CONMED Corp. Q2 2009 Earnings Call Transcript

Jul.30.09 | About: CONMED Corporation (CNMD)

CONMED Corp. (NASDAQ:CNMD)

Q2 2009 Earnings Call

July 30, 2009 10:00 am ET

Executives

Joseph Corasanti - President and Chief Executive Officer

Rob Shallish - Chief Financial Officer

Analysts

Matt Miksic - Piper Jaffray

Raj Denhoy - Thomas Weisel Partners

James Sidoti - Sidoti and Company

Dalton Chandler - Needham & Company

Brad Even - Heartland Advisors

Operator

Good day ladies and gentlemen and welcome to the second quarter 2009 CONMED earnings conference call. My name is Heather and I will be your coordinator for today. (Operator Instructions).

I would now like to turn the presentation over to your host for today's call, Mr. Joseph Corasanti, President and CEO. Please proceed, sir.

Joseph Corasanti

Thank you, Heather. Good morning, everyone, welcome to CONMED Corporation's second quarter 2009 earnings conference call. With me today is Rob Shallish, our Chief Financial Officer. After formal remarks the call will be opened for questions.

Before we begin, let me remind you that during this call we will be making comments and statements regarding our financial outlook, which represents forward-looking statements that involve risks and uncertainties as those terms are defined under the Federal Securities laws.

Our actual results may differ materially from our current expectations. Please refer to the risk factors and other cautionary factors in today's press release as well as our SEC filings for more details on factors that may cause actual results to differ materially. You will also hear Rob and me refer to certain non-GAAP measurements during this discussion.

While these figures are not a substitute for GAAP measurements, company management uses them to aid us in monitoring the company's ongoing financial performance from quarter-to-quarter and year-to-year on a regular basis and for benchmarking against other medical technology companies.

Non-GAAP net income and non-GAAP earnings per share measure the income of the company excluding credits or charges that are considered by management to be unusual or outside of the normal ongoing operations of the company. These unusual items are specified in the reconciliation in the press release issued this morning.

With these required announcements completed, I can now turn to my comments.

We are now nine months through an extraordinary and difficult period in the world's economy and healthcare, in particular. Like many other medical technology companies, CONMED has been adversely affected by unfavorable foreign currency exchange rates, reduced capital spending by hospital customers and for some surgeries a lack of typical growth and procedure volume.

And well, may be sometime before the company returns to the sales volumes and profitability of 2008, we believe that our top line has stabilized and that the cost efficiency actions we have taken will result in a stronger business as we enter 2010. However, as I will discuss shortly, we are taking a conservative view of the second half of 2009.

So with that brief summary of the company's operational status, let me review the second quarter's results. Sales in the June 2009 quarter were $164.6 million, about 15% less than sales in the June 2008 quarter, but slightly better sequentially than sales in the first quarter of this year. While the comparison to last year's second quarter is disappointing, it is not unexpected in light of currency changes and a well reported slowdown in capital spending by hospitals.

From a profitability standpoint, net earnings are a fraction of last years' second quarter on a GAAP basis and reflect the adverse effect of currency changes, reduced sales volume and the cost of our various efficiency restructuring programs.

On a non-GAAP basis adjusting for unusual items, our pre-tax profits are sequentially higher in the second quarter of '09 compared to those of the first quarter of this year. With second quarter sales of $164.6 million and non-GAAP diluted earnings per share of $0.17, the business performed to the expectations we provided you three months ago on our last earnings conference call.

We hear a lot these days about green shoots indicating that things are getting better for the economy. For CONMED, we see green shoots and the relative stability of our business between the first and second quarters of this year as well as from the indications from our customers that capital product sales should pick up as the end of the year approaches.

Although, the overall economic instability has presented our business with short-term challenges, we remain steadfast in our belief that the company is well positioned for strong future growth. The economic slowdown will reverse in due course and the positive demographics for healthcare remain unchanged and in time the pent up need for the replacement of capital equipment and for surgeries will create enhanced demand for the medical devices of our company as well as for other medical technology providers.

In the last six months, we have seen single-use products which make up 75% of our business, decline about 2% constant currency compared to the same period in '08. Typically, we would have growth in mid-single digits.

We have every reason to believe that this reduced growth is result of the general economy. If the current economic conditions improve, we expect that this portion of our business will return to typical rates of growth.

The 25% of our business that is normally associated with the capital purchasing budgets of hospitals have suffered the most from the current economic conditions. In this most recent quarter, it was evident that customers continued with the cash conversation measures that we saw in the previous six months causing routine capital, equipment purchases to be deferred.

However, we continue to expect that these deferrals can only last a short period of time before the regular surgical schedules of hospitals maybe disrupted. In fact, as we alluded to earlier, we are starting to see signs that some business that was deferred in the first half of the year may come to fruition in the second half of the year strengthening our belief that we should experience an improved second half of 2009 compared to the first half.

As you know, our capital equipment products minimally invasive surgical video, surgical drills and saws and electrosurgical generators are subject to routine use and abuse and must be replaced on a regular basis for efficient conduct of surgery. We believe that delays in the normal replacement cycle can only last for so long, before surgical schedules are disrupted.

Since we have now been through nine months of reduced capital spending for our products, we believe we are closer than ever to a return to a more normal purchasing cycle.

