Exactech, Inc. Q3 2009 Earnings Call Transcript

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 |  About: Exactech, Inc. (EXAC)
by: SA Transcripts

Exactech, Inc. (NASDAQ:EXAC)

Q3 2009 Earnings Call

October 28, 2009, 10.00 am ET

Executives

William Petty M.D. – Chairman & Chief Executive Officer

Jody Phillips – Chief Financial Officer

David W. Petty – President

Analysts

Matt Menze – PearlDiver Technologies

William Plovanic – Canaccord Adams

Jeffrey Johnson – Robert W. Baird

James Sidoti – Sidoti & Company

James Terwilliger – Duncan-Williams Inc.

[Kurt Krueger] – [Krueger Capital]

[Dave Joshe] – [PearlDiver Technologies]

Operator

Ladies and gentlemen, welcome to the Exactech Third Quarter 2009 Earnings Conference Call on the 28 October, 2009. Today’s presentation all participants will be in a listen-only mode. After the presentation there will be an opportunity to ask question. (Operator Instructions).

I would now hand the conference over to Dr. Bill Petty, CEO of Exactech. Please go ahead.

William Petty M.D.

Thank you, [Yon]. And welcome to our third quarter earnings conference call and a good morning from Gainesville, which in spite of the fact it’s almost November, is warm but also still somewhat humid, but we are still happy to be here. And before we get into the meat of the call, I want to read the disclaimer.

This release contains various forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the SEC Act of 1934 they represent the company’s expectations or beliefs concerning future events to the company’s financial performance.

These forward-looking statements are further qualified by important factors that could cause actual results to differ materially from those in the forward-looking statements. These factors include the effect of competitive pricing, the company’s dependence on the ability of third-party manufacturers to produce components on a basis, which is cost-effective to the company, market acceptance of the company’s products and the effects of government regulations. Results actually achieved may differ materially from expected results included in our statement.

For the third quarter of 2009, Exactech revenue was up 12% to $42.4 million from $37.9 million in the same quarter of 2008. Net income was $2.7 million resulting in earnings per share up $0.21. Last year in quarter three, net income was $2.1 million or $0.16 of earnings per share, the change from 2008 to 2009 in net income is an increase of 28%. If we exclude the cost of $845,000 related to the ongoing Department of Justice inquiry, net income was $3.3 million or $0.25 per share.

Going to the specific product segments, hip implant revenue increased 24% to $6.8 million from $5.5 million last year. Knee revenue increased 4% to $17.3 million from $16.6 million. Biologic and spine revenue was up 7% and that’s to $6.5 from $6.1 million. Extremity implant revenue increased 31% to $5.5 million that is up from $4.2 million last year. And the other product revenue increased 13% to $6.3 million from $5.5 million and just as a reminder the other product includes our cement product line it also includes instrument sales to distributors.

Now to look at first nine months of 2009, our revenue was $129 million, it represents an increase of 6% over a $121.4 million for Q3 last year. Net income for the first nine months of 2009 was $7.8 million representing a 2% decrease from the first nine months of 2008. However without the impact of the Department of Justice inquiry expenses of $3.4 million for the first nine months, net income for the nine months would have been $10 million.

Also for the nine months period, hip implant revenue increased 14% to $20 million from $17.5 million. Knee implant revenue decreased 2% to $54.7 million from $55.6 million last year. Biologic and spine revenue increased 5% to $20.5 million from $19.4 million. Extremity revenue increased 38% for the first nine months and that’s now at $16.4 million for Q3 of ‘09 compared to $11.8 million in the same quarter last year.

The other product revenue increased 2% for the first nine months and that’s from $17.1 to $17.4 million. The break down for U.S. and international, our U.S. sales increased 15% to $30.2 million from $26.3 million in the third quarter of 2008. International sales increased 5% to $12.2 million compared to an $11.6 million last year.

