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Tornier N.V. (NASDAQ:TRNX)

Q1 2013 Earnings Call

May 7, 2013 4:30 pm ET

Executives

Shawn T McCormick – Chief Financial Officer

David H. Mowry – President and Chief Executive Officer

Analysts

Bob Hopkins – Bank of America

Michael J. Weinstein – JPMorgan Securities LLC

Matthew O'Brien – William Blair & Co. LLC

Matt Miksic – Piper Jaffray

Larry H. Biegelsen – Wells Fargo Securities LLC

Operator

Good day, ladies and gentlemen, and welcome to the Tornier Inc. First Quarter 2013 Earnings Conference Call. At this time, all participants are in a listen-only mode. After our prepared remarks, we will conduct a question-and-answer session and instructions will follow at that time. (Operator Instructions) And as a reminder, this call is being recorded.

I would now like to turn the conference over to your host, Shawn McCormick, Chief Financial Officer. Please go ahead, sir.

Shawn T McCormick

Good afternoon and thank you for joining us today for the Tornier’s first quarter 2013 investor conference call. I’m Shawn McCormick, Tornier’s Chief Financial Officer and with me is Dave Mowry, our President and CEO. After I cover the formalities, Dave will start the call by reviewing key operating and financial achievements for the quarter. I will then discuss first quarter financial performance and provide financial guidance for the second quarter and fiscal year 2013. Finally, we will open the call for your questions.

Before we begin our detailed discussion, I would like to remind you that during the course of this call, we will make forward-looking statements regarding our future financial and operating results and our business plans, objectives and expectations. These forward-looking statements are covered under the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995 and Tornier desired to avail itself of the protections of the Safe Harbor for these statements.

Please be advised that actual results could differ materially from those stated or implied by our forward-looking statements due to certain risks and uncertainties, including those described in our most recent annual report on Form 10-K.

We suggest that you read these risk factors and our SEC periodic reports and other future filings that we may make with the SEC. You should also know that Tornier disclaims any duty to update or revise our forward-looking statements.

On this call today, we will also disclose certain non-GAAP financial measures. We use non-GAAP financial measures as supplemental measures of performance and believe these measures provide useful information to investors in evaluating our operations period over period.

For each non-GAAP financial measure that we use on this call we have included in our press release or on our website a reconciliation of the non-GAAP financial measure to the most directly comparable GAAP financial measure. Please note that non-GAAP financial measures have limitations as analytic tools and should not be considered in isolation or as a substitute for our financial results prepared in accordance with GAAP.

In addition to announcing our first quarter 2013 financial results earlier today, we also announced in a separate press release the commencement of an underwritten public offering of the company’s ordinary shares. The focus of this call is to discuss the financial results for the first quarter ended March 31, 2013. In light of this and giving considerations to SEC rules and regulations, we will not be disclosing, discussing nor answering questions relating to the public offerings. I would now like to turn the call over to Dave.

David H. Mowry

Thank you, Shawn. As demonstrated by our operating and financial achievements for the first quarter, we have a solid start of fiscal year 2013, validating our business strategy and demonstrating our ability to execute critical initiatives discussed on our previous call. We remain fully committed to the plans outlined for the full year 2013 and are increasingly confident of our ability to achieve the goals and objectives that we believe will return the company to double digit constant currency revenue growth on a pro forma basis during the second half of 2013.

Our revenue for first quarter of 2013 reached $82.7 million compared to first quarter 2012 revenue of $74.5 million, an increase of 11% as reported. On a constant currency basis, our first quarter revenue grew 10.9% over prior year period. First quarter revenue generated by extremities product categories totaled $67.3 million compared to $58.2 million a year ago, an increase of 15.7% as reported and on a constant currency basis. This growth was attributable to strong performance from both our upper and lower extremity product categories including the contribution from OrthoHelix.

Our extremities revenue represented 81% of reported global revenue for the first quarter of 2013 and included $8.4 million of revenue generated from OrthoHelix. Giving pro forma effect to the OrthoHelix acquisition to include OrthoHelix revenue in prior year period, our first quarter 2013 constant currency revenue growth was 1.7% year over year while extremities constant currency revenue increased 3.6%.

Now let me provide you with more detail on our extremities revenue by product category. Revenue from our upper extremity, joints and trauma category was $48.1 million, an increase of 2.3% in constant currency over the same quarter in 2012. This growth was primarily led by our Shoulder Arthroplasty Product portfolio, including the Aequalis reversed shoulder and Aequalis Ascend, which continue to be widely accepted by shoulder specialists around the world.

During the first quarter, we were pleased with the performance of our Ascend product line including the Ascend Flex, the new convertible version of the Ascend Shoulder line. The Ascend Flex is now midway through our planned limited user release as the business prepares for commercial launch in early third quarter of 2013. As we have described previously, the addition of he Ascend Flex into Tornier Shoulder product portfolio provides a bone sparing solution to the large and growing Press-Fit reversed market segment while also offering convertibility. We believe Ascend Flex ease of use and differentiated lateral adjustability represents a best in class total shoulder system.