As we've positioned ourselves for the economic recovery at the heart of our efforts will be the launch of new products. We are encouraged by the initial customer reaction to the recent introduction of our new Shoulder Restoration System from our arthroscopy development team. We believe that the system advances the technology for rotator-cuff repair and will be an important contributor to our long-term growth prospects.

The ECOM device for monitoring cardiac output on a minimally invasive basis during surgery continues to gain traction. While not yet significant from a revenue standpoint, we have added more institutions to the customer base and we are experiencing reorders of the single-use devices from prior hospital placements of the monitor, clearly a positive sign in this economic environment.

In the past, we have mentioned the anticipated roll out of the tissue sealing device from our electrosurgery group. We had hoped to have this product ready for market release during the third quarter of '09, but in order to maximize the products' profitability potential, we continue to work on the most efficient manufacturing techniques. While I cannot estimate a revised product release date at this time, we still expect this device will have significant revenue potential in the future.

Now turning to the company's cost structure, I can now report the transfer of production to our new plant in Chihuahua, Mexico is substantially complete. We have moved two product lines from upstate New York as well as all of the production that was previously conducted by a contract manufacturer in Juarez, Mexico.

This amounts to approximately 15% of our total manufacturing output. We started this process last summer even before the economy was significantly affected by the recession. Although, we have incurred certain costs during the current implementation phase, we have continued with the project knowing that the long-term benefits to our manufacturing cost structure will far outweigh the start-up costs. We anticipate that the expected cost savings will be realized fully in 2010.

Most recently, we implemented a consolidation of the administrative offices of our Endoscopic Technologies division into our corporate headquarters facility, previously located in Massachusetts. The merger of administration, marketing and R&D within the Utica, New York organization is expected to produce annual headcount cost savings of approximately $3 million to $4 million once finalized.

We would expect to begin seeing some of these savings during the fourth quarter of this year. As you noted, the sales organization for this division remains completed unchanged. Accordingly, we would not expect any disruption to our customer base of GI endoscopists and pulmonologists.

Over the last year, this division launched four new products. We plan on continuing a similar level of product development in the future. We will also continue to treat this product line as a distinct segment for financial accounting purposes and we will disclose revenues and profitability as we have in the past.

In addition to our ongoing efforts to improve the manufacturing and administrative cost structure, we've delayed hiring for certain open positions, reduced production where there are sufficient finished goods on hand and frozen the company's defined benefit pension plan for United States employees.

All of these actions have been taken knowing that we must keep the cost structure in line with the current business realities. However, we have not reduced our previously established sales, marketing and R&D activities, which we believe are critical to the future prospects of CONMED.

As I mentioned previously, as we look to the reminder of this year based on our discussions with customers and our own sales professionals, we believe that the second half of '09 should show improved financial performance over the first half.

The third quarter of the year with its summer months is traditional the softest revenue quarter of the year. While this year is far from traditional and we now foresee the third quarter is shaping up much like the first two quarters of the year.

We expect third quarter revenues to total $163 million to $168 million and non-GAAP earnings per share to approximate $0.15 to $0.20. This non-GAAP EPS estimate excludes the manufacturing, restructuring costs, facility consolidation costs and the additional non-cash interest expense required by FSP APB 14-1.

For the full year of 2009, although we are seeing signs of improved second half performance particularly in the fourth quarter, we are revising our previous full year guidance out of an abundance of caution. We now expect total of year 2009 revenues to approximate $670 million to $680 million, a $10 million reduction from our previous estimate.

We expect that for the full year, the related diluted earnings per share on a non-GAAP basis will be $0.85 to $0.95, a reduction of $0.07 compared to our previous estimates. These non-GAAP estimates exclude the additional non-cash interest expense required by FSP APB 14-1.

Net pension curtailment gain from the first quarter and all of the manufacturing, restructuring and facility consolidation costs expected to be incurred in 2009 that are presently not determinable.

In conclusion, we believe that we have experienced stability in the business from our sales standpoint and that we should start seeing sequential growth as we enter the fourth quarter of this year. We have a strong diversed product portfolio that meets the needs of surgeons and hospitals.

We have managed and will continue to actively manage the cost components of our business that will result in a very positive effect on the profitability of the business, as we exit 2009 and enter 2010. I am confident that we are moving in the right direction and are well positioned for increased profitability as the economy improves.

I would now like to turn the call over to Rob Shallish, our CFO, for a further review of the financials.

Rob Shallish

Thanks a lot, Joe. I will spend a few moments of this morning to discussing our second quarter's financial results and then spend the remainder of the time on a more detailed explanation of our second half forecast.

While, we typically compare our financial results year-over-year, because of the adverse economic changes from a year ago, for the purpose of this discussion I think it maybe more useful to compare this year's second quarter results to those of the first quarter of this year.

As you may recall from our first quarter conference call, we forecast that the second quarter of 2009 will produce financial results very similar to the first quarter on a GAAP adjusted operating basis. This in fact did occur with the company second quarter sales slightly better than the first quarter and was slightly higher non-GAAP income from operations than that of the first quarter.

Non-GAAP diluted earnings per share in the second quarter were equal to $0.17, $0.02 less than the $0.19 in the first quarter. But only because of favorable income tax adjustment in the first quarter, that cause the effective rate to be much lower than normal.

Foreign currency exchange rates moved in our favor during the second quarter when compared to the first quarter of the year. However, the rates remained unfavorable compared to the second quarter of 2008 and sales were $9.5 million less than they would have been if that 2Q '08 rates were in effect.