International sales for the third quarter of 2009 represent 29% of our total revenues compared to 31% in the same quarter last year. I believed it was a strong quarter with our hip, extremities and other segments increasing sequentially for Q2 of ’09. For all segments expect extremities our growth in Q3 was greater than it was for the nine months period. The only expectation was the extremity segment, which increased a solid 31% in Q3 compared to last year.

Overall we are very pleased with our progress over the [somewhat] slow first half of 2009 especially with its occurring in the traditional and slower third quarter. I am now going to ask Jody Phillips, our Chief Financial Officer to give a little more financial detail. Jody?

Jody Phillips

Thank you, good morning everyone and thanks for being on the call. Initially I would like to add a little background to our gross margin trend. During the third quarter our gross margins remained relatively flat on a comparative basis at 64%, but improved from the 62.3% we reported in the second quarter.

The key reasons behind these improvement on a sequential basis are stable pricing, relatively stable U.S. versus our U.S. sales mix and most importantly increased internal production volumes. We commented about lower production volumes during our second quarter call and projected higher volumes for the balance of 2009 that turned out to be the case in the third quarter and we continue to project higher production volumes for at least next two to three quarters.

Despite the fact that we’ve reduced total inventories during the quarter we continued to increase the total dollar volume of components produced in-house relative to those components that are outsourced and that is the large driver behind the stability in the gross margins.

We expect fourth quarter gross margins to be roughly in the 64% neighborhood, which will result in a full-year gross margin improvement of approximately 50 basis points, which would be within the range of our expected improvement for 2009 that we projected at the beginning of the year.

In the operating expense area clearly the two centers of note for different reasons are the G&A and the R&D spending. The 6% drop in G&A spending was primarily attributable to lower DOJ inquiry related expenses. However, even excluding these expenses our G&A costs were only up 2% as a result of our cost management efforts.

In the R&D cost center area, while the 41% increase in spending may of your concerning we actually have been projecting R&D spending to be up 7% to 8% of sales range for sometime now. And frankly, we are pleased that many other projects have progressed to the more costly final testing regulatory approval and release stage. We continued to project future R&D expenses to be approximately 8% of sales, which implies that the R&D spending will be increasing somewhat faster than our sales growth.

In total, we feel we are on track with our plans with operating expense increase of 12%, which was consistent with our sales growth. From a balance sheet perspective and as I commented in the press release we experienced a $5.8 million reduction in total debt during the quarter, which was significantly better than our expectations. This is primarily due to lower than expected inventory levels as we experienced the $2.9 million reduction in inventory during the third quarter.

Our forecasting, planning and operation teams continued to improve our supply chain processes and this is having a positive impact on our cash flows. We ended the quarter with $3.3 million in cash with $10.7 outstanding on our $40 million revolving credit facility.

Our AR continues to be slightly higher on a year-to-date DSO basis at 66 versus 61 for the first nine months of 2008. However we have not experienced any additional expansion in those payment terms since the second quarter of this year.

Based on our year-to-date sales performance we have increased our full year diluted EPS range to $1 to $102 that is exclusive of projected DOJ inquiry cost and it assumes stable gross margins and increased research and development expenses as a percentage of sales, as we continue with our core development and product launch activity.

That is all the comment I have at the moment. So I will turn it back over to Dr. Petty

William Petty, M.D.

Thank you, Jody. [Yon], we are happy to begin to take questions now.

Question-and-Answer Session

Operator

Thank you, sir. (Operator Instructions). Sir the first question comes from the line of Matt Menze from the company – PearlDiver Technologies. Please go ahead.

Matt Menze – PearlDiver Technologies

Hello. Thank you for taking my call. I was just wondering if we could have an update on the spine business and how the Altiva acquisition is playing out. And also if you’re seeing any what the pricing trends look like in spine as well? Thank you.

William Petty M.D

I am going to ask David Petty to respond to that.

David W. Petty

Sure. Okay, so I think everybody is aware that following the acquisition we saw a decline in revenues that was based on some revenue reduction that we expected. We didn’t like it, but we expected to struggle little bit on the revenue side the early stage and we really have spend the better part of the last 18 months focusing on two very specific areas related to spine.

