It's a fair question. We've been satisfied with our technology implementation. Obviously, we've been having so much resource in the company focused on the consolidations and integrations of the acquired companies. Putting all these pieces together, it's put a lot of strain on the research and development groups to cross link and coordinate, and obviously we just completed the research and development facility here in Western New York to move all of these groups together.

We just had some recent hires in the orthopedics group. They'll be moving to Western New York to finish out the research and development center, so we're really on the research and development side still sub-optimal in my opinion. But in the core business, Cardiac Rhythm Management and the neuromodulation pieces and the vascular pieces in Minneapolis, we look very good. So by the component areas we look strong.

In the newer technology areas, the ones you mentioned, like MRI, Q, Wet Tantalum, a lot of that stuff has been funded and has been running for years. We're in very good positions. We have multiple programs running right now. We're getting a lot of traction. We obviously don't have any revenue, but it's a significant amount of R&D and engineering expense right now. We're very confident those are going to pay off. A lot of the revenue we're harvesting now in our business is really the bets we made in 2004 and 2005 programs that are reaching commercialization.

I guess I'm satisfied with what progress we've made, but I'm never really satisfied because I look at all the technologies we have that we could work with more customers. I'm particularly excited about the orthopedics business opportunities. There's a lot of exciting things that we can do for customers in that area. We spent several very hard and focused years acquiring the operations there to really professionalize like we have in the rest of Greatbatch, how we run manufacturing, the systems of how we do things.

There's undoubtedly going to be more investments this year and in 2010 to continue the capability and capacity expansion. I'm very excited about that. It will link very nicely with a lot of key customers and their strategic plans. So overall on a technology front I still think we have, despite the economic conditions, I still think we've got a very good landscape to run and grow through innovation at the technology level.

Unfortunately, the frustrating thing is obviously because all of our contracts end up being confidential with our customers. As much as we'd like to brag about where we're winning - we don't win 100% of the time, but we're obviously growing the business faster than the market; we know we're winning in places with our key customers and enjoying that growth - but we're always short of our ability to brag about it. That's just the fact. That's the way we're going to continue to run the business.

But we definitely think we're on the right track and in general the technologies, certainly Q, certainly MRI, are going well. And we've got some work to do on the capacitor side, but I'm still very excited about the programs we're in and look forward to those achieving a revenue production milestone which will come up in the near future.

Operator

Your next question comes from Jeffrey Englander - Standard & Poor's.

Jeffrey Englander - Standard & Poor's

I'm wondering if you can just give me maybe a little color on what you're seeing in terms of CRM and the orthopedic business in the current quarter? You did a nice job there and just any sense of how things are looking?

Thomas J. Hook

I think I'll cover orthopedic as there's obviously a lot of concerns about the softness in the market. I think at the end of 2008 when we were planning 2009 we were looking at 2009 being challenging with regards to everything that's happening globally, so I think we've been very careful with regard to how we look at 2009.

The other big change that took place is there's a fairly large shift in the foreign currency translation impact, which is a headwind that affects the revenue line for us a little bit on the operating income line that changes since we mostly have our operations in orthopedics in Europe. That FX adjustment is unfavorable to us in 2009, which hurts revenue growth percentages.

I think in the Cardiac Rhythm Management side of the business we probably have been in the pessimistic view of the market for the last three years, since a lot of the dynamics in the market. I don't think we've really changed our view. There's obviously a lot of activity going on in the market right now. We obviously have close partnerships with multiple OEMs that we are deeply invested into, so we think we have a broad cross-section in that there's still a lot more opportunities to grow.

But I don't think fundamentally our view of the underlying Cardiac Rhythm Management market has changed much since last year or even 2007. I think it's consistent. And I think while it's evolving, because of technologies and competitive dynamics, I think that it pretty much is consistent as we had planned. We don't really view it making any dramatic shifts at this point.

Jeffrey Englander - Standard & Poor's

The other quick question is you mentioned in your response the $3 million of FX impact on orthopedics. Can you give us an idea of what you're forecasting internally on the currency?

Thomas J. Mazza

Somewhere around $15 million for the year, assuming the current rates.

Operator

Your next question comes from Keay Nakae - Collins Stewart.

Keay Nakae - Collins Stewart

First of all, in CRM you've continued to show some nice gains with filtered feed throughs. How much further can that go or will that driver start to temper?

Thomas J. Hook

I think it's really fair to say that I've always said that we can pick up projects with specific customers at specific times, but we cannot outpace what the market's going to grow at. Because we're reaching some good success there but we're also reaching maturity, and there is a ceiling on how much we can do in this area.

So I think we have to be pretty careful as we benefited from a lot of hard work in the 2005 timeframe to win projects and we're enjoying these product launches, but underlying that the market just isn't going to magically allow us to keep growing that type of product line because our market share is quite high now. So we're just going to run out of legroom to be able to drive improvement. It's just going to be a glass ceiling.

