Synovis Life Technologies, Inc. F3Q09 (Qtr End 07/31/2009) Earnings Call Transcript

| About: Synovis Life (SYNO)

Synovis Life Technologies, Inc. (NASDAQ:SYNO)

F3Q09 Earnings Call

September 2, 2009 11:00 am ET


Richard W. Kramp – President & Chief Executive Officer

Brett A. Reynolds – Vice President of Finance, Chief Financial Officer


Stan Manny – Manny Family Investors

Gregory Brash – Sidoti & Company

Ernest Andberg – Feltl & Company

Matthew Dolan – Roth Capital Partners


Good day, ladies and gentlemen, and welcome to the third quarter 2009 Synovis Life Technologies, Inc., earnings conference call. At this time, all participants are in a listen-only mode. We will be conducting a question-and-answer session towards the end of the conference. (Operator Instructions).

I would now like to turn the presentation over to your host for today’s call, Mr. Richard Kramp.

Richard W. Kramp

Welcome to Synovis Life Technologies’ 2009 third quarter conference call. Brett Reynolds, our CFO, and I will present the highlights of this milestone quarter. As we discuss the quarter’s achievements and future expectations, please keep in mind that forward-looking statements made in the course of this phone conference are made pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. These statements can be identified by words such as should, could, may, will, expect, believe, anticipate, estimate, continue, or other similar expressions.

There are certain important factors that could cause results to differ materially from those anticipated by the forward-looking statements made during the course of this conference, and the company has no obligation to update its forward-looking statements, references made to the company’s annual report in Form 10-K for the year ended October 31, 2008, and all public filings made by the company thereafter.

Results presented today are for the consolidated the company and for the current quarter unless otherwise specified. Comparisons are always to the same period of the prior fiscal year unless specified differently.

Before I ask Brett to present our financial results for the quarter, I want to say a few words about a major achievement for Synovis which took place during the third quarter. I refer of course to the acquisition of Pegasus Biologics, now Synovis Orthopedic and Wound Care or OWC. During the third quarter of 2009, with the acquisition of Pegasus Biologics, Synovis took a significant step toward our goal of being a leader in soft tissue repair, reconstruction, and regeneration.

This acquisition brings the following to Synovis: Two orthopedic product lines plus a family of wound care products, both FDA and CE Mark released and thus with immediate access to the full US and EU markets. If we started today, it would take up to 3 to 5 years to do the necessary development, testing, and regulatory work to have access to these markets. We now have immediate access to these markets with a total potential of $985 million. We got a second pericardial based collagen matrix—equine pericardium—which appears to be free of the political, cultural, religious, and health concerns some countries harbor against bovine products. For example, Japan, Taiwan, and other Asia Pacific countries have barriers to the use of bovine tissue, and China will not allow most US-sourced beef products including bovine tissue to be implanted.

This equine tissue has the potential to open these large and potentially lucrative markets for all of our products and could also be a backup for existing bovine based matrix if a supply issue ever developed. We got a new patent-protected processing technology which has some of the characteristics of our crosslinked apex technology and some of the characteristics of our non-crosslinked remodelable Veritas technology, opening more potential applications for exploration including combination products.

And finally, with a buy price of $12.1 million which included over $2 million in salable inventory and $700,000 in fixed assets, this acquisition left us with more than enough cash to make the necessary investments to bring it to positive cash flow and profitability without interfering with the growth of our base business or otherwise restricting our activities. In short, we got a deal.

I’ll now ask Brett to provide you with the financial details of our double digit revenue growth, increased gross margin and net earnings which under GAAP were $0.42, but for pre-acquisition business without the effects of the one-time charges were a strong $0.16 per share.

Brett A. Reynolds

Thank you for participating in our third quarter conference call. As you can tell by reading our earnings release this morning, we had a very dynamic third quarter. During the quarter, we generated record revenue and we made great strides in expanding our surgical salesforce. In addition, we acquired the assets of Pegasus for what we believe was a very attractive price of $12.1 million and have named this business Synovis Orthopedic and Wound Care, which I will refer to by its acronym of OWC.

We also recorded three special charges during the quarter, which I will go over in detail later. My comments today will focus on our results excluding these special charges, but I refer everyone to read our earnings release which provides a reconciliation of our results on a GAAP basis to the adjusted basis I will speak to today.

Overall, we’re pleased with our operating performance and the results for the quarter. Highlights for the third quarter include the following. We had record revenue in the quarter which is our twelfth record revenue quarter out of our last thirteen, we had gross margins in the quarter of 72%, up 3 percentage points; operating expenses which grew at a rate faster than revenue growth, but this was expected as we invest in our expanding surgical salesforce and we incurred costs to reestablish the operation of OWC; our operating income in the quarter after excluding special charges of $2.4 million, which is up 7% from operating income of $2.3 million in Q3 of last year; and earnings per share attributable to our historical operations of $0.16 in the third quarter, up from $0.14 in the year ago period. The EPS of $0.16 is adjusted for the effect of the special charges we recorded in the quarter as well as adjusted to exclude the operating cost of OWC and the benefit of a change in our tax rate.

I will now comment on our third quarter financials in greater detail. Revenue totaled a record $15 million in the third quarter, an increase of 12% or $1.7 million as compared to Q3 of last year. Approximately $1.2 million of the increase in revenue came from higher worldwide unit volumes sold and product mix changes, driven by higher unit sales of Veritas and Tissue Guard products. The remainder of the revenue increase of approximately $475,000 was due to higher average net selling prices.

