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Executives

Bob Yedid – ICR

Joseph J. Corasanti – President and Chief Executive Officer

Robert D. Shallish Jr. – Executive Vice President-Finance, Assistant Secretary and Chief Financial Officer

Analysts

Mike Matson – Needham & Company, LLC

Jeffrey Cohen – Ladenburg Thalmann & Co. Inc.

Mark Landy – Summer Street Research Partners

Dale Dutile – The Boston Company

CONMED Corporation (CNMD) Q3 2013 Earnings Conference Call October 24, 2013 10:00 AM ET

Operator

Good day ladies and gentlemen and welcome to the Quarter Three 2013 CONMED Earnings Conference Call. My name is Sheela and I will be your operator for today. At this time all participants are in a listen-only mode. We will conduct the question-and-answer session towards the end of this conference. (Operator Instructions) As a reminder this call is being recorded for replay purposes.

I would like to turn the call over to Mr. Bob Yedid of ICR Please proceed, sir.

Bob Yedid

Sure, thank you very much. Good morning everyone. Before we begin, let me remind you that during this call CONMED’s management will be making comments and statements regarding their financial outlook, which represent forward-looking statements that involve risks and uncertainties as those terms are defined under the Federal Securities Laws.

The company’s actual results may differ materially from current expectations. Please refer to the risk factors and other cautionary factors in today’s press release, as well as in our SEC filings for more details on factors that may cause actual results to differ materially.

You will also hear management refer to certain non-GAAP adjusted measurements during this discussion. While these figures are not a substitute for GAAP measurements, the company’s management uses these figures to aid in monitoring the company’s ongoing financial performance from quarter-to-quarter and year-to-year on a regular basis and for benchmarking against other medical technology companies.

Adjusted net income and adjusted earnings per share measure the income of the company, excluding credits or charges that are considered by management to be special or outside of the normal ongoing operations of the company. These adjusting items are specified in the reconciliation in the press release issued this morning.

With these required announcements completed, I will turn the call over to Joe Corasanti, CONMED’s Chief Executive Officer and President for his remarks. Joe?

Joseph J. Corasanti

Good morning. Thanks very much Bob. CONMED sales for the third quarter were $179 million, a decrease of 1.4% versus the prior year period and this was below our guidance range of $184 million to $189 million, principally due to weaker sales of capital equipment specifically video and power systems.

However, our adjusted earnings per share for the third quarter of 2013 were $0.40 within our guidance range of $0.37 to $0.42 that we provided to investors on our last call. While our adjusted earnings per share for the third quarter of 2013, $0.40 was below the $0.43 reported in the prior year period. Remember that the new medical device tax cost us $0.03 in the third quarter this year. So earnings would have been stable year-over-year.

On a GAAP basis, diluted EPS was $0.20 per share, compared to $0.32 in the third quarter of 2012. The difference is principally due to higher special charges that Rob will discuss in his remarks and the $0.03 hit from the medical device tax which took effect in 2013 for the first time.

Adjusted operating margin of 10.1% for the third quarter was basically consistent with the prior year period; despite the new medical device tax which cost us $1.4 million or 80 basis points this quarter. Adjusted EBITDA margin was 16.7% in the third quarter represented a decline of 70 basis points, versus the prior year period which was due solely to the medical device tax burden. Cash flow from operations was a strong $30.5 million, representing more than one half of the year-to-date cash flow in over five times the quarter’s net income.

In August our Board of Directors declared a quarterly cash dividend of $0.15 per share which was paid on October 4th. In the U.S. we believe healthcare utilization is starting to show modest improvement in procedures in the third quarter based on our discussions with hospital and surgeon customers and the metrics we follow: A continuation of the trend we saw in the first half of the year. However, we’re seeing major hospital company still reporting flat or only modest 1% to 2% increases in their adjusted admissions in the past quarter.

As you can see in the press release, our sales of single-use products in the third quarter were up 1.3% on a reported basis and 2.4% on a constant currency basis. While still modest year-over-year growth, this is a sequential improvement in single-use products sales after a decline in the first quarter and flat sales in the second quarter. CONMED sales of single-use orthopedic products were solid in the third quarter of this year with a strongest showing in sports medicine. In contrast our capital equipment sales were disappointing with the decline of 11.9% on a reported basis and down 11.1% on a constant currency basis.