We continue to be encouraged by our Simpliciti stemless shoulder system, a further extension of our design philosophy of bone sparing products. We are excited about our global market opportunity for this product as our clinical trial program that we have discussed on prior calls remain on track. We expect to receive U.S. approval for Simpliciti in the first half of 2015.

We continue to receive positive interest in our Latitude UV Elbow prosthesis commercially released in the fourth quarter of 2012. This product performed well during the first quarter and we are working to take advantage of the positive market feedback in the near-term with additional surgeon trading programs as well as the deployment of additional sets. We remain focused on increasing this product global market share throughout the course of 2013.

First quarter revenues for our lower extremity joints and trauma category increased 114.5% in constant currency to $15.1 million, driven by our acquisition of OrthoHelix. On a pro forma basis, to include OrthoHelix in prior-year period, revenue from lower extremities products increased 11.4% constant currency compared to the first quarter of 2012.

The market leading Salto and Salto Talaris ankle arthroplasty products continued to demonstrate solid market acceptance on a global basis. Strong contributions from these products largely offset the declines from older legacy Tornier lower extremity product lines, including the (inaudible) screws and plates and Suture implants.

Within the OrthoHelix product portfolio, the IFS Hammer Toe product demonstrated good market acceptance following its fourth quarter 2012 launch. We expect the IFS product will continue to grow and gain market share throughout 2013 in the greater than $100 million Hammer Toe correction market.

We will also continue to see strong contributions from the innovative MaxLock and Mini MaxLock plate and screw system specifically design for foot and ankle procedures. First quarter revenue from sports medicine and biologics was $4.1 million, a decrease of 0.6% in constant currency over the first quarter of 2012, had strong growth in our Suture and BioFiber products was offset by decreases in the rest of the business product lines, including our Conexa product and certain anchor products.

We remain committed to developing our biologics portfolio and participating in this exciting high growth orthopedic segment. One of the key elements of our efforts is the expansion of our BioFiber product line. This expansion includes the introduction of larger sizes as well as the addition of our collagen coated BioFiber patch.

In the first quarter, the new collagen coated product BioFiber CM went into full commercial release within the U.S. We planned to further expand our BioFiber offering by entering into a limited user release of a novel, high strength, resorbable suture later in 2013. Revenues from our large joints and other product categories decreased 6% on a constant currency basis over the first quarter of 2012 to $15.4 million, representing 18.6% of our global revenue during the first quarter of 2013.

During the first quarter of 2013, we saw some benefits from the introduction of new, minimally invasive instrumentation as well as from initial engagements with our designing surgeons on patient specific cutting guides. Both of these programs are early in their limited user release. We are pleased to report that our R&D team made progress on the new cementless KneeTec product, which we plan to introduce into our existing market during the second half of 2013.

While pressures in this product segment remained, we expect to see a reversal of market share losses during the second half of 2013 with the further deployment of our MIS instruments, the expanded launch of the patient-specific guides and the initial introduction of our cementless knee product.

Looking forward, we intend to continue to enhance the positions of our large joint business in certain European markets, most notably France, through targeted development efforts. Additionally, we intend to continue to use our large joint product lines, where appropriate to provide a critical mass to products to independent distributors who are helping Tornier gain access to and develop new international geographies outside of the traditional European markets for our extremity lines.

As we discussed on our last few calls returning to double-digit constant currency revenue growth on a pro forma basis during the second half of 2013 remains an immediate goal for the company. We believe that investments in research and development as well as in clinical affairs will be critical to sustaining double-digit growth going forward as they fundamental in strengthening our competitive position within the current markets as well as expanding into bone repair, sports medicine and biologic market segments.

From the perspective of clinical education and adaption of innovative product, as of the end of March, we had 28 physicians trained and performing procedures as part of our limited user release of the Ascend Flex convertible shoulder system. We have continued to execute on our product introduction plans and now have 46 physicians trained on this product.

The commercial release of the product is planned for the third quarter of 2013 following the completion of our limited user release. We anticipate having over 100 physicians trained and performing procedures with the Ascend Flex by the end of 2013. We remain on track with this key metric as a leading indicator of our future growth of this critical product.

We are excited about the market opportunities of our new products and we remain committed to developing innovative market shift in products and technologies. One example is our pyrolytic carbon humeral head designed for our Ascend product family. This ultra-low friction material has the potential to expand the shoulder market by providing an early intervention humeral replacement without requiring the more complicated glenoid replacement, a procedure referred to as a hemi shoulder.

We expect to have the first clinical use of this novel humeral head component in Europe during the fourth quarter of 2013, while we work with the FDA to create a future pathway for U.S. market approval.

Other highly anticipated new product developments from Tornier in 2013 will include a novel patient specific image driven glenoid replacement. BioFiber resorbable high-strength sutures, resorbable bone anchors and the cementless KneeTec product.