Our gross margin percent of sales on a GAAP reported basis was 47% in the second quarter compared to 46.5% in the first quarter of 2009. Adding back the appropriate quarters manufacturing, restructuring cost included in cost of sales, the pro forma second quarter gross margin percentage was 49.2% compared to 48.3% in the first quarter.

Lastly, adding back a $9.5 million second quarter currency effect to both sales and gross profits for the second quarter, yield a gross margin percentage at 52%. The similar calculation for the first quarter yields the very same gross margin percentage.

The point of all this is that, when adjusted for restructuring and currency the second quarter was a repeat of the first quarter from a gross margin standpoint, as almost exactly the same gross margin percentage as the second quarter of 2008.

SG&A expense as a percentage of sales in the second quarter was 39% compared to 37.7% in the first quarter. The amount is higher than anticipated percentage for the full year of 2009 because of higher marketing cost in this quarter, which we expect to moderate during the reminder of the year.

Research expenditures were at 4.5% of sales in the second quarter compared to 5.2% of sales in the first quarter of 2009. The decrease is a result of the completion of certain projects in the first quarter. Our target for R&D for the rest of the year is approximately 4.5% of sales.

The company's income tax rate in the second quarter was 37.5% compared to the first quarter's rate of 23.9%. As I mentioned, the lower income tax rate in the first quarter was a result of the completion of the 2007 IRS audit and a reversal of reserves the company had previously established for potential adjustment.

We expect that the rate for each of the next two quarters will approximate the 37.5%. As I always do, I mentioned that payment of nearly all of this tax provision is deferred to future periods because of differences in reporting expense for financial accounting compared to tax accounting, thus increasing the company's current cash flow.

Now turning to the balance sheet. The company's cash balances are approximately the same as December 2008. The company's balance sheet debt decreased approximately $500,000 since December 2008. And usage on the receivable securitization facility also declined $3 million, which results in a net $3.5 million decrease in financing since the end of last year.

As a result of the company's earnings, and debt reduction, debt-to-total book capitalization declined to 24.9% at June 30, 2009 compared to 25.6% at the end of December 2008. Because of the retroactive restatement for FSP APB 14-1 affecting our convertible bonds, these debt-to-total book capitalization amounts are less than what we have previously reported due to characterizing a portion of the convertible bond as equity rather than debt, as required by the new pronouncement.

Our days investment in inventory at June 2009 was equal to 169 days, above where we have been running in the last several quarters. Accounts receivable days in June 2009, adding back the effect of the $39 million utilization of the securitization facility were 73 days in-line with our historical average. In absolute dollar terms, receivables have decreased since December 2008.

Let me now spend a few moments on our rationale for our forecast for the rest of the year. As Joe mentioned the total sales forecast is $670 million to $680 million. To achieve this sales level, we expect that the third quarter sales will approximate what the company achieved in each of the first two quarters of the year, about $165 million and that the fourth quarter will produce revenues in the neighborhood of $180 million.

So why do we anticipate an increase in the fourth quarter sales of approximately $15 million over what we have seen recently? Importantly, the usual seasonal pattern for the fourth quarter is to be the strongest sales quarter of a given year.

For example, in 2006 the fourth quarter sales were $15 million higher than the third quarter sales. In 2007, the quarter-over-quarter increase was even higher, $25 million. Last year, this did not occur because of the significant downturn in the economy that began in the September, October timeframe.

The economic climate now, while far from ideal has certainly improved as compared to the fourth quarter of last year and we believe it reasonable that we will return to a more normal seasonal cycle as we progress through 2009.

Further, in discussions with our customers, we are hearing that frozen capital budgets may be starting to thaw for items considered necessary for replacement of capital equipment currently in use. While it is possible that a thaw may not occur in short order, due to any number of reasons, delays in purchasing replacement capital equipment that have been in effect cannot last indefinitely.

Turning now to profitability. Our quarterly sales increase of approximately $15 million should produce $0.10 to $0.12 of earnings per share when considering the cost of the products sold and variable costs such as commissions. Also with increased volume, our manufacturing plants operate more efficiently and we would expect an increase in gross margin.

Lastly, cost reduction programs that we have implemented should start having an effect in the fourth quarter as the manufacturing, restructuring benefits start to be realized, as well as reduce costs from the consolidation of the Endoscopic Technologies administrative office.

In the end, we believe that all of these factors can result in a reasonable expectation that the fourth quarter's earnings this year can achieve non-GAAP EPS in the [mid-30 some] range. As a result, that would be a result that would be very comparable to the $0.34 of non-GAAP earnings per share that the company earned in the fourth quarter last year.

Now with that Heather, I would like to open up the lines for questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions). Your first question is from the Matt Miksic with Piper Jaffray. Please proceed.

Matt Miksic - Piper Jaffray

Hey Joe, hey Rob, couple of questions. Thanks for taking our questions this morning. First on the hospital trends that you're seeing, you mentioned I think in the past that you're seeing sort of increased evaluations and I think your comments this quarter are more focused on what some of your customers are saying to you regarding the back half.

Could you sort of give us a sense of what exactly you're hearing or may be how that compares to previous years? What kind of leave time you might normally get from purchasing managers that they think about the back half?