We are seeing a very choppy capital spending environment and many of our hospital customers are being conservative in replacing existing capital equipment. And proportionally we could do not see this conservative spending past year changing in the foreseeable future and we expect to spending patterns will be volatile. For example, after stronger sales of surgical visualization systems in the second quarter of 2013, visualization sales were down 16% in the third quarter of this year.

With regard to capital sales, about one half of decline in capital sales overall for CONMED was due to a decline on our visualization product sales. We believe that CONMED sales were hurt by a lack of new product in 2D systems that we sold directly to hospitals. As part of series of new products that CONMED will introduce in 2014, we will be selected previewing a new 2D system at the Arthroscopy Association of North America or AANA, meeting in November and then proceeding with a limited launch of this product line in the first quarter of 2014.

Now we’d like to update investors on a few operational initiatives. First I’d like to comment on the new products. While we introduced four new upgraded products this year, we expect 2014 to be more productive with eight new product introductions. These agent reductions will include both new products and upgrades to existing products. Upgraded products incorporate better technology or features that improve CONMED’s competitive position in the marketplace, they position us to take market share and in some cases allow us to increase the price of the product.

For 2014 we expect that there will be three new our upgraded product introductions in sports medicine, three in endomechanical, one in advanced energy, which is a new electrosurgical council which will improve our product line position and the new video system I previously mentioned. With regard to one of our newer products, called Altrus, we have sales over $900,000 in the third quarter. While this is slightly below second quarter levels of $100 million due to the normal summer seasonality, it’s more than double the sales of the third quarter last year.

Second the central focus of CONMED has been a track record of expanding our adjusted EBITDA in operating margins on a consistent basis while having our focus on reducing costs. We have boosted our adjusted EBITDA margins from a recession low of 13.4% in 2009 to 17.4% in 2012, an increase of over 100 basis points in each year. The consolidation of our Tampere, Finland manufacturing plant into our U.S. locations is continuing and should be completed by the end of the year, this disciplined of reducing costs in our manufacturing and SG&A functions is an ongoing process and we have a number of lean manufacturing and cost reduction projects happening at all times.

Third, over the past three or four months there is an increased number of potential acquisitions in the marketplace that we are reviewing. We’re seeing more opportunities to acquire products and technologies that are complimentary to our core product lines. While we can make no assurance that any acquisition will be completed, we’re encouraged that these could be a good fit with CONMED and we would leverage our current infrastructure and keep strengths in sales and marketing, as well as manufacturing.

For example, in January 2012, we signed an important agreement with Musculoskeletal Transplant Foundation to be their worldwide marketing representative for sports medicine allograft tissue. This partnership has preceded well and was accretive to earnings beginning in the first year, by $0.15 per share.

On a year-to-date basis, we are pleased to report revenue growth of these product lines in the range of 4% to 5%. While surgeons frequently use Patellar Tendons and Achilles Tendons in their surgeries, we are working with them MTF and our sales force to get surgeons comfortable with using other tissue forms in their surgeries including hamstring tissue which is available in grater supply as well as other related tissue forms.

With regard to uses of cash, we mentioned on the last conference call that we have completed a $50 million share repurchase program that was announced in October 2012. The Company has a share repurchase authorization of $60.1 million remaining from the Board, which chose not to repurchase additional shares in the third quarter after buying back 1.6 million shares authorized by the program, I mentioned above. Our dividend which is paid in an annual rate of $0.60 per share continues and has returned $17 million to our shareholders over the past four quarters.

Now on to our guidance, based on what we see in the markets, there continues to be choppiness in the sales of our capital products on a worldwide basis. In the U.S., we anticipate flat to only modestly higher levels of healthcare utilization trends, there is still lot of uncertainty among our hospital customers with regard to the impact of healthcare reform with potentially greater volumes offset by lower reimbursement rates. We find that U.S. hospitals are still hesitant to purchase new capital equipment.

Moreover, international managers are seeing major European governments maintain or impose new controls or caps on healthcare spending. While we’ve seen some sequential improving in our European business, we are still seeing year-to-date declines in the U.K. and Germany markets. In light of these four conditions, we are guiding that the fourth quarter of 2013 will have revenues of $195 million to $200 million and adjusted earnings per share will be in the range of $0.47 to $0.52. Accordingly, we are reducing full year 2013 revenue guidance to between $754 million and $759 million as compared to our prior range of $770 million to $775 million.