Now let me take a moment to briefly review our key operating achievements. During the first quarter, we continued to make excelling progress with the OrthoHelix integration process particularly with the orientation of our internal sales management in support of both the Tornier and OrthoHelix sales channels.

We are now operating with a combined lower extremity sales bag in three territories while our sale management is integrated under a single leadership structure. We have also developed specific sales training program to ensure our lower extremity sales representatives are fully versed on the combined Tornier and OrthoHelix product portfolios.

Additionally, we have organized our lower extremity’s research and development programs under the skilled leadership of the OrthoHelix team. We are very pleased with the strong contributions to our top line by OrthoHelix for the second consecutive quarter and look forward to further benefiting from the acquisition and its expected synergies.

We’re also pleased with the project with the progress towards introducing the OrthoHelix product line into our international geographies. As previously reported, we completed the compilation of our regulatory materials and leveraged the existing Tornier infrastructure to complete the CE Mark filing.

I’m pleased to announce that we received CE Mark registration for the first grouping of OrthoHelix products and have initiated the required Tornier branded inventory builds. We expect the international launch of the OrthoHelix products into France and Germany to occur on plan early in the third quarter of 2013. We tend to expand into other international markets with the OrthoHelix product during the fourth quarter of 2013, building additional lower extremity momentum entering 2014.

During the first quarter, we made considerable progress in executing on our plans for U.S. distribution channel with dedicated sales representation aligned to upper or lower extremity specialists. This transition is a natural evolution of 28 specialist serving specialist philosophy and is consistent with the planned expansion of our product lines as well as the trend towards further medical practice specialization.

At the end of the first quarter, we had transition agreements for dedicated up and lower 20 sales representatives in territories representing 21% of our U.S. revenue on track for our mid year and end of year goals. We believe this transition revenue metrics is the leading indicator of our sales stability and future revenue growth performance. We expect to exit 2013 with this metric at approximately 60%.

In our international markets as noted on our previous calls we completed the conversion of our Canadian distributor model to a direct model at the end of January and now have a direct team in place and saw a positive impact on revenue in the first quarter. Several of our geographies made strong contributions during the quarter, however, these contributions were offset by fewer selling days in the first quarter of 2013, our conversion from a direct model to a distributor model in Spain as well as continued pricing pressure in certain markets namely Italy.

Our international large joint revenue was also negatively impacted by the termination of our distributor relationship in Turkey, which was largely the result of pricing pressure. Internationally, we experienced an overall pricing decline of approximately 150 basis points, which was largely offset by improved mix. We continue to expect relative stability in our European markets but are also aware of the potential volatility.

And now I would like to turn the call over to Shawn to review our first quarter financial results and outlook for second quarter and fiscal year 2013.

Shawn T McCormick

Thank you, Dave. As Dave has already reviewed the components of our revenue, I will focus on the components of our earnings and the balance sheet and discuss our financial guidance for the second quarter and fiscal year 2013. Our adjusted EBITDA for the first quarter of 2013 decreased 10.2% to $9.1 million compared to $10.2 million a year ago.

As a percentage of revenue, our adjusted EBITDA was 11% compared to 13.7% for the first quarter of 2012. The decrease in our adjusted EBITDA margin was primarily attributable to investments in our U.S. sales and training organization, IT infrastructure and distribution channel transitions both in the U.S., and in international markets and the medical device tax.

Gross margin in the first quarter of 2013 was 71.4% as reported compared to 71.6% in the first quarter of 2012. Excluding approximately $1.8 million of inventory step up charges relating primarily to the acquisition of OrthoHelix, our non-GAAP adjusted gross margins expanded 200 basis points over the first quarter of 2012 to 73.6%. This improvement in non-GAAP adjusted growth margin was driven by production efficiencies and the impact of OrthoHelix excluding the inventory step up.

Looking forward, over the next three quarters, we expect to continue to record cost of goods sold charges relating to inventory step up totaling approximately $3.7 million to $4.2 million. The majority of this is anticipated to occur in the second and third quarters of 2013. We believe that through a combination of manufacturing efficiencies, additional in sourcing activities and contribution from OrthoHelix gross margin, we are well position to continue to increase our gross margins over time to the mid-70s as a percent of revenue.

Operating expenses in the first quarter of 2013 excluding special charges and intangible amortization increased 17.9% to $58.3 million or 70.5% of reported revenue. This compares to operating expenses of $49.5 million or 66.4% of reported revenue in the first quarter of 2012. As discussed during our fourth quarter 2012 call, this increase as a percent of revenue was driven by strategic investments in our U.S. sales organizations including sales leadership and training personal, going direct and certain U.S. territory product training and education programs, expansion in Japan, conversion to a direct distribution channel in Canada and Belgium and the medical device tax.