From a product line perspective, Q3 revenue includes the following highlights. Revenue from our biomaterial patch products which include the Tissue Guard product line as well as Veritas collagen matrix totaled $6.4 million in the current quarter. This represents an increase of $1.4 million or 28% when compared to the third quarter of fiscal 2008.

Veritas revenue surpassed $2.3 million in the quarter, up 82% from a year ago, primarily due to unit volume growth as well as beneficial mix of product sizes and some pricing benefit. Tissue guard revenue was nearly $4.1 million in the quarter, an increase of 10% from Q3 of a year ago, with strong growth both domestically and internationally in vascular applications. Higher unit sales were the primary driver of the growth in Tissue Guard revenue along with some pricing benefits.

Peri-Strip revenue totaled $4.8 million in the third quarter, essentially flat with the year ago. We believe revenue from PSD in the third quarter was impacted by Covidien’s introduction of a pre-applied buttress to certain of its staplers. This product was launched by Covidien at the beginning of this year on a limited basis and was fully launched in April. In the third quarter, our worldwide revenue from PSD products used with Covidien staplers decreased 23% from the second quarter of 2009, while revenue from all other PSD products increased 10%. Revenue from PSD for Coviden staplers represented approximately one-third of our total PSD revenue in the quarter, down from a historical mix of approximately 45%.

Revenue from our microsurgical product line was $2.4 million in the quarter, a 10% increase over Q3 of last year and a 15% increase sequentially driven by increased from the Coupler. We did record any revenue from our newly acquired OWC business in the third quarter of fiscal 2009. We are in the process of obtaining the California Department of Public Health manufacturing license necessary to repackage the aquired inventory with Synovis labeling and to manufacture new products. We expect to obtain this license late in the fourth quarter of fiscal 2009 and to begin manufacturing and selling OWC products at that time.

Our gross margin was 72% in the quarter, up 3 percentage points from Q3 of last year. Reasons for the increase include favorable product mix in the current periods, improved manufacturing efficiencies and average net selling prices. We expect our consolidated gross margin to decrease somewhat in the future as we begin to sell our OWC products due to expected unabsorbed manufacturing costs as we initiate the OWC manufacturing activities as well as the fact that the inventory we acquired has a stepped up basis to fair value as part of the required purchase accounting. Based on present expectations of sales and cost, we estimate OWC will impact our gross margin only slightly in the fourth quarter, most likely by 1 or 2 percentage points.

Based on present expectations of sales and cost, we estimate OWC will impact our gross margin only slightly in the fourth quarter, most likely by 1 or 2% points. SG&A expense in the third quarter totaled $7.4 million, an increase of $1.3 million or 22% from the same period a year ago. Over half of this increase was due to the expansion our surgical and microsurgical sales force as well as increased marketing cost and support of the expanded sales force. The remainder of the increase in SG&A expense was due to 200,000 of operating expense related to OWC, higher legal cost due to our patented infringement, law suit against Gore, and investments in regulatory and clinical affairs. In addition, our current quarter non-cash stock-based comp was just over $250,000 or $0.02 per share, up from $128,000 in the year ago period.

We expect to incur significant additional SG&A expense in our fourth quarter as compared to Q3. The increase in SG&A will be due to a full quarter of expense related to our expanded salesforce, which we expect to increase SG&A by approximately $500,000 in Q4 over Q3. We also will incur a full quarter of operating costs related to the operations of OWC. We currently expect OWC operating costs in the fourth quarter to range from $1.2 to $1.5 million, up from the $200,000 incurred in Q3.

The fourth quarter estimate for OWC includes the expected amortization of identifiable intangible assets acquired which is approximately $135,000 per quarter or $540,000 per year.

R&D expense totaled $945,000 in the quarter, an increase of $98,000 or 12% from the prior quarter. R&D priorities in the third quarter included final stage development work on the Flow Coupler, product enhancement initiatives for Peri-Strips, and work on current and future indications for Veritas. We did not incur any significant R&D cost for OWC in the third quarter and do not expect to incur material R&D cost for OWC in our fourth quarter.

Again, our adjusted third quarter operating income excluding special charges was $2.4 million, which equates to an operating margin of 16.3%. This represents a 7% increase from operating income of $2.3 million in the third quarter of last year.

Special charges in the quarter: As I mentioned earlier, we recorded three special charges totaling $8.2 million in the third quarter. These charges include the following. First, we recorded a $4.1 million impairment of our auction rate securities as this impairment is now expected to be other than temporary. Previously, we had assessed the impairment of our auction rate securities as temporary given our intent and ability to hold the securities to a potential complete recovery of fair value. The change in classification of the impairment from temporary to other than temporary was based on us no longer having the intent to hold these securities until a complete recovery of par value.

Second, we recorded $3.5 million of expense related to the in-process research and develop we acquired in the acquisition of assets of Pegasus. This in-process R&D relates to projects acquired that have not yet achieved technological feasibility, and under the current accounting rules applicable to Synovis, the value of such projects must be expensed immediately.

