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Wright Medical Group Inc. (NASDAQ:WMGI)

Q2 2009 Earnings Call

August 3, 2009 4:30 pm ET

Executives

Gary D. Henley - President, Chief Executive Officer, Director

John K. Bakewell - Chief Financial Officer, Executive Vice President

Analysts

Matt Miksic - Piper Jaffray

Raj Denhoy - Bear Stearns

Rick Wise - Leerink Swann

Taylor Harris - J.P. Morgan

Mike Matson - Wells Fargo Securities

Glenn Navarro - RBC Capital Markets

Joanne Wuensch - BMO Capital Markets

Jeff Johnson - Robert W. Baird & Co

Operator

Good afternoon ladies and gentlemen my name is Shamika and I will be your conference operator today. At this time I would like to welcome everyone to the Second Quarter Wright Medical Group Incorporated Earnings Conference Call.

This conference may contain forward-looking statements as defined in the Federal Securities Laws. Forward-looking statements reflect management’s current knowledge, assumptions, beliefs, estimates, and expectations of our management. They also express our management’s current views of future performance, results, and trends and may be identified by the use of terms such as anticipates, believes, could, estimate, expect, intend, may, plan, predict, project, will and other similar terms. Actual results may differ materially from those described in these statements.

Forward-looking statements are subject to a number of risks and uncertainties including the factors discussed in our filings with the Securities and Exchange Commission. These SEC filings include our 10-K for 2008 and our subsequent 10-Qs for 2009. These risks and uncertainties could cause our actual results to materially differ from those described in the forward-looking statements.

Although we believe that the forward-looking statements are accurate there can be no assurance any forward-looking statements will prove to be accurate. A forward-looking statement should not be regarded as a representation by us that the results described within therein will be achieved. You should not place undue reliance on any forward-looking statement. All forward-looking statements are made as of today’s date, and we assume no obligation to update any such statement after this date.

I would now like to turn the call over to Mr. Gary Henley, President and Chief Executive Officer. You may proceed sir.

Gary D. Henley

Thank you. Good afternoon everyone and welcome to our second quarter earnings call. Today we will be sharing with you details of our second quarter 2009 financial results, which reflect solid operational execution and excellent expense control, which enabled us to meet our bottom line expectations despite the headwinds we are experiencing in our current operating climate.

With me on our call today is John Bakewell, our Executive Vice President and Chief Financial Officer. As we have done in past calls I will start today with a summary of our top and bottom line results, then move into a detailed review of our revenue performance. John will then address other key line items that make up our financial performance and share with you our guidance outlook both for Q3 as well as our latest views on the full year 2009. Together we will wrap up our prepared section of today’s call with some business updates before we begin taking your questions.

As we get started I would like to point out that we will be using a number of non-GAAP financial measures to describe our performance. Regarding that I will refer you to reconciliations that appear in the tables of today’s press release as well as on our website. Note further that our Form 8-K filed today provides a detailed narrative that describes our use of such measures. Please note that unless otherwise stated all of todays discussions regarding results of operations refer to our as adjusted results.

Before we launch into our second quarter review I think it’s worth taking a few minutes to offer up some perspective on how 2009 is shaping up for us. Clearly the economic slow down has created some significant challenges for our industry to date and we would acknowledge that its impact is proving to be more significant than we had originally anticipated during the earlier part of this year.

Like everyone we have been concerned since the end of last year about the economic climate and its uncertainties, and well our expectations for 2009 were for another year of industry leading growth, we recognized as well our visibility into predicting the markets procedural demand was more limited than ever before.

That said, well the rest of the industry began to decelerate during Q4 of ’08 our in plant growth rates remained quite strong, and we followed that Q4 performance with Q1 results reflecting just a moderate amount of procedural deceleration within our customer base while most of the industry, most of our industry counterparts experienced considerable further sequential deceleration. Through out that time frame, as you know, we made adjustments to our outlook to reflect our best and current views of what was developing in the market and with our business and as our second quarter results would indicate it appears that our own procedural trends have now decelerated into a range that is consistent with that being experienced through out our industry. Consequently, we will be sharing with you, later in the call, a revised outlook for our 2009 year that reflects the trends we are now seeing in our business.

Although we cannot change this overall environment, we certainly can and will remain focused on mitigating the earnings impact of this procedural slow down while continuing to make operational improvements and investments that position us to share the success of an eventual market recovery. In that regard, we are very pleased with the progress that we’ve made through out the first half of this year and improving the core performance potential of our company.

With that said, let’s get started with the business review.

Net sales for the quarter totaled $118.9 million as compared to net sales of $118.5 million in the second quarter of 2008, finishing short of our previously communicated guidance range of $120.5 to $123.5 million. Excluding the unfavorable impact of foreign currency on our international revenues, which totaled approximately $3.1 million, global net sales increased 3% during the second quarter.

Second quarter sales results continue to be negatively impacted by the global economic conditions with the effects impacting each of our major product lines. Despite these impacts our Extremities franchise continues to excel posting 24% growth in the US and 19% constant currency growth globally.