Our earnings per share guidance range for 2013 is $1.75 to $1.80, as compared to our prior range of $1.80 to $1.85. This revised forecast is disappointing me and entire senior management team at CONMED. As we look forward to 2014, we want to be prudent both due to company’s specific and market issues.

As mentioned above, we will have a limited release of a new 2D video system in the first quarter of 2014, but we continue to believe the hospitals are being cautious in their purchases of new video systems overall. The surgical visualization product line accounts for 9% of our sales, while the new and upgraded product cadence will improve in 2014. We will take time – it will take time for the sales force to be educted above these products and roll them out to the marketplace.

In addition, we phase specific pressures on our healthcare markets in the U.S. and in Europe that we outlined above. Based on these factors we believe it is prudent to be more conservative in our forecast for the year ahead. For 2014, we are guiding the revenue between $770 million and $780 million an adjusted earnings per share between a $1.90 and $2 per share. Management and the Board feels it is important to maintain our investment in sales and marketing and R&D going forward rather than make short-term cuts in these expense levels which will damage CONMED’s franchisee and ability to compete in the future.

In summary, while we have some short-term challenges we are confident about CONMED’s core attributes. We continue to hold the number two and number three market share position in our key product lines, including sports medicine and powered surgical instruments that comprises 54% of our business. We will have a number of new and upgraded products that are coming to the marketplace and we will continue to invest in R&D to fuel the pipeline of product that will be attractive to our customers.

We have also improved our razor, razor blade model by improving our product mix to include 80% single-use products. We are a global company with over 50% of our sales in international markets and 10% of CONMED’s sales are in emerging markets. Where we will continue to invest in R&D [ph] structure. Moreover, we are using our strong cash generation to fund – to both fund growth and return cash to shareholders through a combination of dividends and stock buybacks.

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

Robert D. Shallish

Thanks very much, Joe, and good morning everyone. As Joe mentioned, total sales for the September quarter came in at $179.3 million, a decrease of 1.4% from the third quarter 2012 on a reported basis and a modest 0.4% decrease on a constant currency basis. In constant currency this was comprised of 2.4% in single-use devices offset by in 11.1% decline in capital products. Most of the decrease in capital products was due to weakness in our surgical visualization and powered instrument businesses.

Now I will review our three categories of product line sales disclosures. Orthopedic surgery, general surgery and surgical visualization. Our orthopedic surgery product line experienced a sales decline of 0.6% versus the prior year period although the product line was up 0.8% in constant currency. On a report basis the procedure specific and biologics product groups within sports medicine increased approximately 8%. While the resection and fluid spots medicine lines were flat. Powered instruments declined 4.5% in constant currency with an increase of 2.4% in sales of single use products while the capital products side of the business was down 12.8% reversing a positive trend from the first of the year.

Sales in the general surgery product group had an increase of 1% on a reported basis and 1.7% increase in constant currency. This increase was driven by slight increases in both single use products and capital sales. Our Endomechanical business was up 3.5% year-over-year and advanced energy previously referred to as electrosurgery was up 3.4% from the prior year period, principally due to higher generator sales in that product line. These positive performances were offset in part by a modest decline in GI and Pulmonary sales of 1.8% and by a 2.9% decrease in patient monitoring.

As Joe, we had the greatest challenges in our surgical visualization line, this product line includes our 2D and 3D imaging products and we experienced a decline of 16.4% on both the reported and constant currency basis. By geography sales in the United States for the third quarter came in at $89 million, a decline of 3.6% over the prior year period. International sales were $90 million, a 0.8% increase from the prior year period on a reported basis and a 2.9% increase in constant currency.

Foreign currency exchange rates including the effects of FX hedging program caused sales to be $1.9 million less in the third quarter of 2013 compared to sales in the prior year period. Canada and the Americas experienced flat sales in constant currency with single-use products increasing slightly offset by declining capital sales. Our Asian business increased 3.5%, while the European business was up1.6% in constant currency.

Turning now to the other components of the income statement; adjusted gross margins excluding restructuring costs came in at 54.1% compared to 54.8% in the third quarter of 2012, an increase of 30 basis points. Sequentially compared to the second quarter of this year, the adjusted gross margin increased 90 basis points. As discussed on our conference call, we anticipated the sequential improvement in gross margins based on the visibility we have with regard to our accounting for manufacturing variances.