Third, we recorded a $600,000 impairment of identifiable intangible assets associated with the 4Closure Surgical Fascia System. Since acquiring this product in ’07, we have experienced several issues related to packaging, manufacturing, and other related problems that have caused delays and the re-launch of this product. These issues have collectively contributed to the 4Closure sales being lower than expected. Based on our analysis of expected future cash flows from this product and given the focus of our salesforce on higher value products, we determined in the third quarter that the intangible assets were impaired by $600,000.

While these special charges are significant and greatly impact our GAAP reported numbers, they were appropriately reflected in the quarter based on facts and circumstances. These charges will not have any impact on our operations on a go-forward basis.

Taxes: On a year-to-date basis, we record income taxes at an effective rate of 28% on pretax income excluding the $4.1 million impairment of our auction rate securities. We did not record any tax benefit on the impairment of our auction rate securities as this impairment represents a capital loss, and we can’t be assured that we will have capital income to offset the capital loss if and when we choose to sell our auction rate securities.

Our current expected fiscal ’09 effective tax rate is lower than the 33% that we had reported through our second quarter of fiscal ’09 as the pretax income used to estimate our effective tax rate decrease in the third quarter due to cost incurred and expected to be incurred related to our OWC business as well as the impairment of identifiable intangibles in the third quarter of ’09. Our current estimate of permanent items is consistent with the estimate made in the second quarter. This change in tax rate benefited third quarter earnings, excluding special charges by $0.04 per share.

Summary of net income: Our adjusted third quarter net income after excluding special charges was $2.2 million or $0.19 per diluted share, up from net income of $1.8 million or $0.14 per diluted share in the third quarter of last year. The adjusted EPS of $0.19 per share includes the operating cost of OWC which totaled $0.01 per share in the quarter as well as the previously mentioned tax benefit of $0.04 per share. Excluding these items, our third quarter EPS for historical operations would have been $0.16 per diluted share.

Now, I want to turn to the balance sheet and cash flows. Our balance sheet is very strong. We have total assets of over $90 million, networking capital of $59 million, and no debt as of July 31st. We’re positioned very well by our strong balance sheet to continue to invest in our businesses and to continue to explore other opportunities.

Of our total assets, we have $58.3 million in cash and investments which equates to $5.04 per share. This is down from the $67.2 million we had at the end of the second quarter as we used cash of $12.1 million to purchase the assets of Pegasus, partially offset by very strong operating cash flow in the quarter of $4.4 million. Reflected in our July 31st balance sheet is a fair value of the assets we acquired from Pegasus. We paid $12.1 million in cash for these assets plus incurred transaction cost of $200,000 resulting in a total purchase price of $12.3 million. As noted above, in the preliminary purchase price allocation of the acquisition, we determined that $3.5 million of the purchase price was related to R&D projects that have not yet achieved technological feasibility, and we immediately expense such.

Other remaining purchase price, $2.1 million was allocated to inventory, and $700,000 was allocated to property and equipment. The remaining $6 million was allocated to identifiable intangibles with an expected useful life of 11 years. This purchase price allocation is preliminary at this point and could change.

As I mentioned earlier, we recorded a $4.1 million other than temporary impairment charge on our auction rate securities during the quarter. These securities have par value of $9 million and estimated fair value of $4.9 as of July 31st. This fair value was estimated based on both an estimated valuation by a third-party valuation firm and various internal valuations. It could change in the future.

Previously, we had assessed the impairment of our auction rates as temporary. The change in classification from temporary to other than temporary is due to a change in our intent to hold such investments until a complete and full recovery of the investment’s par value can be achieved.

Current quarter considerations which contributed to our change in intent include no progress apparent to us in the litigation between Washington and California and our third party broker, our use of cash for the acquisition of assets of Pegasus, further credit rating downgrades of the issuers of our auction rate securities and the monoline insurers of these securities, and the fact that the estimated fair value of our securities have been below par value for the past year and that these securities have been illiquid now for 2 years. I want to stress that we no longer have the intent from an accounting perspective to hold these securities to a complete recovery of par value, we do not have any current plans to sell or liquidate these securities in the near term.

Looking forward, as most everyone knows, we do not provide formal earnings guidance. We will not be making any further comments about the remainder of fiscal ’09 given we only have the fourth quarter remaining. We expect to provide our high level thoughts on fiscal 2010 at our next conference call in December.

Overall, we’re excited about the events of our third quarter and the high expectations we have for the future of Synovis. We’re pleased with the progress we are making in further establishing the building blocks which we believe will provide for growth in the quarters and years to come.

Now, I’ll turn the call back to Rich.

Richard Kramp

Synovis delivered a record revenue in the quarter as we achieved double digit revenue growth for the thirteenth consecutive quarter. We like so many other companies in the medical sector are dealing with some challenges imposed by an uncertain economy and the ever-present confrontation of competitive technology. However, Synovis has distinguished itself by assertively and successfully undertaking promising opportunities to increase our value to our shareholders through the expansion of our markets and the products we offer to our customers.

Take a moment to remember back to the last quarter of our fiscal 2005. The company after having sold its products for 20 years through distributors took the bold step to build a direct salesforce beginning with 24 individuals dedicated to Synovis products. In the ensuing 3 years, our surgical salesforce grew from the original 24 to 40 sales professionals, a 67% increase while quarterly revenues increased 105%.