Joseph Corasanti

Sure. There's one large institution in particular that we think is finally releasing the order for capital, so that's one indication, and maybe even more importantly this two hospital systems IBNs if you will large ones that have indicated that they are willing to release some budget money for capital for the second half of the year.

So I think we are relying on those three sources and maybe several others that we hear from our sales force regarding individual hospital accounts and a lot of these are hospitals accounts for the evaluation that we were completed or are in process and they are getting indications that deal's on the way.

Matt Miksic - Piper Jaffray

Okay, that's helpful. And then on spending also wondering whether you are seeing any change in either the kinds of evaluations you are getting pulled into or the way hospitals are behaving around sort of value pricing preferences for the second or third tier product offered at better pricing versus sort of the premium priced [to real end of] the market. And if you are seeing any of that first of all and if any of that does happen. Do you see any of your businesses benefiting from that kind of more selective behavior?

Joseph Corasanti

Well in Electrosurgery, our generators are priced a little bit under the competition. Though we could see a benefit there if that were the case, but I haven't seen any indications that the customers are seeking out more value propositions with capital. In terms of the video systems, pricing has consistently been pretty equal with the three or four competitors that have high definition video.

But I haven't heard of customers seeking out value propositions in terms of not buying high definition or a more extreme example would be foregoing a three chip camera in favor of a less expensive single chip camera. I have not heard of any incidents like that.

Matt Miksic - Piper Jaffray

Okay. And then on the P&L I guess I mean a question for you or for Rob, as I look at the reduction in the top line and for the full year number 10 million and I sort of do some rough math on how that drops through the P&L. The $0.07 reduction looks like a pretty steep drop through of that $10 million.

Yet, you are talking about some consolidation of administrative offices I think based on where rates were in currency earlier in the year it seems like there would be some slight benefit potentially to the bottom-line, as well since that's where a big part of your talk was in the beginning of the year, right was around the hit from FX.

I guess I was hoping for and would have expected maybe a little bit more reduction here some around your operating expenses or some benefits just from the effects in the back half to make that bottom-line cut, a little less severe than the top line cut, which I should say conservatism I think is welcome in this environment.

We just love to see maybe a little less hit to the bottom-line. Any color you can provide on how you are thinking about the top and bottom-line, or anything you could do to quantify these administrative cuts that you are talking about?

Rob Shallish

Well, sure Matt. With the sales numbers we do want to provide a conservative estimate. So consequently we've brought the numbers down now from our previous estimate in April. I think that is the major factor there maybe the third quarter more so than the fourth quarter that three months ago we expect a little bit more of a pick up in the third quarter than I think we're going to get, and so consequently I think the reduction is more related to the third quarter than the fourth quarter.

Now in the fourth quarter we still expect a strong finish to the year. From a cost perspective, I think you are right that the $10 million of sales change is effectively that $0.07 number on an earnings per share amount. We're a little bit cautious on the manufacturing restructuring. We think that that will provide positive benefits to us, but it's little bit higher to quantify exactly because the manufacturing benefits first roll into inventory on FIFO accounting basis and then roll out to the P&L as inventory turns.

So as Joe mentioned that we're pretty much complete with the Mexico implementation of that plant and we should start seeing the production of that plant to produce lower cost product than we previously have had, but we still have to account for it on a FIFO basis. So I am a little bit cautious on when that benefit would roll out, whether we would see very much of it in the fourth quarter or certainly in the first quarter, and then with the restructuring of the Endoscopic Technologies sales office.

We do expect to see some benefit in the fourth quarter but perhaps not as much as we would typically see as we would go through 2010. So, we've taken those factors into consideration, tried to provide a conservative estimate and I do believe that the actions that we're taking will end up with favorability on a profitability line as we enter 2010.

Matt Miksic - Piper Jaffray

Just to push you a little bit on the cut. It almost looks like you should have taken your $10 million cut you've dropped it through as you say assuming modest to very conservative improvements from the manufacturing restructuring, but it almost seems like you are baking no benefit from the endoscopic SG&A reductions or improving FX rates. Am I not reading that the right way, I mean have you taken that conservative approach?

Joseph Corasanti

Well, I think the answer is, yes. I think that to some small degree we may have considered foreign currency which obviously is not necessarily guaranteed matter at this point, and the reduction for the administrative offices that's in rough terms about $0.02 a quarter, so it's within the range of variability that we've given $0.85 and $0.95. So, in a way it's a little bit difficult to actually quantify that as a, specific pennies per share number.

Matt Miksic - Piper Jaffray

I see. So maybe those things might push you to the top end of your range if they were to come in, but you may wind up at the bottom and range if they are less. Is that fair?

Joseph Corasanti

Yes, I would agree with that and we've obviously got an information forecast from each of our divisions what they expect to be doing for the rest of the year. If you add all that up that comes to a much stronger number than what we are talking about right here.

So we herein in head quarters have taken a conservative approach, cut that little bit in case the economy is little bit softer than what our divisions are expecting and effectively result in that $0.85 to $0.95. We could be very fortunate and see much higher than that, but as I say, we want to provide a conservative estimate.

Matt Miksic - Piper Jaffray

Okay, well thanks for taking the questions. I will get out of the way here for some other folks to jump in.

Operator

Your next question comes from the line of Raj Denhoy with Thomas Weisel Partners. Please proceed.