The GAAP gross margin declined to 53.2% compared to 53.8% last year. The decline in gross margin on a GAAP basis was due to higher cost incurred with the termination of ECOM product line and continued costs related to facility consolidation. Selling, general and administrative expenses for the third quarter 2013 were $73.5 million or 41% of total sales compared to $74.1 million or 40.7% of total sales in the same quarter last year.

The medical device excise tax amounted to $1.4 million this third quarter, and is listed as a separate line item in our income statement. Research and development spending was $7.1 million for the third quarter, up very slightly from the third quarter of 2012. R&D spending as a percentage of sales was 4% relatively flat compared to the prior year period. We will continue to fund meaningful research and development activities, passiveness on our analysis of the merits of individual projects. There will be some variation in R&D as the percentage of sales as individual projects commence or are completed.

Overall, the adjusted operating margin in the second quarter of 2013 at 10.1% was consistent with the prior year period, despite the inclusion of the medical device tax. The operating margin using GAAP amounts was 4.9% in the third quarter compared to 7.8% in the last year’s third quarter, with the decline associated with 190 basis points from higher restructuring and 80 basis points from the inclusion of the medical device exercise tax. Specifically in the quarter, we decided on plan discontinuance of the ECOM product line and endotracheal measure cardiac output which we intend to sell to a third party. As part of this move, we took a charge for inventory write-offs and intangibles of approximately $3 million after tax.

The adjusted EBITDA margin in the quarter was 16.7%, a decline of 70 basis points, versus the prior year period caused by the 80 basis point negative effect from the medical device tax. EBITDA margin using GAAP amounts for the quarter was 11.4% of sales. For the third quarter diluted earnings per share were $0.20 per share compared to $0.32 in the third quarter of 2012.

Adjusted earnings per share were $0.40 per share, compared to $0.43 in the third quarter of 2012. If one were to add back $0.03 hit from the medical device tax, then adjusted EPS would have been the same in both periods. The adjustments for unusual items of $7.9 in this third quarter are reconciled in the press release issued this morning and include costs associated with the ongoing consolidation of certain administrative functions and manufacturing activities including severance and relocation costs, termination of the ECOM product line and an ongoing patent dispute.

For the remainder of 2013, we expect to incur additional pretax special costs of between $3.7 million to $4.7 million on projects currently in process. Please note that the medical device excise tax is included as a reduction in adjusted earnings per share as well as GAAP.

Turning now to cash flow; cash provided by operations came in at $30.5 million in this third quarter, greater than the third quarter last year due to an improvement in working capital items. Offset by a slight decline in GAAP net income. As discussed in the past, we like to emphasize a strong cash flow CONMED is able to generate.

This quarter’s cash from operations is more than five times the net income for the quarter. For the nine months of 2013, cash from operations is more than two times the net income for the period. As we look to the fourth quarter’s cash flow and the full year’s free cash flow, we believe that 2013 free cash flow will be slightly below the $73.7 million of last year due to the effects of the medical device tax.

As of September 2013, our cash balance stands at $49.8 million. Days and accounts receivables were 66 days and inventory days were 170. Both of these metrics are in good ranges. As of September 2013, the debt-to-book capitalization calculation was 27.5%, marginally higher from the 21.1% at December 2012 as a result of common stock repurchases and The MTF contingent payment of $34 million in January of this year.

Our effective tax rate for this third quarter was 23.4% on a GAAP basis and 27.4% on an adjusted earnings basis, compared to 28.3% in the third quarter last year on an adjusted basis. For the remaining quarter of this year, we anticipate a tax rate of approximately 33% to 34%. As we have discussed in the past, the cash tax rate is less than the book tax rate. This year we anticipate a 15% to 20% cash tax rate.

Before the turning the call back to Joe, I would like to point out that the medical device tax and the FX headwinds have reduced our earnings by $0.15 per share for the first nine months of the year. Adding back these amounts would have made adjusted earnings per share equal $1.43 per share a 12% increase compared to the prior year period.

With that I would now like to turn the call back over to Joe for final remarks, before we open the line for questions.