It was a step into new territory, but it was well thought out and well executed, and the promised rewards were realized so much so that we are just a few weeks away from completing an additional 40% expansion of that salesforce from 40 experienced and dedicated individuals to 56. As we made the significant decisions executed this quarter, we also reflected Synovis’ decision to enter the ventral hernia market with our Veritas product in the spring of 2007. This too was a step into new territory for the company in that we had never before entered a major market where the call point was the general surgeon, and we did so with a product that had little or no clinical history for that application.

In the 10 quarters since that product was launched into the ventral hernia, Veritas sales have grown from an annualized rate of under $0.5 million dollars to a rate approaching $10 million, growing by 82% in the third quarter compared to a year ago, and we believe we are still in the early growth phase of this exciting product. These ventures into new territory were carefully planned and precisely executed. With respect to past and recent salesforce expansions, we were confident that increasing the number of individuals specifically trained in our products and devoting 100% of their time to our customers would increase sales.

Likewise, with our launch into the hernia market, we were very comfortable with our knowledge of pericardium in general and Veritas in specific, even though we had little clinical experience in the hernia application. In spite of the dominating market presence of AlloDerm, a human skin product, which was approaching 10 years of clinical experience, we were able to identify specific performance features of Veritas that would allow us to make a place for ourselves in this large and competitive market. It is because we recognized and acted upon these opportunities that Synovis has experienced double digit growth in spite of economic and competitive challenges. We have the same confidence, expectation, and excitement regarding our acquisition of Pegasus Biologics. We believe that with this acquisition, we have taken one of the biggest and most promising steps for Synovis’ history.

This was a significant strategic step. It was a step into something new and yet familiar to Synovis. We know tissue. We’re experts in the field, and the acquisition of Pegasus Biologics was a key step for fulfilling Synovis’ 5-year revenue and earnings growth objectives.

While this acquisition will require the building of a new salesforce, we know how to do this. We have done this before successfully. While it will require entering new markets with new call points, we have done that before also successfully, and while it will require our focus on execution and judicious control of expenses, we have continuously demonstrated this capability as supported by our strong performance record. We have deep experience, knowledge, and comfort with the production and performance of pericardial based collagen substrates.

Synovis’ biovine pericardium and the Pegasus Biologics equine pericardium share many fundamental similarities. The acquisition gives Synovis two biological substrates, and we can build on their similarities and minor differences. We have the significant advantage of knowing that the orthopedic and wound care products we acquired produced revenue growth from $0 to over $9 million in less than 3 years with no previous clinical history.

Many of the selling techniques we had developed and many of the implant techniques our customers developed when we first introduced Veritas patches for hernia have already been worked out and the new markets we’re entering with the Flex-linked packages. I’ll not minimize the fact that we have the usual execution challenges an acquisition integration presents, but I can tell you much of it feels like old and familiar ground.

Over the last few weeks, we have talked with numerous employees and customers from Pegasus. We’re excited by the passion of the former employees many of whom are forming the nucleus of our new team in California, and we have been delighted and reassured by former Pegasus customers who are impatiently waiting for our return to the market. Our near term revenue growth potential has taken a leap forward.

Although I still have more I want to tell you about Synovis orthopedic and wound care, I’ll move on for the moment to other important aspects of our business. Our tissue patch products grew a healthy 28% this quarter over the same quarter last year, driven by our Veritas Collagen Matrix which grew a very strong 82%, more than an order of magnitude above the underlying market growth rate. Veritas was launched in February 2007 and has this quarter already achieved an annualized run rate of $9.2 million, and there is still a lot of room for growth in this $250 million complex ventral hernia market.

In July, a paper titled “Novel propylene oxide-treated bovine pericardium as a soft tissue repair material and potential scaffold for tissue engineering” was published by the Universal Medical Press in Surgical Technology International, Volume 18. This is a scientific paper about the material characteristics of Veritas and its many potential applications. It is important because future clinical papers will likely reference this paper to provide the material science to support observed clinical results. We’re very happy to have this paper in print and are also looking forward to a powerful clinical paper discussing the performance of Veritas in complex ventral hernia repair. This paper due to be published in October will include the use of Veritas in the very challenging bridge position where primary closure of abdominal tissue cannot be achieved. The market leading patch product in this area exhibits an 80% failure rate in this demanding situation.

Looking now at another our product families, sales of PSD, our Peri-Strips staple line reinforcement products, were up slightly over last year in spite a new competitor and procedural volume decreases in some hospitals. However, year over year growth slowed to just 1%. We have mentioned in earlier webcasts that one of the stapler manufacturing companies, Covidien, the former US surgical division of Tyco, had introduced a stapler with an integral buttress, the combination being called Duet. This product started to appear in the market on a limited basis in January of this year, and it was officially launched into the market in April 2009 at the Society of American Gastrointestinal and Endoscopic Surgeons meeting.

Covidien has access to many bariatric accounts because of their stapler business, and a number of hospitals are using the Duet buttress on a trial basis, and some are using both Synovis and Duet side by side. While the Covidien buttress supplied on the stapler may save a few minutes in preparation and mounting, this time saved is certainly not significantly enough to offset the disadvantage of inferior clinical performance in terms of reduction of blood or gastric fluid leakage.