Number one is giving the sales organization that loss a little bit more bit more effectively. And number two and actually really number one is the product pipeline. And what we've done this year is made some improvements to our pedicle screw system instrumentation, which was a little bit of a barrier to sales for respective customers. And trying to get some products into the pipeline that we expect now to launch in the second half of 2010 and that’s the new 5.5 pedicle screw system, a posterior cervical system as well as the comprehensive peak interbody cage platform. So I guess what I was saying about it is that as we anticipated it’s a little bit of a expense, it’s a longer road, it’s not going be a short-term accretive and positive revenue situation for Exactech that’s not what we expected, its not what we are experiencing and we are intending for 2010 to bring both revenues and also just start to cover the expenses in the spine business.

William Petty M.D

He also asked you about pricing.

David W. Petty

I’m sorry, yeah pricing, well okay pricing in the spine, in our experience which bear in mind we’re a very small player is stable and I don’t think one can look at our spine business and really claim any interpretation about the market trends based on our size. I will through add that on our hip and knee business our pricing is very stable. And that we’ve been watching that closely with all of the discussion about healthcare reform and so, as always we, always in discussion with hospitals about pricing, but our experience currently is that our pricing is remaining on a very stable in our hip and knee business.

Matt Menze – PearlDiver Technologies

Great. Thank you.

David W. Petty

You are welcome.

Operator

The next question sir comes from the line of Will Plovanic from Canaccord Adams. Please go ahead.

William Plovanic – Canaccord Adams

Great. Thank you. Good morning.

William Petty, M.D.

Good morning Bill.

David W. Petty

Good morning.

William Plovanic – Canaccord Adams

Couple of questions for you, just you talked about R&D at 8%, kind of where the gross margins are at 64% just on the R&D is that 8% number something we expect to roll through 2010 as well or is that just a kind of finishing ’09 strong and then we’ll see a pull back?

Jody Phillips

We are expecting it to increase in 2010, Bill from where we will end 2009 some where between 7.5% to 8%, it’s probably a realistic expectation. And that’s basically a strategic decision by the company to continue to heavily invest in R&D.

William Plovanic – Canaccord Adams

Okay. And then if you look at the third quarter is a very solid quarter revenues were up sequentially year-over-year everything was positive given that trend is there something in procedure volumes or somewhere else that would give you reason to give the cautious guidance that you gave because you’re almost giving us flat fourth quarter barely up when typically the fourth quarter is seasonally much stronger. So there is something you are seeing that’s driving that conservatism?

David W. Petty

Will this is David. So from our perspective we over the last four quarters, Bill, including the fourth quarter of last year have seen specific numbers that have defied our history consistently. And so well we’re optimistic or want to be optimistic about Q4 and even first half of next year based on what we experienced in the third quarter, when we look at the way the month came in and the quarters came in and Q4, Q1, Q2 and even Q3 on the positive side. It’s just hard for us to have the lot of confidence about saying, okay now for sure we know exactly how it is going to go on a go forward basis. I’d like to give at least another quarter or two under our belt, before we figure we’re out of the words on sort of these anomalies in the way the sales have come in, in this economy and all the other things that are going on in the world.

William Plovanic – Canaccord Adams

Given how much uncertainty and how sporadic business has been. I was wondering if you be willing to kind of walk us through maybe procedural trends as we looked at July, August, September and now even through October. And how that may I compare to historical trends?

David W. Petty

Okay. Well, I mean compared to historical trends of pricing flat, you to make an interpretation based on what we have reported though we haven’t given you domestic and international breakdowns, but clearly our third quarter procedures were up compared to prior year and I’m speaking about hips, knees and shoulders, now I think more interesting to me is the sequential look. And just bear in mind that we were very disappointed with and frankly surprised by our Q2 domestic and I’m going to speak specifically about knee, knee procedure volumes and we studied that hard, we figured at the time that we had not really lost customers that our existing customer base is down, we verified that by looking at the data and talking to the customers. We double our efforts both on new customer acquisition but also on paying attention to our existing customers bases volumes nothing we can do a whole lot about them. And what happened in the 90 days that followed is that we went from negative revenue and procedures in need in Q2 to let's just say meaningful positive domestically in Q3, but there is a meaningful turnaround so in our case we saw procedure volumes come back at least in a moderate way in the third quarter with existing customers and we also by design and a lot of focus and hard work added enough new customers that helped as well.