Although our Q2 revenue performance did not meet our guidance range, we were able to achieve adjusted net income of $7.1 million or $0.18 per diluted share for the quarter meeting the mid-point of our guidance range of $0.17 to $0.19. Our expense control was very good during the quarter enabling us to produce operating expense leverage of 110 basis points over prior year. We were quite pleased to see our business model demonstrate this degree of versatility during the quarter.

n addition to the excellent expense control we also had a very good working capital management as our initiatives to improve the Company’s cash flow profile have paid off very nicely in the first half of the year. We produced free cash flow of $9.4 million for the second quarter and $14.9 million year-to-date representing a year-over-year improvement of $56.2 million as compared to the first half of 2008. This first half cash flow performance makes us feel very good about achieving our objective of producing positive cash flow for the full year of 2009 which represents a year-over-year $80 million plus improvement.

Looking now at our sales results in detail, first geographically, in the US our sales totaled $73.1 million during Q2 an increase of 6% over prior year. Domestically we experienced a slowdown in procedure rates at levels greater than we experienced in the first quarter across all of our product lines resulting in decelerating growth rates for each line. Despite these macro pressures our US Extremities line continued to perform exceptionally well posting 24% growth with only a slight benefit from acquisitions in the past 12 months.

Internationally we experienced headwinds from currency and slower procedure growth and as anticipated in the stocking distributor portion of our business. International sales totaled $45.8 million representing a decline of 7% as recorded and a decline of 1% before the unfavorable impact of currency.

Despite these headwinds we continued to see good growth in many of our direct markets, particularly in Japan. Previously we had anticipated the recovery in the second half of 2009 in the stocking distributor portion of our business. Although we are still positive about the underlying fundamentals of our stocking distributor markets, the current state of the global economy, and in particular the credit markets, make it unlikely that we will see any meaningful recovery in the second half of the year in this portion of our business. We will touch on this more in the guidance section of our call.

Switching gears now I would like to discuss our sales on a product line basis.

During the second quarter our global hip sales totaled $41.1 million decreasing by 1% as reported and increasing 2% in constant currency. Domestic hip growth totaled 2% during the quarter while international hips declined 3% as reported and increased 2% before currency. Knee product sales totaled $30.2 million in Q2, a 3% decrease as reported and a 1% decrease over prior year before currency. Domestic knee sales in Q2 increased by 1% over the prior year; international sales decreased by 5% on an as reported basis and were flat in constant currency.

Our Extremities business was clearly the top performer for us this quarter holding up well thus far in these economic headwinds. Extremities sales totaled $25.6 million during the second quarter increasing by 17% as reported and 19% before currency. Domestic extremities grew 24% during the second quarter including a 3% point contribution from products acquired during the past 12 months. This performance came on top of the 53% comparable for Q2 of last year and despite procedural headwinds our domestic extremities growth rate, before acquisitions, accelerated from 17% in Q1 to 21% in Q2. Our domestic Extremities business is driven by the continued success of both our core products within our CHARLOTTE line of foot and ankle products as well as the excellent performance in our DARCO and Inbone product lines. Internationally extremities declined 8% as recorded and grew 3% before currency.

Our global biologic sales totaled $19.5 million during the second quarter representing a 6% decline over the prior year as reported and a 4% decline on a constant currency basis. Domestic biologics sales were flat in Q2. In the second quarter international sales of our biologics products decreased by 28% as recorded and 28% before currency, primarily due to the previously discussed reimbursement challenges specific to the Turkish and Belgian markets.

In summary we are pleased with our bottom line performance for the second quarter and with the progress we have made to improve our working capital efficiency and produce meaningful free cash flow. At the same time, while our Q2 revenue growth was below our expectations and our long-term objectives, we were pleased with the progress we have made in expanding the capabilities of our business and are excited about our future growth potential.

At this point I will turn the call over to John Bakewell, our Chief Financial Officer and he will discuss additional financial details of our second quarter. John?

John Bakewell

Thank you Gary, good afternoon. I will follow our usual format today and pick up where Gary left off by reviewing with you our second quarter P&L performance below the revenue line and then I will discuss our current financial outlook for Q3 and for the full year 2009.

As has been our practice today’s press release provides you with our P&L results in accordance with GAAP requirements. It also includes tables that provide reconciliations of certain of our P&L components from an as reported GAAP basis to one that is adjusted to exclude the impact of those items noted including non-cash stock based expense, charges related to the ongoing US governmental inquiries, and the impact of ongoing charges related to the closure of our Toulon, France based operation.

We recognize that many of you evaluate our performance on a basis that excludes stock based expense as well as these other non-recurring items, so we continue to provide you with the necessary information for you to model our P&L either excluding or including those items. With that let’s move into the discussion of our as adjusted results. I will begin with a review of our gross margin performance and from there work downward through the rest of our P&L.

Beginning with our Q2 gross margin, overall we achieved 69.4% for the quarter which, as we were expecting, is lower than the 70.9% posted in prior year Q2. As we anticipated, unfavorable year-over-year currency exchange rates pressured our gross margin this quarter as did the unfavorable commodity price variances that have been impacting us since the second half of last year. Although the effect of those two variables will ease in quarters three and four we are also beginning to experience the impact that slowing production volumes are having on our absorption rates. As a result, we now expect a 2009 gross margin performance somewhere in the neighborhood of 70% on a full year basis, lower than our previous expectation for a mid to upper 71% outcome. For Q3 we would expect so see something close to 7-% as well.