Keay Nakae - Collins Stewart

And then you mentioned some improvement in coded electrode revenue. Are you seeing a rebound with your customer where you had lost sales due to their product recall?

Thomas J. Hook

No. I think we have to be, again - this very much is a launch-driven model on this stuff, so as we pick up product lines we'll pick back up, but the big bolus of business that was lost there has not come back yet. But obviously we're tightly linked with that customer and all our customers. As they re-qualify products and re-launch them, it will come back to us. It's a timing question. I'm confident there, but that wasn't the effect. It was other products.

Keay Nakae - Collins Stewart

And those other products, is that sustainable growth or was that more one time in nature?

Thomas J. Hook

It's sustainable. The business is sustainable. The growth change is not going to be sustainable. But, you know, when you go through a launch cycle you're going to go through kind of a build inventory, get the product launched, and then the growth rate will temper. But usually if the product launches successful, we'll still get some nice growth continuing and steadily building. Especially if it's cannibalizing or slopping out another product that we make, there's usually kind of a sluicing effect from one product line to the other. But usually it's more dramatically in our favor in terms of the change over.

Keay Nakae - Collins Stewart

And then on the commercial side, you talked about some inventory drawdown by customers. How much of that is left to go before we start to see some resumption of pull through?

Thomas J. Hook

We're very tightly linked, as you know, to oil services. Obviously, with all the gyrations in that market and the global energy markets, their business is off precipitously. So it usually takes a couple of quarters for them to make inventory adjustments, so we've ratcheted down the rate at which we're sending them product and obviously they're chewing up their high levels of inventory in the field. Really, I think what we're looking at is kind of the half-year point. We'll start bleeding back in the other direction, we'll stop the downward pressure. So we're very carefully watching how those customers are managing their products. Obviously they can't deplete their inventory to zero, so the downside is limited here.

And I'll also say that it's a great opportunity. I love the Electrochem business. It's a great opportunity for them to really focus on the consolidation projects - and they have a lot of them going right now - but finish those up on schedule, which is a huge accomplishment for us, moving all of those facilities, five facilities, into one. I think it gives them an opportunity to really operationally get all that stuff done.

And also I think in the marketplace as they're making increasing investments in sales and marketing right now, we're going to be able to use some of the weaker market conditions to get new partnerships and when the market does come back, which it inevitably will - the energy markets, you know, they have some vicious cycles, but they will come back - is we'll be in a better position to exploit growth again. So for us right now it's all about repositioning in the down market. There's a lot of pressure on Susan Bratton and the Electrochem team to do that. It's a very good operating team. They've got new facilities, good engineering resources, and an expanding sales team, and we're going to use the next couple of quarters to reposition and come out smoking.

Keay Nakae - Collins Stewart

So kind of adding everything up, given your near-term visibility is better than your longer-term visibility and given that your comparable in Q2 is a little more difficult, we really shouldn't expect to see much sequential revenue growth in Q2, I would imagine?

Thomas J. Mazza

Yes, I think, you know.

Thomas J. Hook

As you know, we're trying to keep our expectations contained given a lot of these uncertainties and we're trying to manage conservatively and outperform. And I think your comment is completely accurate and very fair. And pretty much we're trying to just run with the hatches battened down, but run hard.

Operator

Your next question comes from Gregory Macosko - Lord Abbett.

Gregory Macosko - Lord Abbett

Could you talk if you would a little bit about you mentioned 200 basis point margin range. As I remember I thought it was more in the line of 150 to 200. Is that 200 kind of the standard now at least for the coming year?

Thomas J. Hook

Well, I'd say since really the beginning of 2008, the first quarter of 2008, we kind of talked and benchmarked where we were for the year, which was going to be we were going to target around 10% in '08. And we said the trajectory is to improve over each of the next three years by 200 basis points. And we've continued that trajectory through 2008; we're in that direction in 2009 and I see that continuing on.

Our plan is to go from 10% operating income to 16% operating income by driving the top line, driving aggressively the consolidation and integration in back office elimination, and also the funding of R&D. The only way we can get from 16% operating income to 20% operating income is literally to have an ever-increasing shift of our product innovations reach the revenue line item. So it's critical last year, this year and next year to drive that 200 points of operating income improvement in these multiple fashions so that we can fund R&D and drive the outer year operating income improvement. And that 200 basis points is pretty much the direction we're driving the business towards right now.

Gregory Macosko - Lord Abbett

You also mentioned margin improvement from new products, R&D, so I assume that would be incorporated into that 200?

Thomas J. Hook

No, that actually talks to the out years. From 2008 to 2010 we need to fund our key R&D programs to produce revenue out in the 2012 timeframe. Those higher-margin products, higher-value products, more comprehensive sets of technology from Greatbatch allow us to not only grow the top line but operating income at an increasing rate.