We made very good progress in our U.S. sales channel transitions during the first quarter and we were favorable to our projected level of spending that is our spending came in at a level lower than our internal budget. As a result of the timing of hiring and certain programs, we also experienced favorability as a result of timing and spending for marketing in R&D programs. As this favorability related primarily to timing, we expect our overall spending for the year to remain consistent with our initial projection. Specifically, we expect approximately $1.5 million to $2 million in spending intended to occur in the first quarter to shift to the second and third quarters due to the timing of these investments.

During the first quarter of 2013, we recorded special charges totaling $1.5 million is operating expenses. these charges relate to the acquisition and integration of OrthoHelix and U.S. distribution channel transition. We expect to continue to record special charges in 2013, primarily related to the integration of OrthoHelix and transition of our U.S. distribution channel.

We estimate that these charges will total between $8.5 million to $10.5 million for the full fiscal year 2013. In the first quarter of 2013, our interest expense totaled $2.2 million, compared to $0.5 million a year ago. This increase was attributable to our debt that was incurred in conjunction with the OrthoHelix acquisition in October 2012 and increasing of the OrthoHelix contingent consideration liabilities.

Looking to our balance sheet, we ended the first quarter of 2013 with cash and available credit of $64.8 million. This amount was comprised of $35.8 million of cash and cash equivalents and $29 million in available revolving credit. Our outstanding long-term debt totaled $113.4 million at the end of the first quarter.

During the first quarter of 2013, our non-GAAP adjusted free cash flow was positive $8.7 million. The first quarter included $4.9 million of investments in implant instruments and $2.8 million of additional property plant and equipment.

Now let me provide our financial outlook for the second quarter and fiscal year 2013. As I do this, we are taking into account recent currency exchange rates, European market dynamics, our efforts to strengthen our U.S. sales channel, the timing of holidays and the number of selling days, product launches and our acquisition of OrthoHelix. As you have seen from our past results with a meaningful percentage of our business based in international markets, currency exchange rate fluctuations can create a significant difference between our reported and constant currency growth rate.

For this reason, we continue to focus on communicating the revenue of our business on a constant currency basis. In calculating our reported estimate, when it comes to predicting the value of the dollar versus the euro, we assume exchange rates similar to the current level.

That said, we do expect to see continued fluctuation in currencies in 2013. For the second quarter of 2013, we project constant currency revenue to be in the range of $76 million to $79 million inclusive of revenue from OrthoHelix of $7.4 million to $8.4 million, representing constant currency growth of 15.1% to 19.7% over the second quarter 2012 revenue.

Based on recent currency exchange rates, the second quarter 2013 reported revenue is projected to be in the range of $76.2 million to $79.2 million inclusive of OrthoHelix revenue. This represents growth of 15.5% to 20%. Second quarter 2013 extremities product categories revenue inclusive of OrthoHelix is expected to grow 19.7% to 24.4% in constant currency. We project our adjusted EBITDA as described in the GAAP to non-GAAP reconciliation provided in our earnings release, for the second quarter of 2013 to be in the range of $5.3 million to $6.6 million or 7% to 8.3% of reported global revenue.

Moving now to our annual guidance, based on our first quarter performance in and current business trend, we are reaffirming our prior guidance, which projects 2013 constant currency inclusive of OrthoHelix to be in the range of $310 million to $322 million, representing constant currency growth of 11.7% to 16%.

Based on recent currency exchange rates, 2013 reported revenue inclusive of OrthoHelix is projected to be in the range of $311 million to $323 million representing reported growth of 12% to 16.4% over 2012 revenue. Revenue from our extremities product categories in 2013 is expected to grow 15.5% to 20.2% in constant currency.

We project 2013 adjusted EBITDA to be in the range of $33 million to $38 million or 10.6% to 11.8% of reported revenue. As noted today and on our Q4 2012 call regarding 2013 adjusted EBITDA guidance, the 2013 initiatives, Dave and I have discussed primarily impact selling, general and administrative expenses, which we expect will remain at elevated levels in 2013 as a percentage of revenue until the benefits of these initiatives are reflected in our revenue growth.

In addition, as mentioned previously, we expect to record operating cost special charges totaling $8.5 million to $10.5 million in 2013. Of this, we expect $1.4 million to $3.0 million to occur in the second quarter. We also expect to record approximately $5.5 million to $6 million of inventory step-up charges in cost of goods sold during 2013, of which approximately $1.8 million to $2.0 million is expected to occur in the second quarter.

Amortization expenses are estimated to be approximately $15.7 million $16.2 million in 2013, compared to $11.7 million in 2012. We anticipate interest expense for fiscal 2013 to be in the range of $7.5 million to $10.0 million, including anticipated interest accretion charges of $1 million to $1.5 million relating to the contingent consideration for the OrthoHelix acquisition.

We also continue to expect the medical device excise tax to have a 100 basis points to 110 basis points negative impact on our 2013 adjusted EBITDA. With that update, we’d now like to open the call to your questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) Our first question is from Bob Hopkins of Bank of America. Your line is open.