Turning now to our operating expenses on an adjusted basis total operating expenses for the second quarter totaled $70.4 million or 59.2% of sales compared to $71.5 million or 60.3% of sales for Q2 of last year, a 110 basis point improvement despite the increased costs related to our compliance investments initiated at the start of the year. We are particularly pleased with our ability to control expenses this quarter and to deliver this bottom line performance despite the challenges we experienced on the sales line.

As for the line items making up our Q2 operating expenses on an adjusted basis selling, general and administrative expenses totaled $60.6 million or 51.0% of sales for the second quarter compared to Q2 2008 SG&A expense of $62.2 million or 52.5%. a 150 basis point improvement.

As adjusted our R&D expense totaled $8.5 million in Q2 or 7.1% of sales compared to $8.0 million or 6.7% of sales in Q2 of last year. Finally, amortization expense totaled approximately $1.3 million for the quarter compared to about $1.3 million in Q2 of 2008. Excluding any future acquisitions you can expect quarterly amortization expense to remain at this level for the remainder of 2009.

To summarize our performance at the operating income level our second quarter operating income as adjusted was $12.2 million or 10.2% of sales down from $12.5 million or 10.6% of sales in Q2 of 2008 reflecting operating margin contraction of 40 basis points overall as our excellent operating expense leverage was offset by lower gross margins resulting from foreign currency headwinds and commodity price variances.

Below the operating income line net interest expense totaled approximately $1.3 million for Q2 which was in line with our expectations. Lower investment yields on our excess cash portfolio have clearly been impacting our investment income levels this year creating difficult comparisons with the prior year. All together we have seen investment yields decrease by approximately 200 basis points since Q2 of last year. That accounts for essentially all of the year-over-year difference seen in our net interest expense line. Going forward we anticipate quarterly net interest expense of approximately $1.4 million for the remainder of 2009.

Moving to taxes our Q2 effective tax rate as adjusted was approximately 35.6% for the quarter as compared to 38.5% in Q2 of 2008. The primary reason for our lower effective tax rate is the R&D credit which was not enforced in the first three quarters of 2008, but is for 2009. Going forward from here, consistent with our December guidance, we continue to anticipate an effective tax rate of approximately 36% through out the remainder of 2009.

To wrap up our P&L review, as Gary reviewed with us earlier, net income as adjusted totaled $7.1 million or $0.18 per diluted share for the second quarter 2009. Although Q2 EPS declined by $0.01 due to the difficult comparables relating to foreign currency and investment yields, we are quite pleased to have delivered an EPS outcome in the middle of our range considering procedural slowness we’ve experienced thus far this year.

Briefly regarding share count our second quarter per share results as adjusted are based on an adjusted diluted share number of $43.5 million for Q2 of this year and average diluted shares of $43.6 million for Q2 of last year. Going forward we expect that our average share count for full year 2009 will be approximately 43.6 million shares diluted. For Q3 we anticipate an average share count of approximately 43.7 million shares diluted.

Before we get into our guidance review let me point out that our very solid balance sheet has continued to strengthen and we now carry a combined cash and marketable securities balance totaling $154 million as of June 30th. As Gary noted previously, we are very pleased with our cash flow performance this year with approximately $9.4 million free cash flow being generated during the second quarter and $14.9 million generated through June 30th representing just over $56 million of improvement versus the first six months of 2008. We accomplished this while still investing approximately $9.2 million in capital expenditures during Q2 and $19.1 million during the first six months.

The final topic in my portion of today’s call is our current sales and earnings per share outlook for full year 2009 and for the third quarter. As stated in today’s press release we are revising our previously communicated full year, as adjusted earnings per share outlook from $0.85 to $0.92 per share to a new range of $0.78 to $0.85 per share and we are revising our 2009 revenue outlook range from $500 to $510 million to a new range of $475 to $485 million. As Gary noted in his opening comments, during the second quarter we saw a further decline in procedures as evidenced by our Q2 revenue performance.

Based on the information we have at this time, we believe that our procedural volumes have stabilized and they will not see further deterioration as we move through the second half of the year; however we currently have no visibility as to when we will experience a return to more normal procedural rates of growth. Additionally our previous guidance anticipated a recovery in the stocking distributor portion of our business in the second half of 2009.

As we discussed previously a second half recovery in stocking distributor order rates does not appear likely at this point. These two factors combined with our Q2 results are the primary drivers of the change to our full year revenue outlook. At the same time however, we are focused intently on driving tight expense control through out the remainder of 2009 and that should significantly dampen the bottom line impact of our downward sales revision. We intend to aggressively drive these expense control measures while at the same time being careful to ensure that we continue making necessary investments that position ourselves for long-term growth. The downward revision of our adjusted EPS outlook represents the net impact of these factors.

Finally although we do not give formal cash flow guidance, I do want to note that we are still committed to achieving our original goal of positive free cash flow or better in 2009. That would represent more than an $80 million improvement in free cash flow year-over-year.

As for our guidance regarding the third quarter of 2009 I would like to recap with you what we have stated in the outlook section included in today’s press release.

Our anticipated target for third quarter of 2009 for net sales is in the range of $111 to $115 million representing as reported growth in the range of 0% to 4% and constant currency growth of approximately 3% to 7% for the quarter with adjusted EPS results ranging from $0.13 to $0.16 per diluted share. Please note that these targets for both the upcoming third quarter of 2009 and the full year of 2009 exclude the effect of possible future acquisitions or other material future business developments, restructuring charges associated with our Toulon closure, acquisition related inventory step up amortization, the impact of non-cash stock based expense, and special costs associated with our current US governmental inquiries.