Raj Denhoy - Thomas Weisel Partners

Hi, good morning. Wonder if I could ask a little bit about the arthroscopy product line. I mean that was one that deteriorated even from the first quarter number. And I'm curious, if there is something behind that?

Joseph Corasanti

No, nothing really behind that from our capital standpoint, we have this business we call Integrated Systems which is a very enhanced video system in an operating room where the monitors are hung from the ceiling and we integrate the camera with the monitors with the computer control system.

I think we've talked about this before that this particular business can be somewhat choppy because of how hospitals give us their orders and then when they allow us to get into the operating room to do the installations. That particular business was down about $2 million from the first quarter. So I don't necessarily see that as an overall negative just because of that kind of a decline.

So if we add the $2 million or adjust for that $2 million the arthroscopy business is pretty much in-line. And I do say I guess I do have to say that I'm on a single-use line, we are down a little bit more than we were in the first quarter. I think in the first quarter we were down 1.5% or so and now we are down about 4% on a single-use basis. But we don't really see any trend that might be developing. I think it just happens to be the normal variation that we see in the business from time-to-time.

Raj Denhoy - Thomas Weisel Partners

Well that's actually when I was kind of getting, I think it was flat in the first quarter and then it was down 4% this quarter and I think Smith & Nephew just reported this morning and they showed I think pretty strong growth in kind of single-use for arthroscopy. I know it doesn't compare exactly across. But I guess I was just trying to see if there was anything maybe on the competitive side that was happening there or if you have any other explanations around that?

Joseph Corasanti

I really don't. What we do feel very positive about is this Shoulder Restoration System that we just came out with about three or four weeks ago. We really feel very positive that will help us to grow that business more than the market.

Raj Denhoy - Thomas Weisel Partners

Okay. When the cash flow is on the margin side, on the SG&A line which was higher this quarter I think you mentioned you had some higher marketing cost scenario expected to moderate. Maybe you could explain a little more what that was?

Joseph Corasanti

Yes. In the second quarter there are just many more marketing opportunities, various conferences that we go to and we are preparing for the roll out of the Shoulder Restoration System. So all of that added up to more than what we would typically see on an annualized basis.

Raj Denhoy - Thomas Weisel Partners

Okay. But we should expect that to moderate on a dollar basis going forward or it would be relatively flat here?

Rob Shallish

Moderate on a dollar basis and also as a percentage of sales.

Raj Denhoy - Thomas Weisel Partners

Okay. On the plant consolidation to move to Mexico, interesting, to see gross margins being basically flat, on the first quarter and also on the second quarter last year. I guess on one hand your capital business has been a lot weaker than your disposal business. I'm surprised why that gross margin hasn't maybe improved a little bit?

And then secondly, as we move into 2010 with the move in manufacturing and the consolidation of plants here, what do you think that gross margin can start to do? I mean, we were talking something in the low 50s, mid 50s and where can this number start to move towards?

Rob Shallish

Well, I think the low 50s is certainly a number that we would be working toward. It could be higher than that. But I think at this point anything more than the mid 50s or the low 50s is probably what we are to be looking towards. In terms of the gross margin comparison to the second quarter last year which is about the same as you pointed out, we really haven't seen the benefit yet of the manufacturing change to Mexico.

We're just now fully operational in Mexico and anything that's been produced there is still sitting in inventory from a FIFO standpoint and would not have affected the P&L.

Raj Denhoy - Thomas Weisel Partners

And just lastly, when I look at the foreign currency effect in the quarter, if I am not mistaken and I think you've shared this in the past, about $0.60 of every dollar of foreign currency falls through to the operating lines?

Rob Shallish

Yes, that's a good percentage.

Raj Denhoy - Thomas Weisel Partners

Sort of [that's right]. So I guess, if we look at the increase in operating income in the quarter, over the last quarter, I mean it was actually I think even less than what the foreign currency benefit would have been, which implies that you're still seeing a little bit of potentially negative leverage happening here.

I guess I'm just trying to get at when we can really start to expect to see this leverage flow through because it's been several quarters if not a couple of years that we've been waiting for the leverage to start materializing to a great degree.

I know you're still doing a lot of initiatives in your closing manufacturing facilities, some of the earlier questions, some of the deconsolidation of the operations. But at what point do we actually see the leverage, outside of foreign currency driven leverage really start to play through on your P&L?

Rob Shallish

Yeah, well that's a good question. Yeah, we were starting to see benefit on the leverage and I think through the third quarter of last year and then of course, currency went the other way. So, I do think we were seeing some benefit through say September of last year. I think, so much was masked right now by the economy and the low level of sales that we currently have as compared to what we think we should be having in a more routine situation from an economic standpoint.

So, as we go into 2010, I do looks back to some benefit from leverage. We've seen the negative effect of leverage to-date in the last three quarters. The third quarter coming up probably it's going to be a repeat of what we've seen in the first and second quarter.

So I don't expect too much change there with respect to say operating profits as a percentage of sales. But, when we get to the fourth quarter, with increased sales I think we should see that number go up and then I think it should go up, as we go through 2010.

Raj Denhoy - Thomas Weisel Partners

But, if I'm not mistaken, I mean do you even think the fourth quarter what you're sort of alluding to is that, leverage and in sense, the profit building improvement you're seeing in the fourth quarter is all being driven by the top line. And I'm trying to get, when we'll see start to see some of these expense reductions played through?