Bob Hopkins – Bank of America

Thanks. Can you hear me okay?

David H. Mowry

Yeah, we got you, Bob.

Bob Hopkins – Bank of America

Good morning or good afternoon. First of all, just housekeeping item, can you remind me what the selling (inaudible) this quarter and how much you think that impacted growth?

David H. Mowry

Shawn?

Shawn T McCormick

Yeah, so it was primarily outside the U.S., Bob, and it was – what we’ve said on the fourth quarter call, it was a two day decrease. We really felt it was a little bit more than that based on the way it fell, so it maybe more like a 3 to 3.5 day. But just technically if you look at the 2 days it took about 1.5 of our growth rate.

Bob Hopkins – Bank of America

Okay. And then a couple of things, first specifically, can you just let us know exactly kind of what upper extremity growth do you need to achieve in the second half of this year to get the company to your goal of being on a pro forma basis double-digit revenue growth?

Shawn T McCormick

Bob, we don’t break it out that way and split that out upper versus lower. I think we’ve been very direct about things that we’ve put a lot of our emphasis on both the Ascend Flex and the Latitude UV product both fall into our ortho extremities category. So our focus on our growth is predominantly from those two products and significantly from the Ascend Flex, which won’t really start occurring until third quarter.

Bob Hopkins – Bank of America

All right. And then maybe just lastly, maybe you can just kind of provide for us kind of a list of what are the things that really give you confidence in that line they’re saying that you’ve drawn about the second half. Just kind of run through some of the things that again give you that confidence that you’re going to get there in the second half?

Unidentified Company Representative

Bob, I think it’s the three key initiatives – the critical initiatives we laid out for the company and I’d start by saying its U.S. sales transitions. I think that we have found the ability to work collaboratively with our distribution partners in the U.S. in particular. We’ve been able to create a little bit more a collaborative relationship with them as we move forward. We’ve taken feedback from them and actually started to work actively with them as we move forward.

I think that’s going to help us drive that upper and lower focus that I think we saw, that’s what we need. I think the second lever is the OrthoHelix integration and not only are we going to start to see some additional benefit from that in the U.S. with cross selling opportunities with their customer base and ours combined but we’re going to start to see the international component of that starting in the third quarter. Most of the risk of execution now is starting to move downstream, if you will, into supply chain focus and then ultimately to marketing. We’ve taken the risk of regulatory out of flag.

And I think the last element I’d say is the Ascend Flex we’ve been tracking immediately to our metrics of leading indicator in terms of getting the training done and have done a quite of bit of not only training, but a lot of infrastructure building regarding the roll out of that product. So, all of the critical path items within the company‘s control have been executed to our plans for each of those three initiatives and we are feeling very, very good about it.

Bob Hopkins – Bank of America

Great, thanks. I’ll get back in queue. Thank you.

Operator

Our next question in queue is from Mike Weinstein of JPMorgan. Your line is open.

Michael J. Weinstein – JPMorgan Securities LLC

Thank you, good evening, guys. Maybe a few items here and I just want to follow-up on some comments you made. So first off, you talked about the training path for (inaudible) and you targeted training 100 physicians by the end of the year. Could you put that in some context for us, so when you talk about 100 physicians, and we assume those are going to be on the more important scale to you guys. How does that 100 physicians in their volume looks relative to your overall volume in U.S. operating extremities?

Unidentified Company Representative

Just to be direct, Mike, we haven’t built up model out for folks and talking about what volume that does or doesn’t represent, I think your assumption is right that we’re going to focus on some of the larger opportunities and prioritize those. And what we’ve said historically and I’ll repeat here is that the composition of that 100 physicians trained is a breakout of competitive docks, cannibalization of existing docks that have been waiting for the press that reverse. And then also a combination of folks that have moved some of their reverse business to competitive products, but still use us for the anatomy or primary. And I think that composition, what we’ve said historically is we’re targeting a 60-40 split, trying to build some competitive conversions, specifically in those that have moved their reverse business as lower hanging fruit if you will.

Michael J. Weinstein – JPMorgan Securities LLC

Okay. But maybe we can do this way, let’s put that those 100 physicians in that training curve, that occur your training relative to where you are today and what you’re expecting to train over the next six to nine months. And is that compared to prior launches for 28?

Unidentified Company Representative

Well, I think first of all, I’d stipulate that the launch plan here continues to be what we’ve done historically and that is building and understanding through our limited use of release incorporating those learnings into our training and then stepping that out on a more gradual basis. I think that you would find that our 2013 revenue associated with Ascend Flex has a pretty significant ramp up towards the latter half of the year, obviously and more specifically in the fourth quarter, as we gain additional conversion and folks work through the pricing agreements and IRBs at their hospital et cetera.

Michael J. Weinstein – JPMorgan Securities LLC

Okay. But do you feel like given the timetable for your training and the timetable as well for getting those agreements in place and so forth. That puts you on a path to getting to that double-digit 100%?

Unidentified Company Representative

Yeah.