For those of you who consider stock based expense in your models, our estimated full year 2009 impact of expenses associated with FAS 123R is in a range of approximately $0.22 to $0.24 per diluted share for the full year and $0.06 to $0.07 per share for Q3. Applying a $0.23 mid range estimate to our adjusted EPS outlook for 2009 implies an EPS outlook inclusive of stock based expense of approximately $0.55 to $0.62 per diluted share for the full year. Third quarter EPS, including stock based expense, would be approximately $0.07 to $0.10.

I have one other housekeeping matter to cover as it relates to guidance and then I will conclude.

I am sure this goes without saying, but I would like to cover here, just to be certain, we haven’t offered up any outlook for our 2010 year since we provided it as a placeholder during last December’s modeling call. Given the changes we have seen since then to our 2009 outlook, as well as all of the variables one needs to consider going forward, in case anyone might possibly still be considering our previous commentary on 2010 you should regard that previous guidance as no longer being applicable at this time. We will definitely get back to you with a formal 2010 outlook once we have gained more perspective on how the economic variables are playing out, but that is likely to be either late this year or early next.

With that I will conclude our financial review and I will turn our call back over to Gary for his additional comments.

Gary Henley

Thanks John. In closing, I would like to emphasize how pleased I am with our underlying performance and accomplishments as a business during Q2. Despite the revenue challenges the team was able to deliver our earnings commitment and produce excellent cash flow. I would also like to expand on my earlier comments regarding the core performance potential of the business.

Although none of us are pleased with the current results created by the short-term environmental issues we are facing, I am very pleased with the current state of our underlying business. We have continued to expand our best in class product portfolios and increased the size, focus, and proficiency of our sales force. At the same time we have implemented expense control initiatives and significantly improved our working capital efficiency.

As we move through the balance of 2009 we will remain focused on enhancing our capabilities and operational efficiency: in essence controlling those factors that are within our control. The net result will be an improved business that is positioned well for the long-term growth. I cannot predict when the market conditions will improve, but I can say with confidence that Wright Medical will be prepared to capitalize when they do.

That concludes the prepared remarks section of our call today and now we are ready to take your questions. I will turn the program back over to our moderator who will be coordinating the question-and-answer session. Shamika?

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Matt Miksic from Piper Jaffray.

Matt Miksic - Piper Jaffray

I am just wondering about the orthopedic business OUS. You talked about the stocking impact again this quarter, maybe offset by Japan. As you may have noticed the rest of the group was pretty weak and you are up in the corner. I am wondering if you can give us some color between Japan and Europe, whether what you saw was similar to what the markets saw, if you felt you did a little better than that.

Gary Henley

I think I would probably characterize it as about the same as the rest of the industry saw in Europe. We had some strong points. We continued the turn around we’ve experienced in Italy and we are continuing to make good progress there. So, I would say it is pretty much the same in the European theater. In Japan we continue to do very well there. I would tell you we were impacted a little bit with the swine flu scare there; maybe more there than other parts of the world, but all in all the Japanese business continues to be one of the highlights for us.

Matt Miksic - Piper Jaffray

In line in Europe would be sort of down year-over-year constant currency offset by better in Japan, is that fair to say?

Gary Henley

Yes. You know our Asian Pacific, Japan and Latin American business was all probably a little bit up compared to the European theater just slightly.

Matt Miksic - Piper Jaffray

Okay and one follow up on the P&L. Everyone is pleased to see the leverage in the SG&A line, but heading into the fourth quarter, I don’t know if I’m looking at this right, but does it look like there will be some significant improvement in bottom line performance, so you are stepping up from Q4 from the guidance you have given us in Q3 to Q4 John?

John Bakewell

No, I don’t believe so Matt and there again we haven’t offered up any quarterly guidance for Q4 yet. Our most recent quarter that we have broken out for you was Q2, so we are in the process of rolling through the year and kind of putting the finer point, I guess, on the quarters that are in the back end of the year. But, I don’t think we are planning on any kind of an improvement in Q4 versus the guidance that was maybe implied in our April call.

Matt Miksic - Piper Jaffray

Just a follow up on that, is there anything that we should think about, I am not pushing you for Q4 guidance, but as you head into Q4 is there anything related to the things you’ve mentioned about factors affecting gross margin, factors affecting SG&A, or some of the other lines that we might want to consider as we head into Q4?

John Bakewell

No, the gross margin is pretty straightforward. We are expecting a full year gross margin performance kind of right in the 70% range. We are also expecting about 70% for Q3. That implies that it might be a little bit higher than 70% in Q4 and I think that would be expected considering a little bit easier currency comp as we get into the tail end of the year.

Matt Miksic - Piper Jaffray

Gary, what are you seeing across the market? It is obviously slowing for everybody, but are you seeing any difference in the way you’re being impacted in terms of patient mix? If we look at the whole market being 35% or 40% private pay and the balance being Medicare does that line up to your business pretty well? Do you have more exposure to younger patients? Are you seeing anything in the way these procedures are being deferred that affects you more or less than the rest of the market?