Synovis PSD has a long and impressive clinical experience, and we firmly believe that clinical results show that PSD products protect patients from potentially harmful blood leaks and life-threatening gastric fluid leaks, better than any other buttress on the market including the Duet product. We have already had customers who have trialed the Covidien product return to the exclusive use of PSD due to problems they experienced, and we expect to see more. We are committed to supporting our PSD business, and our recently expanded salesforce will be devoting additional time to securing at-risk business, winning back interrupted business, and expanding PSD sales to the large proportion of the market that does not currently use any buttress during stomach stapling procedures.

We have also have improvements under development which promise to cut buttress mounting time from minutes to seconds. We have a well established and clinically superior product, and we will keep these important advantages before our customer as we move ahead.

Our hard-charging microsurgery group delivered a record revenue quarter for that business with year over year growth of 10% and sequential quarterly growth in excess of 15%. You’ll recall that in the first and second quarter of this fiscal year, we organized our micro sales group replacing three of the six salespeople we had and adding three adding three salespeople to bring the total to nine. The 15% sequential quarterly growth attest to the fact that these new but experienced salespeople are doing an excellent job of building trusting relationships with our micro surgeon customers and our presenting our products well.

We are happy with the rapid adaptation of that group to their respective territories as it is important for us to have this team in place fully integrated and up to speed for the planned introduction of our Flow Coupler in the first quarter of 2010.

Coming back now to our recent acquisition, I want to tell you something about the technology, products and markets which acquired access to and how they fit our business and our future. Flexible cross linking technology describes a process whereby potential antigenic sites, i.e., those expose protein chains in the collagen matrix which could cause inflammation and trigger a rejection response by the body, are linked to one another by a biocompatible molecule, thus shielding them from detection. Unlike our original apex cross linking technology which links potential antigenic sites in the collagen matrix with a short molecule, flexible cross-linking uses a long molecular chain, binding the collagen just as securely, but not as closely. The result is a matrix which retains its natural mechanical characteristics such as flexibility and is more open to infiltration by the body’s own cells than the more closely linked apex. The integration of native tissue is beneficial for strengthening any repair made using this technology.

Flexible cross linking technology resembles Veritas technology in its availability for host tissue integration, but it differs from Veritas technology in that the cross linked equine collagen matrix will not be broken down by the body’s proteolytic enzymes and will not be replaced with the patient’s collagen. It will instead remain permanently in the body as a strengthening scaffold. This makes our newly acquired technology which is patented and for which we have an exclusive worldwide license for many applications particularly attractive for orthopedic repair since integration of tendon tissue occurs over a longer period of time than other soft tissues such as abdominal muscle tissue.

In our view, inclusion of the flexible cross linking technology, Flex Link, with our apex and Veritas technologies completes the spectrum of repair, reconstruction, and regeneration matrices needed to provide the right solution to almost every soft tissue repair opportunity in the body, i.e., we can match the right substrate to the right application.

Through the acquisition, we gained ownership of three product families. The OrthADAPT family of equine collagen patches for open rotator cuff and other tendon repair, the Unite Biomatrix family of patches for treatment of chronic wounds, and the OrthADAPT PR, the PR denoting polymer reinforced, family of devices for arthroscopic rotator cuff repair. This latter product family, the OrthADAPT PR, just received regulatory approval approximately 1 week before the company seized operations and therefore did not contributed to the $9 million revenue generated in 2008 by the other two product families.

The OrthADAPT patches are used for reinforcement of torn rotator cuff and other tendon repairs. The rotator cuff refers to a group of 4 muscles in the shoulder and their associated tendons which combine to form a broad conjoined tendon called the rotator cuff tendon. Primary closure of the tear is accomplished with very strong sutures, and the tear is then closely wrapped with OrthADAPT patch.

Over time, the healing tendon will supply cells which will integrate into the OrthADAPT collagen matrix thereby increasing the strength of the repair. In a similar way, OrthADAPT can be used to repair tears of the Achilles and other tendons in the foot and ankle and elsewhere in the body.

The Unite Biomatrix used to promote and protect healing of chronic wounds such as diabetic ulcers and open pressure wounds is in fact used as an on-lay and is not implanted. Again, unique properties of the flexible cross linking technology come into play because the body generates proteolytic enzymes in the process of healing wounds, and these enzymes would cause degradation of a non-cross linked patch over time. Our Unite Biomatrix patch resist digestion by these enzymes and act as a protective cover for the open wound as well as an aid for the generation of granular tissue and ultimately skin underneath the patch. Eventually, the patch is sloughed off, and the wound reduces in size and completes the healing process.

The markets for these product families are large. We estimate that OrthADAPT patches and OrthADAPT PR could be use advantageously in 30% of the rotator cuff and foot and ankle and tendon repairs performed worldwide. This represents an addressable market of approximately $510 million in 2009, growing at about 5% per year. The adoption of biologic patches to do these repairs already represents $60 million of the $510 million opportunity and is growing at 12% per year, more than twice the rate of the overall market. The wound care market is likewise attractive, with a worldwide addressable market of about $475 million with biologic patches currently representing about $55 million of the addressable market growing at 10% per year.

In the 32 days since we closed on this acquisition, we have been very busy contacting, interviewing, and hiring key employees in manufacturing and quality control, materials, customer service, product management, regulatory affairs, and shipping and receiving. This team now consisting of 26 skilled individuals is in the process of consolidating our OWC operations into 15,000 sq ft of the 22,000 sq ft formerly occupied by Pegasus. Manufacturing processes affected by the move are being re-qualified. Acquired inventory will be re-labeled, and we are preparing for the California Health Department inspection required for our license to manufacture.