Michael J. Weinstein – JPMorgan Securities LLC

Revenue target before…

Unidentified Company Representative

So I think it does, Mike. Our perspective is, this is one of several components that lead us back to double-digit growth. So we’re not relying only on this as that lever and we do believe the contributions from our training program and launch plan do get us back to that double-digit growth.

Michael J. Weinstein – JPMorgan Securities LLC

Okay. What’s happened in adult distribution if we can, you had shared with everybody on the fourth quarter call where you were on the execution of your distribution strategy and putting in place a specialized distribution for both upper and lower extremities, you gave us the update today that you’re down by 21% of U.S. revenues cover. Can you share with us every table that would be an insight into the performance, 21% that you have converted versus the 79% that you’ve not yet converted?

Unidentified Company Representative

So I want to…

Michael J. Weinstein – JPMorgan Securities LLC

It looks like that way there.

Unidentified Company Representative

So Mike, I wanted to start by being crystal clear about the 21%. Shawn alluded to the fact that some of our OpEx are spending, we’ll shift on a go-forward basis. So even though, a 21% are in agreement for transition, some of the sales training, a lot of the investments getting out of the field and helping people be focused and dedicated to that sales channel, if you will, still have to be done. So we’re very pleased to be at 21% under agreement to transition, but we have it effectively executed all the steps necessary to drive that efficiency.

So there’s still quite a bit of headroom for us to improve upon. And what I alluded to in my comments to Bob and his question was that we’ve started to create I think a little bit better working relationship between the management team and our distribution partners that I think will hasten that ability for us to invest in that group on the future.

Michael J. Weinstein – JPMorgan Securities LLC

Okay, and one of the concerns people have had as been, as you go to this process and you approach distributors and say, hey, we want you to change your model, we really only want your to focus on what your best outage maybe upper extremities or lower extremities, not everybody is going to be initially receptive to that. But that does cause in your view, any disruption at this point or do you feel any different about the risk of disruption in the short-term in order to get the long-term gain?

Unidentified Company Representative

Certainly, Shawn I don’t have our head buried in the sand. We’ve recognized there has been some disruption and that has been accounted for in the guidance that we’ve provided to the street. We also believe that there’s future risk in the transitions that has not yet been realized as we move through them. So I don’t think anything has fundamentally changed in terms of our understanding of risk. However I would tell you that I think that we have a larger percentage now of our sales organization in the U.S. that have been moved two agreements. So we’ve reduced the volume of our risk, but we haven’t reduced the impact of disruption.

Michael J. Weinstein – JPMorgan Securities LLC

Perfect, okay. Great, thank you guys.

Unidentified Company Representative

Okay.

Operator

Thank you. Our next question in queue is from Matthew O’Brien of William Blair. Your line is open.

Matthew O'Brien – William Blair & Co. LLC

Thanks for taking the question. Hoping we could start on the lower extremity side, just looking at the Q2 guidance that you provided. So that business, I think the way I’m calculating it, it looks like about 7% growth for the core business outside of OrthoHelix that you’re modeling in there. First of all, is that math right?

Then secondly, that’s a little bit below the overall growth rate of that industry that we’re seeing right now. Is there something on the product side that you’re missing or is it just more a function of a little bit more medical education that can accelerate growth? So should we anticipate that the performance there will improve throughout the course of the year?

Unidentified Company Representative

Well, I’ll need to dig into your numbers, Matt to give a clear answer about legacy Tornier business. I don’t have those immediately in front of me. We’ll work on that. But I think, I could answer your question more globally. I think that there is – we’re still seeing a little bit of drag on the legacy Tornier products in particular. Some of these were in need of being refreshed. Some of these are overlapping with some of the OrthoHelix products. But what we all need to start thinking about is that OrthoHelix is part of the organization. We started to impact our sales and distribution network with that product.

We started to have, if you will cannibalization of product from the Tornier line and discontinuing certain products or at least slowing down those products in lue of the OrthoHelix product. So we have to think about it really is a combination and not as legacy Tornier and OrthoHelix as additional.

Matthew O'Brien – William Blair & Co. LLC

Okay, fair enough. And then I’m sorry I know it’s early days and but the [Flex] is such an important for your upper extremities business going forward. I think you said of that 46 you trained, more of them are more competitive in nature. Can you give us a sense for some of the docs that you’re able to capture back? They move over to competitive convertible shoulders. Just are they basically just traveling the device at this point or they told you we’re really like we see here? We’re probably going to continue to use you guys exclusively going forward.

Unidentified Company Representative

Well, first of all I think generally the movement of orthopedic surgeons is to trial and evaluate and then make the decision and we would expect nothing less than that. We want to characterize the fact that we’ve got a lot of excitements, people want to be trained. We’ve still got training classes and we’d look at doing these in smaller more intimate training session to ensure that we have greater percent of conversions from the training.