Gary Henley

No. We have actually looked at this in depth and I think we are kind of right in line with everybody else in terms of what they’re experiencing. That mix between private and Medicare is about what we experience here. I think we are being affected about like everybody else. What is interesting is we got affected a little later than some of our competitors. I’m not sure why, but I think the numbers bear that out at this point.

Matt Miksic - Piper Jaffray

Okay thanks for the color.

Operator

Your next question comes from Raj Denhoy from Bear Stearn.

Raj Denhoy - Bear Stearns

I wondered if I could follow up a little bit on that recon question. If you look back last year you guys were probably growing at twice the market rate and now you’re growing at probably half the market rate. So the fall off for you guys has been much more dramatic and I am curious if you have any thoughts around why that might be. You are losing share out there, or your surgeons are just more impacted by this, or is there any explanation as to why that growth would be so different?

Gary Henley

I don’t know. I can’t give you just a real crisp answer to that, because I don’t know. We haven’t been losing customers. I mean our customer base is pretty steady, pretty solid, so I think it is just procedural and we see pretty big variances in geography across the country, I mean some areas are more impacted than others.

Raj Denhoy - Bear Stearns

Okay so you guys don’t have any idea.

Gary Henley

I don’t see it on our customer base. That I can say for sure. I think it is strictly procedural volume at this point for us.

Raj Denhoy - Bear Stearns

Okay on the US biologics business, this is the second straight quarter now that has been well off the trend line over the last several years. Now we have flat growth in what used to be a double-digit business for you guys. Do you have any explanation as to what is happening in US biologics and when that might start coming back?

Gary Henley

Well I think some of the pressure that we’ve seen here is in substitutions. I think we’re trying to control some costs in various hospitals. I think that has impacted us a little bit. Obviously OUS we understand that pretty well. I am not overly concerned that this won’t turn around. I mean I think it’s temporary. I think the products themselves, the performance of them, will bear out in the long-term; so I am not terribly concerned that we hit a wall here by any means.

Raj Denhoy - Bear Stearns

Okay. I appreciate that the visibility is pretty poor right now. As you look out over the back half of the year, not withstanding your comments on the recon market not having a great explanation as to what is happening there on your markets, so what gives you confidence that third quarter is going to be an acceleration from the second quarter and then the fourth quarter even on top of that?

John Bakewell

I don’t think we’re counting on a tremendous amount of acceleration. I think what we are seeing is on a constant currency basis growth rates in the back half of the year are pretty consistent with what we are seeing here in Q2.

Raj Denhoy - Bear Stearns

But you guys were basically flat, on a constant currency basis your guidance is 3% to 7% for the third quarter and then obviously there is a range for the fourth, but it implies something in that mid single digit range in the fourth quarter.

John Bakewell

Yes, we are actually 3% positive on a constant currency basis in Q2. So, yes our outlook for Q3 is a constant currency of 3% to 7% growth and we probably will continue to experience a little bit of acceleration in our Extremities business and also the biologics comparable gets just a little bit easier as we move into the back part of the year.

Raj Denhoy - Bear Stearns

So those are two things we should point to then to take you from that 3% in the second quarter to a little bit higher than that. I mean since you are not expecting much out of recon.

John Bakewell

That’s right. I think you can expect growth rates in the back half of the year for recon that are pretty consistent with what we just saw here in the second quarter.

Gary Henley

The thing of it is we don’t want to overlook the fact that when you are still putting up numbers in the 20% growth rates on extremities that is a pretty good achievement. It is also a much bigger piece of our business than it was a couple years ago. So, it’s grown in size and it continues to grow at a very impressive rate, I think.

Raj Denhoy - Bear Stearns

No, absolutely. I don’t want to take anything away from that.

Operator

Your next question comes from Rick Wise from Leerink Swann.

Rick Wise - Leerink Swann

Let me ask Roger’s question a little differently. You have had to lower guidance a couple of times; I know it is not a pleasant experience. Maybe asked a little differently, what makes you a bit more confident that you have captured the right range of outcomes for the full year at this point? Is it that you are seeing the procedures stabilize or is it something about the OUS business? Maybe you could help us think through it that way.

Gary Henley

I think maybe it has whatever you want to call it, stabilized, or hit the bottom, whatever. We think we now have a little better idea on the currency situation. We think we have a little better visibility maybe on the stock and distributor, how long that recovery may take; then just the overall industry growth. We see today what maybe some of our competitors saw one or two quarters ahead of us.

Rick Wise - Leerink Swann

Right and on the OUS stocking distributor stuff you have lowered guidance something like $15 to $25 million roughly relative prior to your prior sales guidance. Can you help us understand how much of that might be coming from the stocking distributor, sort of lack of redound our impact, again if you could quantify that at all?

John Bakewell

If you look at approximately $20 million of revenue outlook take down, and just focus in on what used to be the high end of the range, recognizing that last quarter we pointed everyone really to the lower part of the range; so, kind of off of $505 million. We’ve taken the top end down by $20 and a little bit less than $5 of that was Q2s performance.

Then we have probably another roughly $10 million associated with just procedural slowness in Q2 and how that projects out into the trend line for Q3 and Q4 with about another $5 million associated with a revised outlook for our stocking distributor recovery.

Rick Wise - Leerink Swann

That is very helpful. Commodity price increases again were a drag. Do you see that stabilizing the second half and maybe you can help us understand why? Lastly when should we expect the reimbursement issues in Turkey and Belgium to go away? I think you said you were assuming a second half recovery.