So without producing all this productivity in this 2008 to 2010 period, we can't fund the R&D programs to get the higher margin products in those out years, out in 2012. So we've been outperforming productivity so that we can deliver 200 basis points improvement and also fund the increasing R&D expense so that we can get operating income higher through these innovative products out in the 2012 period.

Gregory Macosko - Lord Abbett

And so, then, the 200 basically comes from sort of efficiencies, restructuring, consolidation of facilities, etc.?

Thomas J. Hook

That's volume along with what you just mentioned, efficiencies across the entire P&L, that's correct.

Gregory Macosko - Lord Abbett

And then you mentioned cross-selling in your opening remarks relative to revenue growth. Could you talk a little bit about that and, as much as you can, give us a sense of where that cross-selling has happened between product areas or anything?

Thomas J. Hook

Well, one of the nice things about - I can't talk any one specific customer, but I know you understand a lot of the customers in this space have multiple operating businesses in various markets, be it Cardiac Rhythm Management, vascular, orthopedics, spine, etc.

Greatbatch is a very sophisticated operating model and a lot of highly capable individuals work within those businesses. That reputation helps us in businesses at OEMs that we don't do business with today. It allows us to get introductions. It allows us to be considered a credible player since we do extensive amounts of business with other operating divisions of those OEMs. And it allows us an opportunity to present proposals that are received as a credible alternative. It's helped us in orthopedics, it's helped us in neuromodulation, and it's also helped us in the vascular access areas.

So we still have to win the opportunities, we still have to be competitive, we still have to bid and make a proposal, but rather than just kind of being a cold knock on the door we have a much more broader base of operations and capability and we look much more credible as a unified company at Greatbatch because of our success with other businesses within those key OEMs.

Gregory Macosko - Lord Abbett

Would you say that the cross-selling opportunity is far from realized and/or should we see some strong results in the current year, fiscal '10?

Thomas J. Hook

It is far from realized. It follows the same business model of everything else within Greatbatch. It takes several years to win a project and get it qualified and reach commercialization stage, so there's nothing that just is picked up and realized instantaneously. I am not satisfied that we have exploited all the opportunities with our key customers to sell to the multiple divisions. We just completed these acquisitions at the beginning of 2008. We have not finished integrating them yet.

Our performance in terms of both operations manufacturing, etc., needs to continue to improve. We're investing the resources to make sure that we achieve that level, both from a facilities standpoint as well as from an equipment capability standpoint. And there's a lot of pressure on the businesses, particularly the sales teams, to open those cross-selling opportunities with key customers and win the business, but we've got to do the hard work for that and we've won some but we haven't won enough to get anybody here overly satisfied that we're really good at it.

Gregory Macosko - Lord Abbett

You mentioned in guidance, you talked about softness in some of the markets and one that you mentioned was orthopedics and yet you talked pretty positively about product development. I assume, then, you're talking much further out and we may perhaps see some near-term weakness in that sector?

Thomas J. Hook

I think it's fair. Orthopedics is kind of, you know, when I look at the end clinical market level the growth has abated with some of the global economic environment. But for us, we're a small player, and as a key supplier in the orthopedics market there's a lot of opportunity for us. Whether the market's growing slow or fast, we have an opportunity to do a good job for our customers and grow this business.

We don't have high percent market shares of any product area and we've got a lot of room for performing for our customers to pick up new projects. It takes several years to do that, but on an opportunity basis it's a very opportunity rich landscape even despite the industry having slowed down. This means we need to be more aggressive. So I'm still going to be bullish on orthopedics and my expectations are that the investments in that area we've made and will make are going to pay off in the out years as we gain more traction and win more opportunities with key customers.

Operator

Your next question comes from Stan Mann – Mann Family Investments.

Stan Mann – Mann Family Investments

I have a couple of questions. One, your plans for the use of free cash flow. Is it still on target to use it for debt paydown after CapEx?

Thomas J. Mazza

Yes.

Thomas J. Hook

Yes, Stan.

Stan Mann - Mann Family Investments

The second question is: Where are we? We started with a revolver and two converts and we're at 315, which was flat with the beginning of the year. Can you kind of give us a picture of where we are and if you have some plans on paydown this year?

Thomas J. Mazza

We currently have in excess of $100 million available under our current revolver.

Stan Mann - Mann Family Investments

So that nets to what? It was $132 million last year.

Thomas J. Mazza

Yes. And part of the thing is in the fourth quarter, you'll remember, we bought down approximately $20 million worth of the convertible debt back, so there's $30 million of the first convertibles and $197 million worth of the second set of convertibles.

Stan Mann - Mann Family Investments

Where are we now?

Thomas J. Mazza

That's where we are.