So we’re very focused on rolling this out in a very thoughtful and methodical path, specially, and you’re right. We have targeted some of the converted or targeted converting competitive accounts in particular with this product, because we have been on decent off a long time and I think that this product in particular allows our sales organization to go on offense, and we’ve seen the impact of that in terms of what positions are willing and able to come to training.

Matthew O'Brien – William Blair & Co. LLC

Okay. And then, just one more for me and this is probably for Shawn, but just the adjusted gross margin in the quarter was quite strong. How should we think about that metric exiting the year given that you won’t have charges to deal with or most of the charges to deal within Q4? And then, I think you talked about some SG&A spending and started to see the benefits of that down the line. Is that more of a 2015, is that we start to get the benefits there or could we start to see some more of that next year?

Unidentified Company Representative

Yeah, so, Matt, part of that answer is in my comments. As we see revenue growth, that’s when we’ll start to see that leverage. We continue to be focused this year on ensuring that we have the right investments in place for the long-term and looking out to 2014, I expect we will see some level of leverage. But really I think it will be 2015 where you start to see significant leverage dropping through.

Matthew O'Brien – William Blair & Co. LLC

Okay. And I’m sorry, just the gross margin exiting the year?

Unidentified Company Representative

Well, in gross margins, the first quarter, I think was reflective of a nice pick up. I think we still have some opportunities for the overall year and as I said before, my guidance to the mid-70s percent is a longer term over a couple of years. But I expect that you will see our margins as we exit this year, a nice pick up from where we exited 2012.

Matthew O'Brien – William Blair & Co. LLC

Okay. Thank you.

Operator

Thank you. (Operator Instructions) Our next question is from the line of Matt Miksic of Piper Jaffray. Your line is open.

Matt Miksic – Piper Jaffray

Hi. Thanks so much. Question, if you could, Dave just on, maybe sketching out, what does the new shoulder launch look like free to in terms of really coming up to a pull headed theme, you’ve talked a fair amount about this early searching group and gaining momentum by the end of the year. But I mean to put it in perspective, does this take 12 to 18 months to sort of really be firing on all cylinders or maybe just to put things into context for us? That will be helpful.

David H. Mowry

Matt, I think what we have historically done with launches of major product platforms is to roll them out through a very methodical process and I don’t see a reason to depart from that. I think with the Synflex, we do have some familiarity with the Syn. So in terms of customers that have familiarity with Ascend in their primary, using it on the primary side. We maybe little bit more accelerated. But the opportunity go after conversions, I think is going to take time and focus from the organization. So I think to get to full ahead of team and really be going out and converting people, you probably are tracking 12 to 18 months to get to the right path if you will.

But what we’ve tried to do is target those lower hanging fruit opportunities in terms of folks that are maybe still using Tornier on the primary side as well as targeting larger volume people that we believe could contribute more aggressively to our revenue growth. And I think those are still playing out very well.

Matt Miksic – Piper Jaffray

Okay, that’s helpful. And then you mentioned Shawn or you had mentioned this preliminarily placement, implant replacement technology through a pre-lab planning or imaging solutions. Can you talk a little bit about that I mean just part of challenges of sort of (inaudible) maybe…

Shawn T McCormick

Yeah.

Matt Miksic – Piper Jaffray

What’s the timing and what’s the impact is this sort of a market expanding opportunity or some color will be helpful?

Shawn T McCormick

Yeah, I don’t think it’s so much of marketing expanding opportunity. We know that glenoids get placed right now on our total shoulders. I don’t think this is going to significantly increase the number of total shoulders placed. I do believe that this is going to have significant consequences on outcomes though.

As you alluded too renovate placement and this association of loosening is the largest complication within total shoulder right now. And I think what we see is five years survivorship of glenoid to be something less than 95% right now. So that’s a significant contributor to overall survivorship of a total shoulder replacement. I believe that with this technology, we can improve and I say this kind of – with all due respect, we can improve outcomes on the lowest common denominator of glenoid placement and level of playing field between those left train to those experts in the field.

Matt Miksic – Piper Jaffray

That’s helpful. And then on finally on some of these biologics product that you mentioned, can you give us some sense of maybe if it’s across which lines of your business that these products have an opportunity to penetrate and maybe to just take $1000 procedure for you and turn it into a $2000 procedure, what percentage of your revenue is spent for, if it’s sports medicine or shoulder (inaudible) biologic pads through it?

Unidentified Company Representative

Well, almost exclusively they fit into the sports medicine procedures. Although we think that there are some complementary opportunities, we’re really modeling these as sports medicine procedures, specifically rotator cuffs and Achilles tendon and even some of the bone fixation procedures as well could benefit from both suture as well as bone anchors.

That being said, we’re really focused on the upper extremity in particular with the products that are currently coming through the pipeline. Although new products that are going into the pipeline through R&D development are probably more heavily focused on lower extremities. So I would say we can look up for the year and bring it down to between upper and lower sports medicine procedures leveraging the biologics suture and anchors.