John Bakewell

I will take the first half off that on the commodity pricing variances. That is now completely washed out. Q2 is the last quarter that we will see an impact from last year’s commodity pricing variances.

Gary Henley

On the Turkey and Belgium issues we still expect slight improvement in the Belgium one the second half of the year here, but we will begin to get a little better comp. We will annualize the issue in Turkey starting in Q3 and Q4, so comps will get a little easier, but we do think that the business also will resolve itself a little bit in the second half.

Rick Wise - Leerink Swann

Thanks again.

Operator

Your next question comes from Taylor Harris from J.P. Morgan.

Taylor Harris - J.P. Morgan

On the 2Q guidance you had been forecasting 6% to 8% constant currency growth, you did 3%, so you missed by 3% to 5%. Are you saying that all of that is due to a procedural slow down or are there any other elements that you would point us to?

Gary Henley

No, I would point you to procedures, absolutely. I mean that is the only explanation that I can get when we look internally here.

Taylor Harris - J.P. Morgan

Okay and the market, I don’t think, has slowed down that much in terms of procedures. Do you disagree with that?

Gary Henley

I don’t know. I think if you look at some of the declines of some of our competitors that occurred Q4 to Q1 and then Q1 to Q2, if you take the broader picture, not just the one quarter for the first half of the year I would say we are sort of still in line with what we’re seeing here.

John Bakewell

Also recognizing that we were posting some pretty heady growth rates in Q3 and Q4 of last year.

A lot of that is associated with uptake from new products and account creation and what not and it was inevitable that we were going to annualize, to some degree, off of that.

Gary Henley

Just like last year Q2 was an 18% growth rate with the comps.

Taylor Harris - J.P. Morgan

So do you have any explanation for why there is this lag effect in you slowing down relative to the market?

Gary Henley

No, I really don’t. I mean that is a mystery to us. We wish we did know.

Taylor Harris - J.P. Morgan

Okay and then going back to what you commented on for Q3, the what we see is a pick up in growth and I get the easier comp in biologics. Did I hear you say that extremities is going to accelerate and if so why?

Gary Henley

It did accelerate Q2 over Q1.

Taylor Harris - J.P. Morgan

As I would look forward I would say well the acquisition benefit, and it is small now, but it is going to diminish.

Gary Henley

Acquisitions were a small part of that, that was only 3%. As I have said many times, we feel like we are just getting started in the foot and ankle extremities business. We have continued to add products. We have some really nice product launches planned for the second half of the year. I think I said on the last call that we looked at that foot and ankle portfolio as being about 70% complete as we entered this year and hope to be more than 90%, maybe 95% complete by the end of the year. So those are significant developments, plus we are continuing to add sales reps. We have a strong add to our sales rep force for the balance of the year and we continue to keep the pedal down on our Med Ed events. I was just told a while ago we have 45 surgeons coming to be trained on our ex fix products a couple of weeks from now. We have a lot of things that are still driving the business.

From my perspective this is a case where the underlying business is much better than the numbers are telling here. So I do have good confidence as we go forward. I have been here a little over three years and I will tell you that I feel better today about our business, the underlying business than I have ever felt.

Taylor Harris - J.P. Morgan

Did you see any change in the impact of pricing on your business and can you just tell us what you’re seeing right now in recon pricing in Europe and then in the US?

Gary Henley

In the US it is pretty flat. I mean just flat. In Europe it is down slightly, not dramatically but down some.

Taylor Harris - J.P. Morgan

Okay and then on your international business, I want to make sure we understand what is happening with the stocking distributors and then in your non-stocking distributor business. So, can you tell us what percent of sales are stocking distributors. How much was that down? Then what does that tell us about the rest of the business outside the US?

Gary Henley

We don’t give all that detail out, but John did earlier. You heard him say that the 3Q 4 impact was about $5 million of that take down with regard to stocking distributors. Off of the top of my head I don’t know if I could tell you what percentage of our international business is stocking distributors.

Gary Henley

I think if you wanted to look further into what are procedural slow downs doing to the stocking versus the direct countries, what we see is it is quite similar. I mean it doesn’t appear to be dramatically different between those two types of markets.

Gary Henley

Again, as I reiterated earlier about our Japanese market, our Asia Pacific, Latin American, Canadian markets, all of those still continue to be good markets for us and if the swine flu doesn’t raise its ugly head again for the back half of the year we are really looking for good things out of the Japanese market.

Taylor Harris - J.P. Morgan

So, John, you are saying your direct business in your stocking distributor business performed the same in terms of growth this quarter?

John Bakewell

No, no, no. I am saying if you are looking to end market procedural demand we are foreseeing the same kind of slowness in both markets. Stocking distributor market has been pretty significantly impacted by the fact that absent any growth capital from financing those distributors can’t create new business. So, their growth rate has been curtailed by the fact that they cannot open new accounts because they don’t have the capital to do it. The demand that we are seeing with their existing book of business appears to be affected very similarly to what we’re seeing in the other direct markets outside the US.

Taylor Harris - J.P. Morgan

Okay I understand. I would just love it if you guys could quantify the impact of stocking distributors and the reason I ask is just you have historically been growing faster than the market in some key direct markets outside the US. So, I am trying to understand if that is still the case or not.