Joseph J. Corasanti

Thanks very much Rob. So I would like to make closing remark regarding our long-term goals in 2013 we’ve faced headwinds from the medical device tax and foreign exchange that cost us over $0.20 per share. In 2014, we will face additional internal and external factors that causes to be conservative and forecast modest growth and sales and adjusted EPS. However, I would like to remind everyone the CONMED was able to deliver EPS growth of 15% or greater from 2010 to 2012 on low single-digit sales growth.

We believe that our two long-term goals are achievable. Our goal of increasing adjusted EBITDA margins by about 50 to 100 basis points annually and driving double digit increases in earnings per share based on modest single-digit revenue growth. We look forward to updating you on our business initiatives during the fourth quarter 2013 conference call and upcoming industrial appearances.

AT this time, I would like to open the call for questions. However, if I do that I was handed a note that mentioned that I may have said Altrus sales in Q2 were $100 million in fact they are $1 million and so the point there is that in this quarter Q3 we had sale of $900,000, Q2 was $1 million net $100,000. Although I hope no one is confused by that. So operator, please open the call up to questions. Thank you.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) Please stand by for your first question. Your first question comes from the line of Mike Matson of Needham & Company. Please proceed.

Mike Matson – Needham & Company, LLC

Thanks for taking my question. I guess I will just start with the new camera that you are planning to launch. I was wondering, what you have seen – I understand the capital environments kind of top, but I was wondering what you have seen from prior camera launches in terms of the impact on your growth in the video business and then just wondering if you can tell us anything about the camera and how any enhancements over the prior model. And then finally just I was wondering if – I know with other companies when they have new camera coming sometimes the sales of the old model will sort of drop off because the sales reps really want to sell that old product ahead of a new product coming. So I guess sort of three questions in one but...

Joseph J. Corasanti

No, not a problem we could handle that. We – the new camera system is going to be a great new product for us, I will acknowledge that its probably a year over do I think internally we expected to have this year ago and it kind of fit into an operational project that we have been taking over the last couple of years and that was the consolidation of our Santa Barbara facility and I have mentioned that before on calls and at conferences and that was a very good consolidation for us and had saved those about $4 million by consolidating that factory with our new Westborough, Massachusetts factory.

Unfortunately one of the consequences of doing that type of a consolidation has delayed the video camera project by about a year. So it would have been very helpful to have that this year. And the reason is the camera system we’re selling now is about six years old. Now you ask how we did in our last launch, we did very well. So six years ago we launched our IM4000 camera system which was the first high-definition video system to be introduced to the world. And we saw sales growth from $50 million to $70 million in about 18 months, so it was very, very good.

We’re not expecting that type of performance with this camera system, because it’s not as revolutionary as the IM4000 when it came out in 2007. But it certainly is going to help us significantly; we’re seeing dramatic declines in our video business which has spill over effect into other business as you recall, to have complete arthroscopy offering, our sports medicine offering, you need to have video.

And videos drives some of the disposable products, I wouldn’t say all of them, but certainly it drives pump tubing and fluid management products, pump tubing and shaver blades, also know as resection products. And we’re seeing some pressure now on the resection products as well as a result of having an older video offering. And we think that both of the lines will improve video and resection with the launch of the new video system. So I hope that answers the question?

Mike Matson – Needham & Company, LLC

Yeah I guess the later part of my question was just really on the degree of the decline you’ve seen recently, I mean, is that some what more maybe more self-inflicted, because you have this launch coming and the all reps are hesitant to sell the old product, or is that really just purely a function of this capital environment?

Joseph J. Corasanti

Yeah I think its three factors, we have a little bit of sales force anticipation, we have markets that are still very, very tight. And having a six year old line and we’ve given our competitors six years to not only catch up, but to may be surpass this in some way as with some of the features on these newer video systems that are out now. So the capital environment is important, let me spend just a minute on that, because not only is it difficult to have increased sales when your customers are delaying, replacement for systems in their hospitals, but you know you have older systems that are in these hospitals that were designed to last six years, some of them that are still in the hospitals are that old.

And what you see happening is that the cables start to deteriorate, when the cabling deteriorates we’re going to see some picture degradation and then the service call start coming in. And so instead of the sales reps who are in charges sports medicine and powered instruments, instead of having them spend their time on selling products their spending their time, trouble shooting some picture quality images with some of these older systems that should have been replaced years ago. So there is a lot of factors going on now circling this video issue for us. I think and the industry and the market.