And it sounds like, if the top line doesn't materialize this year, as your projecting it does in the fourth quarter, that you're not going to see any expense reduction driven leverage in the model, in the sense it's not anticipated, its really come here until next year, is that fair?

Joseph Corasanti

Well, I think it's fair with respect to manufacturing, because as I mentioned before with FIFO inventory, it's probably unlikely that any of the reduced costs from the restructuring will flow through into the P&L until 2010.

And of course, that's going to be factor in leverage. The Endoscopic Technologies administrative change and some of the other things that we've been doing, in the scheme of things they are important and will be beneficial to the organization going forward.

But on a comparison to total expense it's rather low and only a few basis points perhaps in percentage. So, the major thing is the manufacturing restructuring that we would expect to see benefit from in 2010.

Raj Denhoy - Thomas Weisel Partners

Okay, fair enough. Thanks.

Operator

Your next question comes from the line of James Sidoti with Sidoti and Company. Please proceed.

James Sidoti - Sidoti and Company

Good morning Rob, good morning Joe.

Joseph Corasanti

Good morning.

James Sidoti - Sidoti and Company

I just want to go back to your guidance Rob I agree with you say about what's the seasonality in the fourth quarter that all makes sense to me. The question I have now is your guidance for the third quarter basically is looking for flat revenue and if you look at those same years you saw revenue had dropped in the third quarter due to the vacations and such, why do you think this year will be different?

Rob Shallish

Well that's a good question, Jim. You're absolutely right in a traditional year we would see the third quarter being softer than the second quarter sequentially. So, frankly we are expecting, we believe the second quarter and the first quarter were abnormally low because of economic activity and that the third quarter should show some improvement so to speak in economic activity making the sequence of sales and profitability about the same as the second quarter. So, I guess what we are saying is that the second quarter is and first quarter were abnormally low just because of the economy.

James Sidoti - Sidoti and Company

And now that we are about one month in the quarter I assume that you still, these numbers reflect the first month of the third quarter?

Rob Shallish

Well not to get in the monthly information but we obviously do have insight into what's going and in one month of the quarter. One month doesn't make a quarter, however just to be cautious but we do have that knowledge yes.

James Sidoti - Sidoti and Company

Okay and then on the Arthroscopy line I believe a lot of that is healthy distribution. Do you have any comment on inventory levels? Do you think that there could have been some destocking in the quarter or do you have any comment in all on what you think the inventory levels are in some of your distributors?

Rob Shallish

Jim, that's direct selling to our hospitals.

James Sidoti - Sidoti and Company

Okay. So that's all direct even the…

Rob Shallish

Its all direct, sometime in our investor presentations we mentioned that we have a hybrid sales force of about half is direct company employees and the other are third party sales agent groups. But they don't buy our product and resell it.

James Sidoti - Sidoti and Company

Okay, right, so there's not stocking there.

Rob Shallish

Yeah.

James Sidoti - Sidoti and Company

And then the last question I have is on the timeline for the restructuring. Going on to 2010, do you think these charges will all be done or do you think you'll still be taking some charges from either of the Mexico restructuring and now the latest round in consolidating the Endoscopic Technologies plan?

Rob Shallish

Well, I think that the restructuring costs are going to be finished for what we have talked about this year. Though the restructuring cost relative to manufacturing would be finished by the fourth quarter and same would be true to the best of my knowledge of the Endoscopic Technologies restructuring too.

James Sidoti - Sidoti and Company

Okay unless you announce any additional consolidations next year's number should look relatively the GAAP and the pro forma number should look pretty much in line?

Rob Shallish

Yes, exactly. I guess what we've got to do is decide about this non-cash interest expense on the convertible debt. Right now, we're calling that out as an adjustment to GAAP, and so as we get to the end of this year, we'll think about how we call that out.

James Sidoti - Sidoti and Company

Right. I mean the same thing happened with options expense, most companies broken out the first year, but in the second year when you had an apple-to-apple comparison, you'd -- a lot of companies tended to leave it in.

Rob Shallish

Correct.

James Sidoti - Sidoti and Company

Okay, all right. Thank you.

Operator:

The next question comes from the line of Dalton Chandler with Needham & Company. Please proceed.

Dalton Chandler - Needham & Company

Good morning. Just to take it a little more detail on the expense side of the equation here. You've been breaking out in cost of goods, some of the restructuring related expenses. It was about 3.7 million this quarter. With the move to Mexico now largely complete, shouldn't we start to see that number come down in the third quarter and then it sounds like by the first quarter of next year it should be completely eliminated.

Joseph Corasanti

Yes Dalton, you're absolutely right. In the press release I think we gave a number of $2.5 million for restructuring costs for the rest of this year. So that would be split between the third and fourth quarters, probably more in the third quarter than the fourth quarter, but as you can see the $2.5 million for six months is much less than the $3.7 million or so for just one quarter.

Dalton Chandler - Needham & Company

Okay, and then you talked about on the operating expense side you did have some unusually high marketing expenses, but when I look in total at the operating expenses, they're about little over $3 million higher when compared to the first quarter and it doesn't seem like all of that could have been marketing. Was there something else in there?

Joseph Corasanti

If we're just talking about SG&A, SG&A is about 2…

Dalton Chandler - Needham & Company

I was looking at all operating expenses which would include R&D and it was about $69 million in the first quarter and $72.3 million this quarter.