William Petty, M.D.

Bill, this is a quick summary of my personal view is that the volumes have come backs on, are they back to pre-economic turmoil’s levels that we don’t think so

William Plovanic – Canaccord Adams

And then just any color on, was July, August, September really strong or was it more strength to the whole quarter and then how is it October looking at this point?

Jody Phillips

It was consistently solid through the quarter in the third quarter and we’ll talk about October in the context of the fourth quarter in February

William Plovanic – Canaccord Adams

Okay and then last question on, was spine up year-over-year?

David W. Petty

No.

William Plovanic – Canaccord Adams

Okay. Great. Thanks a lot.

David W. Petty

Thank you, Bill.

Operator

The next question comes from the line Jeff Johnson from the company of Robert Baird. Please go ahead with your question.

Jeffrey Johnson – Robert W. Baird

Thank you, good morning guys.

William Petty, M.D.

Good morning Jeff

David W. Petty

Good morning Jeff

Jeffrey Johnson – Robert W. Baird

Couple of questions Jody I’ll start of with you and I’m trying to put this through model quickly as you talk about gross margin and R&D and that because I through all that into my model is that fair to think about what ever top line growth is next year OpEx growth about inline with that and then if you were to get any leverage it would come below the line, is that a fair way to think about it, or is OpEx going to grow above revenues next years with R&D moving up to those level.

Jody Phillips

I think OpEx got a fair change of growing inline with revenues as we get a little bit leverage through G&A.

Jeffrey Johnson – Robert W. Baird

Yeah through the G&A and then its looks like S&M could come down a little bit as a percentage of sales, as well is that fair there looking were its been the last couple quarters relative to last part of '08 and early ‘09.

Jody Phillips

No, we’ve got a lot of new product rollout and I think we kind of projected to continue to be stable as a percent of sale.

Jeffrey Johnson – Robert W. Baird

In the upper 31% range?

Jody Phillips

Yeah specially is, as long we have this robust double-digit domestic sales growth.

Jeffrey Johnson – Robert W. Baird

Okay so if that stays stable G&A as were your offsetting the upper or the higher R&D, so OpEx inline with revenue.

Jody Phillips

That’s right

Jeffrey Johnson – Robert W. Baird

All right. Great. And then just on the stable pricing on the hip and knee side, how much of that is a function of just your customer mix or product mix I know you guys have not taken some the ASP increases over the last five years or so that others have, so are you just at a lower base where hospital don’t feel like they need to push hard as our back on yours others, as they do on other competitors or how do we think about that?

David W. Petty

Couple of things about that, number one we have sense that our ASP in general maybe lower than our competitors based on product mix and things that competitors offered definitively with of course not only surgeries to the knees and of course we have not had metal on metal in our mix in hips and we don’t believe in highly cross-linked polyethylene and knees, and so perhaps our ASP is a little bit lower that our competitors but I also think that we have a sales management team that is very effective in managing their pricing conversations at the administrative level both in buying groups and at individual hospital levels that I say perfectly, I think we’re pretty good.

Jeffrey Johnson – Robert W. Baird

Okay thanks David and then on the knee side, any updates on the CR Slope dollars, we're a couple quarters into that launch and then the PS Logic, where we are with that launch?

David W. Petty

Yeah okay so we’ll start with the Slop we’ve been slowly building that up over the year and we’ve got about 75 sets on that product available in the field domestically we’ve not really done anything meaningful with it outside the U.S. That will be the first half of next year. And then without knowing the precise details I can only tell you that, definitely we have attracted new customers with that product. The more we interact with surgeons and get them understand the philosophy behind that product concept. With more optimistic we become about the fact that this really is a product that they can make a meaningful difference for us on a go forward basis in the positive way. And the logic we called that we were really intended to launch that in the first half in 2010. And based on the early response, very positive response from customers, we accelerate that, we've managed to get a modest number of sets into the field and have attracted a few new customers with logic. That’s going to be more of a first half of 2010, customer acquisition with that.