Gary Henley

Well yes, if you look at Japan absolutely. Market by market we could go through, but I don’t have the numbers in front of me to tell you, but just as an impression we are doing well. As I said early on, somebody asked the first question, our OUS business was the most negatively impacted in the European theater for sure.

Taylor Harris - J.P. Morgan

Okay, thank you guys.

Operator

Your next question comes from Mike Matson from Wells Fargo Securities.

Mike Matson - Wells Fargo Securities

I was wondering why the stock comp was up on a dollar basis. It looked like it was up sequentially quite a bit from the first quarter.

John Bakewell

Q2 is typically a high quarter for us because that is when a lot of our annual merit grant activity takes place. Not just this year, but each and every year. So, because we have all of the stock comp that anniversaries in the second quarter there tends to be a bigger stock based expense that lands in Q2.

Mike Matson - Wells Fargo Securities

Okay and then for the next few quarters on a dollar basis, do we expect that to stay at a similar level or?

John Bakewell

Well yes it is going to be in the $0.06 to $0.07 range on a per share basis.

Mike Matson - Wells Fargo Securities

Okay and then given that you all sell a very high percentage of hard bearings both metal on metal and ceramic hips have you seen any kind of a backslide there in your penetration rates given the cost pressures out there? In other words are you seeing any kind of a negative mix shift?

Gary Henley

No, we haven’t seen that.

Mike Matson - Wells Fargo Securities

So the pricing was flat, you are not seeing a negative mix shift, but slow down was really just pure volume driven?

Gary Henley

That is correct.

Mike Matson - Wells Fargo Securities

The within extremities are you seeing a procedural slow down there as well?

Gary Henley

We have. Again, when you look back at our growth rates of extremities a year ago we were at 50%. Again, some of those were acquisitions, but we have seen it slow a little bit, but we have kind of offset that with more products and expansion of our distribution network on our sales force. We are still continuing to see nice growth in that extremities product line.

Mike Matson - Wells Fargo Securities

Okay and then was there any increase in reserving for obsolete inventory this quarter like we saw last quarter, and what was the impact on gross margin if there was?

John Bakewell

It was not an extraordinary quarter from a reserving standpoint. There is nothing unusual to call out or talk about this quarter.

Mike Matson - Wells Fargo Securities

All right, thanks.

Operator

Your next question comes from Glenn Navarro from RBC Capital Markets.

Glenn Navarro - RBC Capital Markets

I would like you to clarify a couple of points for me. On price, you said price in the US was flat. I am assuming that is inclusive of mix, is that correct?

John Bakewell

Yes.

Glenn Navarro - RBC Capital Markets

Okay and then on the extremities side you said constant currency growth would actually improve in 3Q. Does that also take into consideration the seasonality that the market and you often see in the third quarter?

John Bakewell

Actually Q3 is a seasonally low quarter. There is a little bit better US mix in Q3 so consequently that can boost your growth rate just a bit if your US business is growing faster year-over-year.

Gary Henley

We don’t see quite the impact in the US that we do in like Europe for example.

Glenn Navarro - RBC Capital Markets

Okay and I have two follow up questions. On the M&A front you have been somewhat quiet of late. Is it because there is not as many targets as there were maybe a year or two ago? Are you having problems coming to the final price? Also could you talk a little bit about the M&A front? Then I understand you don’t want to talk about 2010 guidance or outlook, but as analysts we are going to have to work on some models and put out numbers. Could you at least talk to the expense side of the equation? As you look out to 2010 SG&A, R&D is there still a lot of leverage in those numbers?

John Bakewell

Your question on 2010, we really aren’t prepared at this point to go into any kind of a discussion on 2010 guidance. There are just too many variables at play here given the degree of uncertainty around when procedural demand is going to rebound, what impact healthcare reform might have etcetera. We are just going to stay away from making any sort of long-term commitment right now. Just given the uncertainty that we are all dealing with regarding those inputs I think we just need to sit out for a little while before we start discussing 2010.

Glenn Navarro - RBC Capital Markets

Okay and then just on the M&A front can you give us some color there?

Gary Henley

Yes, on the M&A front we continue to look for opportunities. Obviously, as I said earlier, we have almost got our foot and ankle portfolio built out, so the necessity of some of those acquisitions aren’t as great today as they were a year or two ago. We continue to look. We are very pleased with the acquisition we made in the upper extremities, the Rahack acquisition, that product has performed very well for us. We will continue to look at acquisitions and evaluate them and I think there are still opportunities out there for us; we haven’t shut down the M&A department, trust me.

Glenn Navarro - RBC Capital Markets

So the pipeline is full so I am just questioning why we have seen a slow down of late.

Gary Henley

I think that is part of it. Again, as we round out the portfolio that we envisioned when we started the foot and ankle expansion a little over two years ago, we had a lot of holes to fill and we have been successful in filling them.

Glenn Navarro - RBC Capital Markets

Okay so would you say future acquisitions we should expect hand and wrist? Is that like the next target or shoulders or?

Gary Henley

We have been pretty clear that our long-term strategy was to build out a very robust portfolio in foot and ankle. We obviously already have it in the large joint or the recon area, so that leaves the upper extremity area as a third area of focus that we have always been consistent on saying we will address at some point.

Glenn Navarro - RBC Capital Markets

Okay thank you.

Operator

Your next question comes from Joanne Wuensch from BMO Capital Markets.