We were recently notified an inspector has been assigned to us, and this inspection is now scheduled for three weeks from today with a certificate of approval to manufacture expected about two weeks after the inspection. We are now focused on selecting and interviewing direct salespeople and manufacture representatives to resume sales of the products once we have our operating certificate.

The activity has been intense, and the morale is high. We’re reaching out to former customers to inform them of what is happening and offering to answer any questions they may have. It is particularly gratifying when occasionally their only question is when can I begin using these products again.

That concludes our update for the third quarter of 2009, and we would be happy to take your questions now.

Question-and-Answer Session


(Operator Instructions). The first question comes from the line of Stan Manny – Manny Family Investors.

Stan Manny – Manny Family Investments

I have a couple of questions. One, can we assume that the cash that you have will not be used for further acquisitions until this Pegasus operation is profitable?

Richard W. Kramp

From a practical standpoint, our activities with Pegasus are fairly demanding, and our VP of Corporate Development is in fact our integration manager, so he is devoting most of his time to that activity and so it would be unlikely but not impossible for us to have another acquisition. We’re really focusing on getting this to be a profitable product.

Stan Manny – Manny Family Investments

Was the five dollars plus on the balance sheet, is it possible that you might use some of the money for a stock buyback at these very low levels?

Richard W. Kramp

Stan, that would be a conversation we’ll have with our board in the very near term.

Stan Manny – Manny Family Investments

So it’s a possibility of something that you could consider?

Richard W. Kramp

It would be something we could consider, yes.

Stan Manny – Manny Family Investments

The second is it seems to me that the Pegasus acquisition will allow you to have a double digit run rate possible with growth for many years to come. Is my view correct? You got $900 and something million of new market potential to attack, and it seems like you’re going to become a leader in biologic tissue repair.

Richard W. Kramp

We fully believe that Stan. You got the right insight on this as you see it. The beauty of this acquisition for us is it doubles our market, number one. It keeps us in a very familiar soft tissue repair area, and it really leverages our sales ability. Even though we are in new markets here, sometimes the orthopedic markets appears to be a very different market, but what you have to remember is this sales process is a soft tissue body healing repair process because that’s kind of sale it is. That’s different from a mechanical appliance sale, for instance hips and knees, but we have a lot of knowledge in this area. Even the nodular existing salesforce can be transferred over to the new one in knowing how to present biologic products, so we feel we have a lot of ability to take this fairly quickly into a double digit growth rate.

Stan Manny – Manny Family Investments

It seems to me that the gross margin, potential profitability in these new products is similar to the Veritas and other tissue repair products. Is that correct?

Brett Reynolds

As we look forward for the next couple of years, we would expect the OWC margin to be less than what our current business is. Historically, Pegasus had about a 60% margin. We’re certainly making some changes to try to get that margin higher, but with the unabsorbed overhead expect early on the stepped up basis in inventory, for the first couple of years at least we would expect most likely a lower margin.

Stan Manny – Manny Family Investments

I’m not talking about the first couple of years. I’m talking about 3-4 years out, after all the writeoffs are done and the startup. The new products that Pegasus offers, are they in the same gross margin category? They seem to be that they would be.

Brett Ryenolds

Yes. They are.

Stan Manny – Manny Family Investments

So looking down the road and modeling the company, we can use similar operating costs and margins?

Richard W. Kramp

As Brett said, once we get by this inventory we acquired and get the volume up to speed, we expect very similar margins.

Stan Manny – Manny Family Investments

Good job. I think you got basically a transformational bargain in this buy.


The next question comes from the line of Matt Dolan with Roth Capital.

Matt Dolan – Roth Capital

On Peri-Strips, I know you are not commenting on the growth outlook for the rest of ’09, but it appears Peri-Strips is really the only issue relative to your prior expectation. At this stage, what’s your feel for the level of trialing you’re seeing, maybe give us the proportion of accounts that have been impacted, and could we see this trialing come to an end here in the near future, maybe by the end of this fiscal year?

Richard W. Kramp

As you know, this has thing has been going on just about 6 months now, I say from March until April, March-April till now, and we saw little activity in our second quarter. We certainly saw more in the third quarter as our numbers reflect. I think in that period, I don’t have a really a way to tell you how many more hospitals might trial it, although Brett, I think, how many more hospitals might trial it all, although Brett, I think, gave a good example of how many of the hospitals to which we sell. We have seen some diminution of sales, but I think that, I would guess that in terms of this 6-month period, most of the low-hanging fruit has been trialed. We’re starting to see two things happening. Some customers are coming right back to us because they have had some experience that was negative. Some are having, it’s working okay, not better than Synovis, but so far okay, and what we will need to see is a little bit longer term results with some of these hospitals and hopefully clinical papers getting out into the market because we know of the failures that they have had. Of course, communication comes better through clinical papers, and it takes a little bit of time to get those out sometimes, as we know form our experience, six months. So I am expecting that we’ll get continue to see some more of this, whether it be actually growing whether the rate of them trialing more and the rate of them losing some of their trials will come to an equilibrium point in the next month or two is very hard to predict, but I expect we’re going to get more business back. I will also tell you not by way of an excuse but certainly by way of background information, this third quarter for our company and particularly for our field salesforce was very intense with the hiring of additional 14 salespeople. We had a lot of interviewing going on, we had a lot of our regional manager’s time tied up, and we had some defocus as we prepared the new territories for the new adjustment. I think that might have created a few opportunities that we will then be able to win back, so now we go into the fourth quarter with almost 56 people in place, granted some still being trained, but we will not have the focus on interviewing that we had during the third quarter. So we expect to start gaining back some of the share quite honestly in the fourth quarter and going beyond.