Jeffrey Johnson – Robert W. Baird

David a couple follow up, there is a 75 sets of the Slope you have out there. How many sets would you typically put out in the field for a new knee product launch or how do we think about what percentage of that launch are now into on the Slope.

David W. Petty

That’s hard to know because, again, I say being optimistic that if we tell the story right, I am hopeful that we are not very far long with 75 but lets just say 40, 75 sets out over three quarters is a very solid launch that’s right along the lines of how we would like to do a major product launch in general

Jeffrey Johnson – Robert W. Baird

Okay. Great. And then last question just on pipeline it sounds like maybe you are pushing the second half of '10 the Pedicle screw and the cervical system in the Peak cage. Is that correct, I though it was each one of 10 last quarters, what we are talking about.

David W. Petty

Well it is the same, as we said last quarter I think was Q2 but I was probably optimistic and Q2 was nearly the end of Q2 and until we get a little bit more the project under our belt like I thinking Q3 and I was conservative when I said second half.

Jeffrey Johnson – Robert W. Baird

And remind me those would be five 10-Ks and any of the push coming from FDA-related type issues or just we're attacking your internal project.

David W. Petty

It's just getting three projects through a fledgling and developing product development group and we we’re getting the people hired and running the projects and remember, we're this for all a chance of purposes which is a start up and so we’re focussed on the product pipeline. I don’t believe this what I’ve characterize this is a slip from what we said a quarter ago. It's late Q2 or early Q3. So the FDA to answer your precise question the FDA is not an issue on the product.

Jeffrey Johnson – Robert W. Baird

Okay. Great. And then lastly on the shoulder, the fracture plate I am sorry in the [press beck] glenoid maybe the platform, the new platform on the fracture stem, all those, still thinking later this year. How do we think about that?

David W. Petty

Yes. Those did slip we’ve had those slip from Q3 and Q4 and to like I actually I am prepared with more precise data. Today the platform fracture stem is December, the [press beck] glenoid is January and the fracture plate is February. So we are down the months now, not quarters and we have a lot confidence in what I am just told.

Jeffrey Johnson – Robert W. Baird

Yeah, you’re feeling good on those three?

David W. Petty

Yes sir.

Jeffrey Johnson – Robert W. Baird

All right, great thanks guys, that’s all I have.

William Petty

Jeff this is Bill Petty. I am just going to comment on a little more on your question about CR Slope and this is the more as a surgeon than the CEO of Exactech, I am [matching] that’s used to be more of a posterior stabilized surgeon but I’ve had the opportunity recently to utilize this technology and I think it is remarkable. It really provides the surgeon the tools to maintain the function of posterior cruciate ligament better than anything I have ever seen either from a standpoint of technology or technique. So my own belief is that Exactech’s does what it should do this product will substantially exceed hours everyone else expectations.

Jeffrey Johnson – Robert W. Baird

That’s helpful. Petty remind me, industry wide it splits about 60%, 65% posterior stabilized and the rest of that is cruciate retaining just on the market use standpoint?

William Petty

Jeff you probably know that better than I do I've just used the numbers 50-50 you know at least to be 60-40 the other way, are more popular I know that is trended little more towards the PS. And I think one of the reasons for that it's been difficult in the past to make the appropriate cut to give the space you need to place your prosthesis without damaging the PCL. And that is what to see the CR Slope provides the surgeon the tool to do. But again who knows, we may at least reverse, we may at least stabilize that trend and it could even be reversed a little bit, but if your number 60, 40 PSGR I will take that I would just kind of say 50-50 when people asked me, I don’t really know.

Jeffrey Johnson – Robert W. Baird

Well. I’m kind of guessing myself. So I appreciate you guys.