Matt Miksic – Piper Jaffray

I mean in the case of like for example, some of these products are you – does this drive incremental 30% percent of revenues for the case…

Unidentified Company Representative

Well, I’m not sure I can draw to that specific level, but I think you’re thinking about the right way. These are procedures that we’re already participating in and it’s an opportunity for us to increase our sales productivity by driving incremental revenue with the case. And future is not exceeding the expensive product. However, the fact is that it sits there on the shelf and allows our sales team and the company to appreciate kind of almost an annuity of having that surgical or having future years in surgical procedures.

Matt Miksic – Piper Jaffray

Great, that’s helpful. Thanks.

Operator

Thank you. Our next question in queue is from Larry Biegelsen of Wells Fargo. Your line is open, please go ahead.

Larry H. Biegelsen – Wells Fargo Securities LLC

Thanks for taking the question. I wanted to start by focusing on the distribution transition in the U.S. and some comments you’ve made on the calls about going direct in some territories, we have heard that you’re planning to go direct or have some of your largest territories in the countries. And I guess I wanted to know how many, the number of territories you have gotten direct and the plan for that and the rationale and just maybe, just an update on the timing there in the costs associated with that. Thanks?

David H. Mowry

Larry, it’s a great question. I’d first like to be very clear that we don’t have a specific intent to take any geography direct or make any direct territory at distributor. I think what we look for is the best solution for each territory as we move through that area. So there’s no intended plan to move to a greater percentage of direct. I do think that as a result of some of the transactions that have taken place thus far through the year, we do have a slightly higher percentage of direct territories. and certainly, as a company, we appreciate those from our perspective that having mine some mines here if you will, of those folks operating in that space. But that doesn’t suggest for a moment that the direct sales model, is the right model for our territories, nor is it necessarily the right model and so we look at all available options within the territory. So we don’t have a pretty scribed number at all in that regard. That being said, I think that some of the larger territories that we have, we still need to move through in kind of the thoughtful way and work collaboratively with the distribution partners that we have in that space.

Larry H. Biegelsen – Wells Fargo Securities LLC

Okay, Just then I wanted to ask about the guidance, and it came up earlier on this call. But the second half double-digit sales growth on a pro forma basis, is that more or like Q3 or Q4 and then I just got one additional question on the guidance?

Unidentified Company Representative

Well, we’ve set all, I’m going to start the answer and then I’m going to turn over to Shawn, but we said overlong that really the return of double-digit growth is the combination of those three critical objectives we’ve laid out for the company, and we believe that the entire organization is aligned behind those three of sales force transition to direct the OrthoHelix integration, which includes both U.S. cross-selling and OUS sales growth and then the last is the Ascend Flex and other key product launches. And it takes all three, those really kind of hit a concurrent point early in the third quarter as the OrthoHelix approvals and launching the international markets to take place, some of these transitions in the training of the sales reps across the full bag of low extremities start to have some traction, and then finally, the Ascend Flex starts to rollout in commercial launch.

And just a remainder to those on the call, we are still in our limited use of release on the Ascend Flex and have not commercially launched that. So we still have ways to go on each of those. So you’re asking me to pick a point in time and what I would tell you is that point in time swings forward and back depending upon the execution of each of those three. I think we still feel very confident of returning to that double digit trajectory in the second half. And that’s what we continue to stand by.

Larry H. Biegelsen – Wells Fargo Securities LLC

Dave, one last question on Japan. Could you give us, you know, that was a big opportunity and I’m sure it still is to you. Can you give us a quick update on that and the reverse shoulder, I know it was a big opportunity for you there, you’re going to have to meet those (inaudible) today, and a drop. Thanks.

David H. Mowry

That’s a great question. We still have that opportunity in front of us. I would remind everybody that once we get approval which is forthcoming. We will still have to wait six months to get reimbursement in Japan following that approval. So we’re still targeting, getting that launched and fully up and running later in 2013 or early 2014 depending up on the speed of reimbursement.

Larry H. Biegelsen – Wells Fargo Securities LLC

Thanks guys.

Operator

Thank you. And with that I’m showing no further questions in queue. I’d like to turn it back to Dave Mowry, CEO for further comments.

David H. Mowry

Well, thank you operator. I’d like to thank each of you for listening to the call today. As you heard from my comments, I remain confident that our commitment to execution to our critical objectives, including the U.S. sales channel alignment, our international sales strategies, OrthoHelix revenue expansion, and key new product launches will have a significant impact on our financial performance and will result in Tornier’s returns to double to digit constant currency revenue growth on a pro forma basis during the back half of 2013.

Furthermore, our focus on selecting and executing the right projects and programs aligned to our serving specialist strategy provides Tornier with a platform for sustained growth into 2014 and beyond. I along with the entire team appreciate your interest in Tornier and look forward to updating you on our progress on our next earnings call in August. Thank you.

Operator

Thank you. Again, thank you ladies and gentlemen for joining today’s conference. You may now disconnect. Have a great day.

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