Matt Dolan – Roth Capital

With the add sales reps last year, you saw a seasonal or sequential downtick in Q4. It sounds like that shouldn’t be the case here.

Richard W. Kramp

We hope it’s not the case. We’d expect that it will be less, if it is the case. These salespeople are on board now. It usually takes six months for them to become effective. We have not quite three months on some of them, and they should start to have some effect. We hope not to see this fourth quarter a downturn, but we can’t say for sure.

Matt Dolan – Roth Capital

Moving over to Pegasus, revenue is really the key variable for next year with that franchise, so now that you have a little more hindsight on the deal, what’s your comfort level with the purchase in terms of your ability to build up the sales group there and really retain accounts and therefore your comfort with really getting to these ’08 revenue levels?

Richard W. Kramp

Our initial signals are very good, Matt. One, the customers that are talking to us. We’re calling them; some are calling us asking when they can get the product back. They’ve had positive experiences. They are willing to take it back when it comes. Yes, obviously they’re using some other products now, but they’re not using products that are providing the solutions that Pegasus provided. This is particularly true in wound and also somewhat in orthopedics, and we don’t have any history yet on the OrthADAPT PR product. As you know, that was approved just a week before shutting down, so that’ll be an icing on the cake type of thing as we bring that product out.

Matt Dolan – Roth Capital

Have you contacted and feel comfortable with the majority of their accounts?

Richard W. Kramp

I can’t say the majority. I’d say a good many of their accounts, especially the bigger ones. In terms of the maybe the majority of their business or a larger portion of their business, yes. We’ve been contacting some of the higher users and down. So I would say a good portion, maybe a majority, maybe over 50% of the previous volume. We’ve also been talking salespeople some of whom have moved on, but some of the top ones are still very interested in being back selling Pegasus.

Matt Dolan – Roth Capital

One followup on the acquisition strategy. With Pegasus having been a little bit of a surprising opportunity, can you talk about where you are in assessing other opportunities that were probably being evaluated prior to Pegasus? Do you feel you have the bandwidth to execute on something here in the near future, and are there any financial parameters in terms of accretion that you can put around a potential deal?

Richard W. Kramp

As I said to Stan Manny, our focus really as a company but also our VP of Corporate Development is focused on getting this acquisition fully integrated and running, and so we’re not moving forward with some of the other things that had been looking at unless they were very hot and we felt they might be gone if we didn’t move forward. So our real focus is on this current acquisition. I would not expect to see from us anything in the near term other than continue to work on the Pegasus. We have the money to do it as you know, but that is not the reason for us to go out and make something happen. We want to make sure we digest this one properly, and get it in line with the rest of our profit-producing company.

Matt Dolan – Roth Capital

There has been some noise around Stratus having some potentially having negative outcomes in breast reconstruction. Can you talk about where you are with Veritas in that particular application and what type of performance you are seeing in breast?

Richard W. Kramp

We’ve heard those same reports, Matt, and our performance in breast is extremely good, and we know some of the docs that have had problems with the Stratus who are using our product and in fact had been using our product almost in a parallel situation with Stratus, and they have had no failures with our product and have had high degree of failures with the Stratus. In general, breast is a growing part of our business. Breast is done primarily by reconstructive plastic surgeons, not general surgeons. When we brought Veritas to the market, it was first to repair complex ventral hernia. We through that way got introduced to the plastic surgeons because they are involved in the very complex ones and through that connection from plastic into the breast. That business is really starting to flourish. We know have a lot of trials going on with breast reconstructive surgeons now.


Your next question comes from the line of Gregory Brash – Sidoti & Company.

Gregory Brash – Sidoti & Company

Regarding the Pegasus acquisition, you’re assuming you’ll get this licensing approval sometime in mid October and you have some inventory on hand. You have maybe 50% of accounts or 50% of volume interested. Is it fair to assume that you can ramp sales fairly quickly and that when we start looking at first or second quarter of next year, you can start approaching the $1.5 to $2 million range?

Richard W. Kramp

My expectation is that the demand is there. What we have to do is, as we’re a new company and we bring the products into the hospital, we have to find based on hospital regulations, do we have to re-register these products in the hospital under the Synovis name or will they pass right through under the Pegasus name being the same product. So I think we’re going find different rules in different hospitals. If we have to get before committees again, it will slow the process down, and we don’t have a good reading on that just yet. I think from the demand standpoint, we probably could be able to grow fairly quickly, but we’re going to have other logistical issues that we have to face.

Gregory Brash – Sidoti & Company

Do you have any idea how long that could take in a given hospital to get approval on branding?

Richard W. Kramp

Sometimes with a new title, it will be viewed as a new product, so it goes to the new product committee. I think it would go fairly quickly once into the committee. The problem is sometimes those committees only meet once every month or sometimes every three months depending on the size of the hospital.

Gregory Brash – Sidoti & Company

But if that wasn’t an issue, you feel the demand is there and doctors want it?