Joseph Corasanti

Let me just make sure I've got the numbers that you're using here. Okay, in the first quarter the big difference is that other expense line are showing $734,000 of expense in this quarter and in the first quarter I think it was a credit of perhaps $1.4 million, $1.5 million, I can't find my numbers that I want to have look at. So we had credit in the first quarter in that line because of pension freezing there was a gain as a result of that particular decision.

Dalton Chandler - Needham & Company

Okay, got you, and then in the past when you have made changes to your guidance, you've broken out for us the impact of your foreign currency assumptions. Do you have the breakout of that for the new guidance or I should say for the change in guidance?

Joseph Corasanti

Well, I guess to answer your question not directly, but in a way we've included some benefit for currency at on average of the second quarter rates, but not entirely if you will. So we've been a little bit cautious on that as well.

Certainly the second quarter rates of exchange were more favorable for us than the first quarter rates, and we've taken into effect in our thinking and in the rest of the year some additional favorability in currency exchange rates, but perhaps not the full amount that we saw in the second quarter compared to the first.

Dalton Chandler - Needham & Company

Okay, all right. Thanks a lot.

Joseph Corasanti

Thank you

Operator

Your next question comes from the line of Brad Even with Heartland Advisors. Please proceed.

Brad Even - Heartland Advisors

Yes. Good morning. Just to be clear into the third quarter you expect gross margins to be up in the third quarter versus the second quarter, is that correct?

Rob Shallish

Well, I would say it would be some minor improvement in gross margins. But on an overall basis, we think that the third quarter I am thinking about operating profit now, the third quarter would be about the same as the second quarter.

Brad Even - Heartland Advisors

So do you think I am speaking gross margin. So you think gross margins should be flat to slightly up is that what you just said?

Rob Shallish

Yeah I think what's going to happen is that the third quarter gross margin would be slightly higher than second. That's correct.

Brad Even - Heartland Advisors

And I thought I heard somebody say 50%, is that a fourth quarter target than you hope to be around 50% coming out of the fiscal year?

Rob Shallish

In the low 50s as we go into 2010, yes.

Brad Even - Heartland Advisors

Low 50s, okay. Do you expect your operating cost to be down from the second quarter based on your current revenue outlook, so, below the gross profit line selling general and administrative expenses plus R&D expenses. Do you expect the some of those two line items do you expect them to be down versus the second quarter absolutely, not on a percentage basis in absolute dollars?

Rob Shallish

In absolute dollars I think that they are going to be just about the same.

Brad Even - Heartland Advisors

Just about the same.

Rob Shallish

Between the two categories, yes.

Brad Even - Heartland Advisors

How does that number, I realize there will be some -- if you hit your top line number for the fourth quarter obviously some selling commissions that will influence the number. But absent that, do you see that number staying relatively flat as you go into the fourth quarter excluding the sales commissions?

Rob Shallish

I am sorry SG&A, you mean SG&A and R&D.

Brad Even - Heartland Advisors

I am speaking to the sum of selling, general and administrative expenses and R&D in the fourth quarter. I guess what I am asking is do you think you can hold your operating expenses flat, excluding sales commissions if you hit your top line guidance for the fourth quarter?

Rob Shallish

The answer is yes, I think obviously there is going to be some increase for commissions because of variability. We do see increasing healthcare costs and other benefit costs than lot of companies see. And offsetting that, we think that there will be some benefit out of Endoscopic technologies change.

Brad Even - Heartland Advisors

And so there is a chance that we will show positive year-over-year comparisons than in the fourth at some, if the top line materializes?

Rob Shallish

Yes.

Brad Even - Heartland Advisors

I heard a comment about sequential revenue growth, and I think you said, I think the comment was made that you expect sequential revenue growth over the next few quarters. So does that mean that if indeed you are able to meet your top line target for the fourth quarter that we could actually a sequential revenue growth into the first quarter of 2010?

Rob Shallish

What we see typically is that the first quarter's revenues are about the same as the fourth quarter's revenues. Now, we are coming out of an economic cycle, hopefully, we believe we are. So I think that the revenues that we've seen certainly in the past are diminished because of that.

We think that the third quarter revenues are still going to be affected by the economy. But we should see some benefit in the fourth quarter as the economy improves and hospital budgets unfreeze, so to speak. But I still think it's less than what we would typically see in a normal environment.

So it's not that I want to give the estimates for 2010 at this point. But it is possible that the first quarter's sequential revenues could increase over the fourth quarter. But I mentioned that only as an answer to your question Brad, I don't want to give guidance at this point.

Brad Even - Heartland Advisors

No, I understand and I don't want you to, I guess, I'm just trying to just thinking about coming out of a challenging year and entering a period of stability if not some type of modest recovery. It sounds like 2008 would be kind of a good financial model to be thinking about in terms of where the company could perform in 2010, if the economy and year end markets improve as you're hoping.

Joseph Corasanti

Well I do agree with that. I think that 2008 is a model that we'll be shooting for. A lot depends on currency rates because for most of 2010 the rates were fairly, very favorable for us. But as of there, we still should be seeing improvement along the lines of what we saw in 2008.

Brad Even - Heartland

Can I, just ask you in terms of free cash flow deployment. How do you, I saw that you've repurchased some bonds again in the quarter which I think is great. Any other thoughts in terms of free cash flow deployment?