William Petty

And I will say it Jeff in our company it's been more a preponderance of PS for a lot of reasons and of course one of those is our work with hospital for special surgery [Dr. Berstein], et cetera, who are the ones who invented and popularized the PS concept.

Jeffrey Johnson – Robert W. Baird

Right. Now understood. Thanks guys.

Operator

The next question comes from the line of James Sidoti from Sidoti Company. Please go ahead.

James Sidoti – Sidoti & Company

Good morning Dr. Petty, can you hear me?

William Petty, M.D

Yes. Sure Jim. We can hear you loud and clear.

James Sidoti – Sidoti & Company

If we went back nine months and I said your hip implants were going grow 14% this year but your knee implant would be down 2%, I think we both would've thought I was nuts, what do you think happened this year and what you are going to do to get the knee implant growth more in line with the hip implant?

David W. Petty

Jim, this is David, a lot of thing and now you're going back to nine months and just recall that a lot of our international business is knee and in the first half of 2008 we had tremendous stocking orders and recall too that our all-in line company growth for the second quarter of 2008 was 38%. There we were in the second quarter of this year with down economy and procedure volumes clearly down and still 50% of our business is knee and in the phase of very large international cost and declining procedure volumes in the U.S. I think the second quarter I mean we really sort of took it on the chin and that’s where the bulk of our issue is though I acknowledge that we struggled in the first quarter too. We didn’t have quite the comps we had in the second. So what do we do about it and I think I have already described on this call that we’ve put a lot of effort into focusing on new customer acquisition, we always do that. But we redouble our efforts when it was really sore spot in our business. And we have did make a real improvement there from high single digit negative Q2 to high single digit positive Q3 in terms of domestic knee revenue. So that was a 90 day turnaround that I think is important for the company. But your other question was what are we going to do about it to get it back in line with an hip. The hip is a 14%, it's actually doing better than the 14% here in the third quarter with 24% because we had the similar comparative issues in the first half of 2008 with the hip and now we’ve gotten out of woods with the comps on the hip really in the first half of the year. We didn’t get fully out of woods on the comps especially with international stocking on the knee until the third quarter. That should not be an issue in the fourth quarter, that’s going to help us, but the thing is going to help us the most is gaining more new customers with the CR Slope and the PS Logic Knees. And so having said all of that and with our focus on domestic customer acquisition and clearing the comps internationally and being in the middle of the launch of two new products those were all things which will put us in a position to do better with the knee. I am not ready to say we are going to bring it up to 24% like what we've just reported for the hip, but where I think we are moving in the right direction there.

James Sidoti – Sidoti & Company

Okay. And then Jody on the currency issue, I know currency's been headwind for you up till now. With the dollars getting weak again, what do you expect currency to, how do you expect currency to impact the fourth quarter?

Jody Phillips

Well, it turns to a slight tailwind if you want to call it that I think in the fourth quarter at least with the spot rates where they are now. It was a slight headwind in the third quarter it probably had a 1% impact on our numbers in the third quarter and I would expect that to turn slightly positive in the fourth if rates stay where they are currently.

James Sidoti – Sidoti & Company

Okay. And then the other big factor that no one is really touched upon yet is are is the [legal] expenses, its going on almost two years now since this investigation was opened. Do you think you are coming to close to the end at this point or can you give any color on that?

William Petty, M.D.

First of all Jim this is Bill Petty speaking your numbers are close to correct just began for us in December.

James Sidoti – Sidoti & Company

Okay.

William Petty, M.D.

Two years ago it actually began for us before that because once the other companies, VPAs and documents were published we initiated a complete audit and review of our own compliance program, so actually had started that ahead of receiving a subpoena U.S. Attorney's Office. And then just another comparison with the large companies it was 30 months and we’re now at whatever 22 or 23. We continue to cooperate fully not only with the Department of Justice, but also with the Office of Inspector General, which has been involved with the other companies and we are involved which as well and we are interested in getting this result as anyone is and we’ll continue our efforts to do that as soon as we can.