Richard W. Kramp

Yes. Everything we hear is very good in that respect.

Gregory Brash – Sidoti & Company

On the Peri-Strip side, the doctors at least in your accounts who were trialing the Covidien buttress, are they trialing it just because it’s a new product or is it the use of use? Is that playing a big factor in their decision?

Richard W. Kramp

It’s hard to tell. Part of it is certainly they have a relationship, just as they have a relationship with our salesperson, they have a relationship with the Covidien person, and it’s also the fact there’s some convenience, so they’re going to give it a try. There is no real clinical data supporting performance, so it’s got to be on an ease of use and relationship basis, and as our salespeople were a little bit taken out of field doing a lot of other things, mostly distracted with interviewing and so on, that might have created some opportunity. On the other hand, those kinds of trials happen all the time. Doctors and hospitals want to find out if something works and find out the newest thing. What we know from our absolute feedback from many doctors is that this thing does not do what Synovis’ products do. It does not prevent leaks, even by the company’s own literature. It’s lost 50% of its strength in about 7 days, and we know from the doctors telling us that the gastric fluid leaks, not the blood leaks—blood leaks are usually right on the spot—occur 1 to 2 weeks after the procedure, so we can see why the product doesn’t work in that regard as well as Synovis because we have strength for a lot longer than that, and in fact most of our strips are Veritas, and they actually are remodeling to help the wound close. So if there is a factor, it is ease of use. As I said in my presentation, it’s not the kind of factor that will offset clinical results. The doctors see problems. That few minutes of time saving is not going to make a difference.

Gregory Brash – Sidoti & Company

Rich, you talked about product enhancements to your Peri-Strips in lowering the application time from minutes to seconds. When can expect that launch?

Richard W. Kramp

That development process will take probably until the third quarter of 2010. It’s just a fairly long development process just in getting the process down of applying adhesive to our Peri-Strips. So it won’t be available for the first two quarters of the next year, but it will be in the third probably.

Gregory Brash – Sidoti & Company

Any update on CE Mark for Veritas?

Richard W. Kramp

We expect that any day now. I’d like to give you an exact date, but we can’t. We know we’ve gotten a lot of positive signals recently from the regulatory bodies over there and we’re expecting to see that maybe in the next few weeks.

Gregory Brash – Sidoti & Company

You can throw that in the bag of our distributors who are selling Peri-Strips?

Richard W. Kramp

We’ve had and we have some more training programs going on right now in Europe with our distributors selling Veritas in the hernia market.


Your next question comes from the line of Ernest Andberg – Feltl & Company.

Ernest Andberg – Feltl & Company

You’ve been pretty well grilled on Peri-Strips, Veritas, and those types of things. Brett, I have just some number issues. You had suggested after the acquisition of Pegasus was announced that you thought that the fourth quarter could be impacted by about $2 million in terms of the expense line, and in your comments I think you said $1.2 to $1.5. Is that correct?

Brett A. Reynolds

What we said when we announced the acquisition is that we’d expect $1 to $2 million of cost here for the remainder of fiscal ’09. We had $200,000 in Q3, and our current expectation for Q4 is in that range of an addition of $1.2 to $1.5 million.

Ernest Andberg – Feltl & Company

In addition to that, about maybe 1% penalty on gross margins because of the unabsorbed overhead in the facility out there?

Brett A. Reynolds

And a stepped up basis for the inventory we acquired. In purchase accounting, you cannot put that inventory on your books at historical costs. You need to put it out in your books at fair value which is higher than that cost, so that will impact margin as well.

Ernest Andberg – Feltl & Company

The expanded salesforce you think will add about $500,000 of expenses in Q4?

Brett A. Reynolds

Yes, from Q3. We have a few people here, the full quarter, and as we complete the expansion to the full 16.

Ernest Andberg – Feltl & Company

You had said $300,000 or $400,000 a quarter, or some could get shifted into the fourth quarter. That was after your third quarter call of additional sales and marketing expenses. Is this now coming in line with your expectations, Brett?

Brett A. Reynolds

Yes, it is.

Ernest Andberg – Feltl & Company

You discussed the tax rate. You said a 28% rate for the 9 months. Is that what we should use for the year?

Brett A. Reynolds

Currently, that is what you should use for the year. The change in the quarter again was driven by the activities, the acquisition of OWC driving the rate lower, but right now that’s our expectation for the full year rate.


At the moment, Mr. Kramp, I show that you have no more questions.

Richard W. Kramp

After this quarter, we feel that Synovis is in the strongest position for long-term growth than it has been since its inception. We began the third quarter with three very competitive product families in markets totaling just under $1 billion, and we ended the third quarter with 5 very competitive product families in markets totaling $2 billion. As we forth this quarter in the fourth quarter, we will watch with great expectations as our newly hired salespeople establish themselves in their respective territories, create excitement about their products, and build connections with existing and future customers. We will also move forward with the process of building our OWC salesforce, reaching out to former customers, and preparing for approval to manufacture in our Irvine facility, and start generating OWC revenue in the coming fiscal year. The future of Synovis is on solid footing, and the opportunities for growth have never been greater.

We appreciate your continuing interest in and support of Synovis. We look forward to connecting with you again to report our fourth quarter and year end results.


Thank you for your participation in today’s conference. This concludes the presentation. You may now disconnect.

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