Mike Matson – Needham & Company, LLC

Okay, and then just it sounds like you’re pretty active in terms of your business development program. I just – MTF obviously was a good deal, because it was pretty accretive, but just in general what are your kind of guidelines for doing it, for doing deals I mean are you willing to accept dilution to GAAP EPS to cash EPS et cetera?

Joseph J. Corasanti

Yeah with – well we’ve been talking about our acquisition strategy for quite a while and its remained the same, we are looking for acquisition that will be considered tuck-in acquisitions that fit the six major product line areas that we have that our product lines that will fit nicely into our sales channels and in most cases would be accretive and in some instances they maybe breakeven, we really have not done dilutive deals on the past, but its possible to do something that’s slightly diluted to GAAP earnings is its an acquisition that offers tremendous new technology and yet still fits in with sales channel and the product lines that we currently have, our currently platform if you will. But generally speaking our strategies to do tuck-in acquisition that are accretive in year one.

Mike Matson – Needham & Company, LLC

Okay and then my final question, just on the margin, our cost opportunities, I mean obviously as you said on the call you have done a great job getting the margins up over the past few years, especially we are considering the amount of revenue growth that you’ve had, but going forward how much of that opportunity remains, especially if revenue growth were to remain in kind of below single-digits?

Joseph J. Corasanti

Well you know we are still in the process of consolidating the Finland operation and so that’s going to produce some cost savings for us for the remainder of this year and into next year, we still feel that there are some room to run with making other types of cost saving – other cost savings programs, potential consolidations and so there is still some room let I guess to the extent of my comment.

Mike Matson – Needham & Company, LLC

All right, I understand thanks a lot.

Operator

And your next question comes from the line of Matthew Miksic of Piper Jaffray. Please proceed.

Unidentified Analyst

Hi good morning it Mike on for Matt.

Joseph J. Corasanti

Hi Mike.

Unidentified Analyst

So obviously the capital spending environment is challenging right, but can you talk about any share shift differences of capital allocation across the group in the quarter maybe with respect to equipment, robots and just some other items? We’ve seen some variance across the group with some of the larger capital players reported thus far?

Joseph J. Corasanti

Mike I guess it is a little uncertain as to your exact question, we don’t think any of our capital spending matters have been affected by robots at all, if that was your question.

Unidentified Analyst

No, the question is more pointed towards maybe a reallocation of capital and kind of where the priorities are laying and if you are seeing any shifting in spending habits there.

Joseph J. Corasanti

Well from the hospital side of things, I think that healthcare IT has been a big factor with hospitals this past several quarters really having – getting them prepared for affordable care and whatnot, so that’s been a major influence I think among our hospital customers and in terms of robots, I think there may have been some small change with regard to spending on that kind of technology, but I’m probably not an expert on that.

Unidentified Analyst

Okay, okay and next question is just kind of looking at the balance sheet here, can you remind us of how you prioritize your uses of cash and given the outlook for sales, how do you balance potential M&A opportunities versus investing in more organic growth opportunities?

Joseph J. Corasanti

Well, from a cash perspective we were pleased to be able to offer our shareholders the dividend and so that obviously first on the priority list. Then it’s a matter of balancing stock repurchases and potential acquisition. So to the extent of there is an acquisition there is probably going to be less stock repurchases, if there is no acquisition is probably more stock repurchase. And the then lastly would be the depth that we have on the books, but that’s a credit line that allows us to pay down and borrow depending upon the particular cash situation that we have. So we are very pleased to offer the divided and I think our shareholders have appreciated that.

Unidentified Analyst

All right thank you.

Operator

And your next question comes from the line of Jeffrey Cohen of Ladenburg Thalmann. Please proceed.

Jeffrey Cohen – Ladenburg Thalmann & Co. Inc.

Well, hi Joe and Rob how are you, thanks for taking my questions.

Joseph J. Corasanti

Hey, good morning.

Robert D. Shallish

Hey, Jeff.

Jeffrey Cohen – Ladenburg Thalmann & Co. Inc.

Could you provide a little more insight from some of the prior questions related to the capital equipment and visualization and could you talk more specifically about the composition of the 2D systems versus the 3D system from Viking?