James Sidoti – Sidoti & Company

Great, all right. Thank you.

Operator

The next question comes from the line of James Terwilliger from Duncan Williams. Please go ahead.

James Terwilliger – Duncan-Williams, Inc.

Hi guys can you hear me?

William Petty, M.D.

Yes sir, James.

James Terwilliger – Duncan-Williams, Inc.

First of all great quarter, my first question I’ve got for is on the hip business and I wonder if you guys could talk a little bit about the hip business and provide just some additional information, this is a strongest growth percentage the growth rate that I think I’ve seen since 2007 and I think this is a record in terms of actual hip revenue. So is there anything that any additional information you can provide on what happened in the hip business during this quarter?

David W. Petty

We’ve reported on the last couple of conference call that we were launching in the first and second quarters additional component to our innovation hip system, which is our flagship product line, both the fracture system as well as an upgrade to our cemented hip. We also have talked I think on previous conference calls about the Element stem within the Novation line, which is product that is conducive to use with direct anterior approach to the hip, which is coming more popular. And I think when we have three product launches within a product line over the six-month period and get the sale force engaged I think that that can make a big difference. So I think what we’re seeing is a lot of things coming together all at once and being on the sort of the front end of the curve of a more approach to surgery of the hip is becoming more popular and being there ready on the front end of the trend with a good set of instrumentation to deal direct anterior approach is allowing us to access more new customers, more readily and bear in mind too we are operating half of the smaller base with the hips than we are with the knees and I guess I would remind Jim Sidoti of that, too, on his question about growth rates, so I think that with the there we are operating off with a smaller phase with the hip then we are with the knee and I guess I would remind Jim Sidoti about question about growth rate, so I think that’s hopefully I guess little bit more color on how we’ve gotten where we gotten with the hip growth.

William Petty, M.D

Jim, just as an additional comment the Exactech began about four years ago, a major effort in improving our hip lines where we’re disappointed in where our revenues were especially as compared to the knee. And I think we’re beginning to see some of the results of those intensive R&D effort.

James Terwilliger – Duncan-Williams, Inc.

It’s a great number in a very tough environment in talking to other the people in the industry, so I applaud you for that. Jody, I want to switch a little bit to gross margins. Two questions on gross margins how the internal manufacturing initiatives going and have you seen any change when core material pricing out in the marketplace when you’re buying the materials to manufacture the product, have you seen any change in those pricing in that area?

Jody Phillips

I will answer the first part. Initially as I've commented before the production volume in the third quarter were up. Due to demand reason they were lower in the second quarter and we had a nice return to our growing production volumes in the third quarter, and that continues to allow us to bring in-house product that we can manufacturing more cost effectively as well as that contributes to total little inventory management as well. So and again the next couple of quarters at least on the visibility that we have right now we continue to project very robust production volumes and from the raw material standpoint we have not experienced anything overly significant. Our key input there is probably titanium and cobalt chrome and some of those costs have ticked up a little bit, but tha tat least been manageable on overall cost structure.

James Terwilliger – Duncan-Williams, Inc.

Right and if going to my third question actually was the inventory, the inventories have declined from $62 million at the end 12/31/08 to currently $59 million. And with the growing revenue base and the launch the new product should we be looking for the inventories to increase here in Q4 and Q1 going forward?

Jody Phillips

We do continue to project the inventory totals to increase and that’s a number that probably over the next three or four quarters, we would be projecting a $6 million increase or so specifically due to the new products I think we’ve probably pared what we can out of the current inventory yet while maintaining our customer support levels.

James Terwilliger – Duncan-Williams, Inc.

The inventory number looks great and then lastly just in terms of the model, should we be looking for operating margins to fall below 12% or is 12% with your investment in R&D is [12] that operating margins a good number.

Jody Phillips

I won't comment to the specific number because we don’t have any guidance out in 2010 in total as of the yet. But I think generally we think we can offset some of those R&D increases as a percent of sales with G&A leverage and also possibly some additionally improvement on the gross margin line. So that the concept that the operating margin percentage can stay stable we would still stick to at this point.