Thomas J. Hook

That's where we are now.

Stan Mann - Mann Family Investments

You're at $30 million and $197 million?

Thomas J. Mazza

In par value now, I'm talking about, $30 million, $197 million and approximately $115 million under the - I'm sorry, $131 million under the line of credit.

Stan Mann - Mann Family Investments

Is where we are?

Thomas J. Mazza

Is where we are.

Stan Mann - Mann Family Investments

So what are our plans for the year? Have we got a tentative schedule?

Thomas J. Mazza

We haven't given that information out, Stan.

Thomas J. Hook

We have a plan, Stan. There is a plan internally on what we're targeting, but we just haven't communicated it. We don't want to get ahead of ourselves.

Stan Mann - Mann Family Investments

Well, you've already said you've got over $100 million of EBITDA so that's a lot of theoretical cash flow. That's why I asked the question.

Thomas J. Hook

You know we're going to make positive progress on it.

Stan Mann - Mann Family Investments

Okay, so we're not looking for any large acquisitions? Our main goal this year is to pay down debt after CapEx?

Thomas J. Hook

I think that's a very question, Stan. We are not in active acquisition mode. We have been evaluating carefully opportunities that are out there, but we don't see the pressing need to do anything. We're very focused on consolidation and integration as a top priority, and we're not going to change that for 2009. We're going to be very focused on crunching down and consolidating what we've already acquired. But we're going to keep our eyes open, too, but right now we don't see anything that we need to move on.

Stan Mann - Mann Family Investments

Okay. International sales you've not mentioned at all. We now have an international division. What percentage of our sales are international and are they growing? Have you seen the ability to move some of the other product lines into international?

Thomas J. Hook

We're roughly split 50/50, so we're kind of evenly balanced. We have to remember there's a foreign currency effect in the orthopedic product lines in particular that affect that. That's probably the big factor. But we're very consistent that what we're seeing in the underlying markets is that, you know, the growth rates that our customer see wash down to us and it's fairly consistent with what we see. So in certain market segments that are growing faster outside the United States we see a consistent internally to that with our product demand; it's consistent.

Stan Mann - Mann Family Investments

Well, what I was asking is has the acquisition of a foreign sub - has ortho helped us in getting international sales growth accelerated in some of the other product lines?

Thomas J. Hook

It will in the longer run but, again, in the shorter run, because of the regulated nature of the products and needing to get qualified, we can't turn it on that quickly. The only area we have some ability to do that is in the commercial business, Electrochem, and there the international business has held in there a little bit better than the domestic business, but obviously just globally since oil and gas is under pressure the overall business is under pressure and down.

Stan Mann - Mann Family Investments

And our percentage of international sales, you said, is 50/50? I don't think so.

Thomas J. Mazza

Stan, there's two numbers that are important. What Tom is saying what we deliver overseas is approximately 50/50. What is generated from our overseas operations is approximately 15% to 20% of the top revenue line.

Stan Mann - Mann Family Investments

Okay. And you do expect that to grow a little more rapidly in the future?

Thomas J. Hook

It has the opportunity to, but the rate at which it grows is a question that we don't really give a lot of color on because -

Thomas J. Mazza

We don't know where the end customer is.

Thomas J. Hook

We don't know where the end customer will end up being is part of the problem. We could ship to a U.S. company overseas and obviously that's an international shipment; the products could come back into the United States after we ship them. So it's very challenging for us some time to track that after it leaves our facilities.

Stan Mann - Mann Family Investments

My last question is the Electrochem plant expansion, the new plant, can you kind of give us some more detail on what the status is?

Thomas J. Hook

Okay, the plant is done. The existing facility we had in Canton, Massachusetts we've ran with for a decade has been shut down and it's all moved into the new Raynham, Massachusetts facility. We've also shut down our Orchard Park facility and we've moved that to Raynham. We're in the progress of transitioning - well, we already did transition our [Sujo], China operations here to the continental United States. And then the last move is to move the Teterboro, New Jersey facility to Raynham. That is ongoing right now, scheduled to complete by the end of the year, and that will complete all the implementations into the Raynham, Massachusetts, the brand-new facility.

And we're going to use a little bit of the down market opportunity here to just really get these consolidations finished and in on time, but we've made great progress there. The operating team at Electrochem has done a great job consolidating those businesses.

Operator

And that concludes today's question-and-answer session. I'd like to turn the call back over to Marco Benedetti for any closing remarks.

Marco Benedetti

Thanks. I'd like to remind you that both the audio portion of this call and the slide visuals will be archived on our website at Greatbatch.com and will be accessible for 30 days.

Thanks, everyone, for joining us.

Operator

Thank you for your participation. That concludes today's presentation. You may now disconnect. Have a good day.

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Source: Greatbatch, Inc. Q1 2009 Earnings Call Transcript
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