Joseph J. Corasanti

Well, the 2D system that we’ll be coming out with will be the replacement for our six old system IM4000, it will be high definition and have some of the – some new features some CMOS technology as well, I don’t know if I can say much more about that and I don’t think our marketing department would prefer me to not saying more than that so I probably won’t. the 3D system with from Viking, we’ve had it know for about a year we are seeing sales increase outside the United States, it seems that the our OUS [ph]. Customers are replacing higher value on the use of 3D for visualization and laparoscopic surgeries than our customers in the United States.

Currently, we are making every effort to change that that perception and our attitude, but we’ve had some pretty good sales of 3D some larger deals, I guess I should – I can mentioned one that happened in China which is – I have to say surprised me personally that that market was that strong for 3D technology. So it’s a little bit of good news there and we hope it continues.

Jeffrey Cohen – Ladenburg Thalmann & Co. Inc.

Okay. And as far as the size of the market for you currently of 2D systems versus the 3D systems.

Joseph J. Corasanti

Well, the size of the market for 2D visualization is pretty large I think its 509.

Robert D. Shallish

I would say 400 million or 500 million.

Joseph J. Corasanti

$500 million and that’s primarily in the general surgery area, we started out many, many years ago 10 year or 15 years ago selling videos primarily to sports medicine procedures in Arthroscopic and our system back then was designed for use in those procedures. Since then we’ve updated our system and that’s true for the one I mentioned earlier with IM4000 the first HD system.

We design that to be used in general surgery, because that’s the larger part of the market and the next system and 2D will be design for that use as well, so it can be use in general surgery laparoscopic procedures as well as in the sports medicine procedures. So it’s a pretty large market and there are lots of players, actually there are six strong competitors in the video market, some of those competitors are only video companies while they offer video with different types of disposals in our first sports medicine disposals.

Jeffrey Cohen – Ladenburg Thalmann & Co. Inc.

Okay, that’s helpful thank you. And I guess just one more for me. Rob you have spoken about the current quarter Q3 being total $7.9 million in adjustments for unusual items and if correct me for I’m wrong. So you are guiding 3.7 to 4.7 for the fourth quarter?

Robert D. Shallish

Yes, that’s right Jeff.

Jeffrey Cohen – Ladenburg Thalmann & Co. Inc.

Okay. Could you provide any further clarity insurance compensation of those numbers at least for the fourth quarter?

Robert D. Shallish

Probably 65% of that has to do with the manufacturing restructuring; the two that we’re in just finishing now are the finished consolidation into our U.S. plants. And the manufacturing adjustment from Westborough, the Viking product into other of our locations. So that’s about 65% of that number, the other amount would be an estimate of what we believe the legal cost will be associated with that one patent matter that were going through.

Jeffrey Cohen – Ladenburg Thalmann & Co. Inc.

Perfect, okay thanks very much for taking my questions.

Operator

Your next question comes from the line of Mark Landy of Summer Street. Please proceed.

Mark Landy – Summer Street Research Partners

Good morning folks. Can you hear me okay, I’m having some phone issues this morning.

Joseph J. Corasanti

No, we hear you fine Mark.

Mark Landy – Summer Street Research Partners

Thanks and good morning. So Joe it’s a question on the competition of the business. As capital equipment’s weakened somewhat and you get slight tilt towards the single-use. How much of an impact does that have on gross margin for 2014 assuming we stay at kind of the 82%, 80.5% level.

Joseph J. Corasanti

Well, generally speaking the margins on capital are lower than single-use products although in all cases. I don’t have the calculation in front of me, but I think it could help gross margins with as favorable product mix.

Robert D. Shallish

Yes, I think that shift that were taking about would certainly be positive to the gross margin, but its probably only a few – very few basis points when you get right down to it because moving from 80% to 81% or 82% with the extra 2% being at say 56%, 57% as compare to other 2% being 50% its probably not a large metric.

Mark Landy – Summer Street Research Partners

Okay, so I guess the back-end of that question is, if capital starts to pick up again we get to the normalized 78%, 79% level, its not going to be a big hole to fill with other opportunities in gross margin.

Robert D. Shallish

I would agree with them Mark.

Mark Landy – Summer Street Research Partners

Okay fair enough. Joe what is the impact of discontinued business in the 2014 revenue guidance.

Joseph J. Corasanti

That the ECOM product line is one that we have been working on for some time and it just has not developed like we thought that it would. Our annual sales of the ECOM product $100,000 a year.