James Terwilliger – Duncan-Williams, Inc.

Okay, great. Listen guys, great quarter in a very difficult time.

Jody Phillips

Thanks Jim

William Petty, M.D

Thank so much.

Operator

The next question comes from the line of [Kurt Krueger] from [Krueger Capital]. Please go ahead.

Kurt Krueger – Krueger Capital

Thank you for taking the question. Can you hear me al right?

Jody Phillips

Yes, sir.

Kurt Krueger – Krueger Capital

Good quarter, thanks. I know you are a small company, but going back to that hip growth, it is just so remarkable could you talk about it you didn't talked about it as a little in with respect of products, but could you talk about that with respect to marketing distribution side you think that you we were able to develop a better share in the accounts you are in or did you add a lot of new accounts. Can you just give us a little color with respect to the marketplace that drove that that increase?

David W. Petty

We had a modest increase in the account we have meaning the procedure volume have gotten a little bit better, but really more than anything that it's the new customers with the new product. A new hip customers with the new products, in other words it could be an entirely new customer to exact that interested or it could be a surgeon who's been our knees who has become interested in our hip because we have added to new products that they now or we find the feeling as compared to our historical [difference].

Kurt Krueger – Krueger Capital

Great and then just one quick question on the FX effects, you said it was negative 1% was that to your grew, your international business by 5%, I understand in the quarter so now if you did it on constant currency will that be 6% or was the 1% across the entire company.

Jody Phillips

Across the entire company is probably about 0.5% and it was probably a 2% impact internationally so the 5%, if you look at on a constant currency basis internationally would probably be 7%.

Kurt Krueger – Krueger Capital

Okay. Thank you very much.

Jody Phillips

You're welcome.

Operator

The next question comes from the line of [Dave Joshe] from [PearlDiver Technologies]. Please go ahead.

Dave Joshe – PearlDiver Technologies

Hi, I've got just one quick question. The growth rate for shoulder line comparatively from last year I have seen a low decline. Is that due to procedure volume slowdown or is there a pricing trend affecting that as well?

William Petty, M.D.

I think our total annual growth in shoulders for [2009] was about 70%, 72% something like that. And the reason that it was and then let's just all understand right now , we are not signing up for sustaining 70% growth in product line, that that number was high because we had a full year of a launch of an exciting new product, but we think that was the reverse shoulder. We think really provided clinical benefits to patients that were improvement over other product in the market. So we've had a lot to play out of the new product, we were operating off of relatively small phase. And as we've started to get into the comparatives in each quarter this year where we had grown the business substantially in the prior year, yes our growth rates did slow, but as 38% year-to-date, a 31% for the quarter and by all estimates, that market itself is probably south of 15%. So we are better than double market growth, still feel very good about our shoulder program.

Dave Joshe – PearlDiver Technologies

Thank you.

William Petty, M.D.

You are welcome.

Operator

(Operator Instructions) Now we have a follow up question from Will Plovanic from Canaccord Adams. Please go ahead.

William Plovanic – Canaccord Adams

Great. Thanks. Jody just, that was pretty powerful paying down almost $6 million your debt in the quarter. What do you think that that's going to look like in the fourth quarter or through 2010?

Jody Phillip

Bill, there is lot of moving parts there as, I think through the fourth quarter we would expected to tick up a little bit. Its all going to be dependend on the incoming recipt that inventory. If the inventory comes in as projected there could be a $2 million or $3 million increase before the end of the year. And then as we get into next year we're looking at a number of different investment opportunities and we think we may get into line a little more somewhere along the lines of the $20 million type neighborhood that we were at before we are with comfortable that little bit of leverage, and that's still only half of our line. But that assumes we have some pretty significant investment there.

William Plovanic – Canaccord Adams

Right, great. Thanks.

Operator

At this point sir, they happen to be no further questions. Please continue with any other points you wish to raise.

William Petty, M.D.

Thank you to all of you for joining us. You had great questions. Thank you for continuing interest in and support of Exactech and have a great rest of the week.

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