Joanne Wuensch - BMO Capital Markets

Could you please give us an update on the compliance expenses in the quarter and where you are on your discussions with the Department of Justice?

Gary Henley

I can answer the second question first and that is we are in ongoing discussions. I really can’t give you any detailed color on that. We are not in charge of the timeline there, they are.

John Bakewell

On the first half to your question, back earlier this year we added an additional $0.04 to our expense expectation for the year related to compliance related spending and we are tracking to a number internally that is very consistent with that. We expect these incremental compliance initiatives that we initiated at the beginning of the year to cost us about $0.04 for full year 2009.

Joanne Wuensch - BMO Capital Markets

Does your current guidance assume continued decline in volumes or sort of a stable environment at this stage?

John Bakewell

It assumes stabilization. It assumes kind of what we saw as our trend line as we moved our way through the second quarter.

Joanne Wuensch - BMO Capital Markets

Without getting too specific on the second quarter, did it accelerate towards the end, or was it sort of a downward slope, or just give us an idea of.

John Bakewell

No, we are not going to get into the month by month, that is just too many variables that go there, but suffice it to say that as we look at the full year to date, the full six months, that gives us the comfort to say it is going to be level for the balance of the year.

Joanne Wuensch - BMO Capital Markets

That is very helpful. Then where are you on the closing of the Toulon, France facility and what kind of impact do you think that could have on gross margins on a go forward basis?

John Bakewell

Sure, we completely closed, we completed the physical closure of the facility back in December of 2007 and we have for the most part annualized all of the SG&A savings. Actually here in 2009 we are already getting the net benefit, if you will, of a consolidated single plant strategy. Unfortunately we have a lot of other headwinds in gross margin that are clouding your visibility into that right now, but we are indeed recognizing the benefit of the Toulon closure real time this year.

Joanne Wuensch - BMO Capital Markets

That is very helpful, thank you.

Operator

Your final question comes from Jeff Johnson from Robert W. Baird & Co.

Jeff Johnson - Robert W. Baird & Co

I have a couple of questions on biologics. Gary, could you talk at all about bone healing products versus graph jacket and maybe tease out, I know you said some of the pressure just is hospitals are maybe looking to cut costs in some areas and all of that, but how is the graph jacket business doing?

Gary Henley

The graph jacket business is doing well. It is getting better. We are working hard on our reimbursement efforts in certain areas of the country and we are starting to get some traction. So, the graph jacket business is good. I mean it is a fabulous product. The clinical results are just incredible and we just need to continue to take it to the marketplace. The sales force expansion will help that as well in the foot and ankle arena as we add more sales reps, that is an important product to them.

Jeff Johnson - Robert W. Baird & Co

From those comments I would assume graph jacket sales were up year-over-year then?

Gary Henley

Yes.

Jeff Johnson - Robert W. Baird & Co

Okay and again, not going back to a month by month review of your recon business, but I am assuming if you feel like volumes are going to be stable for the remainder of the year that that has to be somewhat the trend you saw over some defined period here in the second quarter as far as stabilizing volumes they weren’t progressively getting worse through out the quarter?

Gary Henley

Yes, again I am not going to go to the month by month, but when I sit here at the end of six months and I look at how it has trended I am comfortable with what we’re projecting going forward for the back half.

Jeff Johnson - Robert W. Baird & Co

All right, fair enough and then just as far as the stocking distributors, currency hasn’t spiked or the US dollar hasn’t spiked over the past six months and it is coming back now, had your prices that you were charging those distributors been going up to try to offset some of the margin pressures there or have you held the prices steady?

John Bakewell

In actual fact we sell to most of those distributors in US dollars.

Jeff Johnson - Robert W. Baird & Co

You do, so there ability to buy let’s say over the last six months has been hampered by the stronger US dollar?

John Bakewell

It has.

Jeff Johnson - Robert W. Baird & Co

Okay so even if credit markets don’t improve a whole lot their access to capital doesn’t improve a whole lot, I am assuming the price they conceptually think they are paying for the product, or in reality are paying for the product, won’t be as high with the dollar having come back here?

John Bakewell

That is true.

Jeff Johnson - Robert W. Baird & Co

Okay and on US versus OUS knee growth rates could you repeat those numbers?

John Bakewell

The knee performance in the US was a decline of 1%; International constant currency was a decline of 1% and global constant currency consequently was also a decline of 1%. International as reported was a decline of 5% and as reported global results were a decline of 3%.

Jeff Johnson - Robert W. Baird & Co

Is that a six-month number or a Q2 number?

John Bakewell

That was Q2, Q2 knee growth.

Jeff Johnson - Robert W. Baird & Co

Okay US was down 1%, international constant currency?

John Bakewell

That was down 1%.

Jeff Johnson - Robert W. Baird & Co

I have it, thank you.

Operator

That concludes our Q&A portion. I would now like to turn the call back over to management for closing remarks.

Gary Henley

I would like to thank all of the participants for joining us today. I am quite pleased with the progress we have made in the business to date and how well our prospects appear to be as we continue through 2009 and beyond. With that, have a good afternoon and I look forward to speaking with you at our upcoming Q3 earnings call. Thank you.

Operator

Thank you for your participation in today’s conference. This concludes the presentation. (Operator Instructions)

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Source: Wright Medical Group Inc. Q2 2009 Earnings Call Transcript
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