Joseph Corasanti

Well actually in this quarter we did not purchase any bonds back. The last time we purchased bonds was back in the February timeframe so

Brad Even - Heartland

I'm sorry, I misread that. Sorry.

Joseph Corasanti

Minor debt reduction we had was really just -- was just in a senior debt in the receivable facility that we have. So cash flow, we would expect that it would be primarily debt reduction as we go through the rest of the year.

Brad Even - Heartland

Do you have a year end target, where you think you might be able to get total leverage to?

Joseph Corasanti

See, I don't have a number in mind to be honest with you, Brad. So I can't comment on that. As I mentioned, we would use the cash flow to reduce debt.

Brad Even - Heartland

Do you expect to be free cash flow positive in the second half?

Joseph Corasanti

Yes.

Brad Even - Heartland

Okay, thank you very much.

Operator

Your next question comes from the line of [Amit Nagpal with WCM]. Please proceed.

Unidentified Analyst

Hi, can you hear me?

Rob Shallish

Yeah, very well.

Unidentified Analyst

Thanks for taking my questions. Just to build on the last caller's questions I wanted to ask about how you're thinking about your operating expense management? In particular is your target spending for 2010 outside of the commissions, are you focused on a certain dollar, absolute dollar target for 2000 spend to get to or are you focused on a percentage of revenue? I would like to just to understand how you look at that from an operating expense management perspective?

Joseph Corasanti

While we are trying to look at it from a bottoms up perspective, so we're looking at dollars and of course we're trying to hold the dollar increase relatively flat as we look to 2010. So that would mean in the presence of increased revenues that the percentages will go up on a profitability standpoint. We haven't done all of our budgeting yet and so that something that we're always starting to think about.

Unidentified Analyst

Okay, and in terms of the gross margin outlook for 2010, once again not asking for guidance. You mentioned proactively that the sort of adjusted for FX and restructuring gross margin was 52% this quarter for the full year last year you were 52%. How would you ask us to think about the gross margin potential in 2010 given that you should have four quarters of the restructuring impacting the gross margin?

Joseph Corasanti

Well, I don't want to get into exact numbers. But we do feel that the restructuring that we've done should be positive for us going forward. Some of the new products that we have, the Shoulder Restoration System that we mentioned, that should have a positive impact, as well as the ECOM product. And we're hopeful that we can get the tissue-sealing product out early next year. So all of those things should be a benefit to the gross margin.

Unidentified Analyst

Okay. So once again to reiterate the comments made to the last caller, the profitability margins on the operating/EBITDA line that you've produced in 2008. Are those your stretch goals for 2010 or do you think that, can you just help us understand how you think about that?

Joseph Corasanti

Well as I said we really haven't set any goals yet for 2010 but looking at 2008 as a model I think maybe something that we should be thinking about. Certainly we should be doing better than 2009 and I guess I will get back to leverage, we do think we can leverage and structure that we have as an organization.

What's happened in the last three quarters is that we have had negative leverage, so sales are less and our structure is such that it results in lower margins than we would typically want to have. The upside is that as sales increase we should see margins which are more appropriate for our business.

Unidentified Analyst

Okay, all right thanks guys.

Operator

(Operator Instructions). And your next question is a follow-up from the line of Matt Miksic with Piper Jaffray.

Matt Miksic - Piper Jaffray

Hi Rob, Joe, one follow up here. I want to circle back to some of the costs you were talking about. Some of the benefits you were talking about as you head into the back half of the year that you weren't necessarily comfortable counting on for Q4, but if we look at the administrative restructuring that you are doing that's getting something like $0.02 a quarter once it starts rolling and maybe a little bit in Q4 but certainly in Q1 we would hope. How should we quantify the manufacturing benefit if we look at the same way?

Joseph Corasanti

Well I think we have talked about it in the past on the manufacturing side is $3 million to $5 million of benefit. Certainly we have got internal estimates which are greater than that and I would say that for sure we got to be hitting the top end of the $3 million to $5 million of benefit.

Matt Miksic - Piper Jaffray

And just to be clear is that $3 million to $5 million incremental to what's been achieved so far?

Joseph Corasanti

Well, I can't say that we have achieved great strides at this point. We certainly have adopted lean manufacturing techniques and portions of our manufacturing plants and I think that's helped us to some extend, and will continue to help us, but I think the real strides will be when the full effect of the Mexican operation comes on line.

As we mentioned we're just now fully operational in Mexico after moving into that plant on an initial basis back in January timeframe. So we got to work through FIFO inventory to see the benefits as I mentioned and so the full amount of restructuring benefit probably won't be seen until the first quarter of 2010.

Matt Miksic - Piper Jaffray

Okay. So that's most of that if we pick the middle of there its sort of $4 million would get us maybe $0.08 a year roughly another $0.02 a quarter roughly?

Joseph Corasanti

Yeah. In rough terms. Yes.

Matt Miksic - Piper Jaffray

Okay. That was all I had for follow-up. Thanks for taking all the questions.

Operator

There are no further questions in queue at this time.

Joseph Corasanti

Well I want to thank everyone for joining us today in our second quarter earnings conference call and we will look forward to talking about our third quarter review on our next call. Thanks very much.

Operator

Ladies and gentlemen, thank you for your participation in today's conference. This concludes the presentation. You may now disconnect. Have a great day.

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