Mark Landy – Summer Street Research Partners

Okay so it’s negligible.

Joseph J. Corasanti

Correct.

Mark Landy – Summer Street Research Partners

You know I guess entering the year the discussion around the MedTech tax was we were hopping to pass that on to our end-user. And I guess as the year progressed that didn’t really pan out. Are you a little behind the curve in trying to illuminate some of the impact of that tax you do speak about it as you kind of give us the numbers for the year. And while other folks may be spend 2012 trying to prepare for their tax, is this – are you doing stuff in 2013 to limit that impact in 2014? And how can we think about that as a margin contributor?

Joseph J. Corasanti

Well you’re actually right, we entered the year thinking we would pass some of that tax under the customers, and if I go back two years, we were talking about how we would in fact even put the tax on a separate line on invoices. I would pass it through that way; it didn’t pan out as you say. So maybe going forward we’ll look to see about raising price on some of our higher technology disposable products and may be some new products as they launch in the capital area.

And you know so video and then the new generator and electrosurgery and some of the other capital items coming out, there’s and opportunity take price with those products. Some other things that we are looking at are otherwise to minimize the tax burden from tax accounting standpoint. I don’t know, I can’t give you real details on that now, but I think there’s some small opportunity there.

Mark Landy – Summer Street Research Partners

Well I guess Rob if I look at 2014 it’s probably a kind of a 100 basis increase in operating margin. Can you break that up from the benefit that you – from the restructuring and manufacturing consolidation versus some of the business shift that you perhaps trying to get to with raising price eliminating some of the benefit of the impact I should say of the MedTech tax? How can we think about that increase?

Robert D. Shallish

Well as we look after 2014 our current expectation mark is that we would see about 50 basis point improvements in operating – in EBITDA margins. So little bit less than what we would typically like to see we – our goal continues to be closer to 100 basis points improvement over year. But given the sales expectation that we have of 2% to 3% growth, we think that that would result in the 50 basis point improvement. Which I think is still good. But to have a little bit greater sales growth would help us get closer to the 100 basis point improvement.

So with regard to where that improvement comes from, it’s primarily as a result of gross margin improvement. And specifically all of the work that we have been doing and will continue to do and been as efficient as possible on our manufacturing costs. So some of that next year would come from, the consolidation of the finished plant some of it from the consolidation of the Westborough manufacturing the Viking Systems into other of our plants. By the way we’re keeping the administration, and research, and marketing groups all in that location as just the little bit of manufacturing that was going on in Westborough that’s moving to other plants.

And then the last component of that is just on our ongoing lean manufacturing activities which have enabled us to reduce our manufacturing cost substantially over the last several years and that will continue. So the bulk of the margin increase that we are expecting is coming out of those activities in our operations group.

Mark Landy – Summer Street Research Partners

So again just to put a [indiscernible] around all of that, they still use runway room left on some operating room leverage while you can focus on reestablishing a slightly higher revenue growth.

Robert D. Shallish

I believe that that’s the case Mark yes.

Joseph J. Corasanti

So that should exist in 2014, would as it a guess, if you kind of look at some of the out years or is that just not on the radar screen yet. Well it’s a little difficult, to be exact, but certainly with all of the activities with our efficiency programs and lean manufacturing, there is definitely runway left on the gross margin side of things.

Mark Landy – Summer Street Research Partners

Thank you guys.

Joseph J. Corasanti

I would say we could see go out to 15 from where we sit today.

Mark Landy – Summer Street Research Partners

That’s – okay its kind of consistent with my modeling, okay guys thanks so much.

Joseph J. Corasanti

Thanks.

Operator

(Operator Instructions) and your next question comes from the line of Mike Matson of Needham & Company. Please proceed.

Mike Matson – Needham & Company, LLC

Thanks. I just had a follow up question on Altrus. So I was just wondering number one, if there any plans to launch additional hand pieces, different style hand pieces and then number two, given that your – you’ve issued your 2014 guidance, so I was wondering if you could give some guidance around what you expect out of Altrus next year, I don’t know if you are planning to continue to give guidance then track the quarterly sales progression for that product, but its definitely helpful I think for investors.

Joseph J. Corasanti

Well at this point we are not I guess prepared to give a guidance number of Altrus for 2014, we are planning – we are in the planning stages now over the next generation Altrus hand piece that we think will improve the ergonomics of it and reduce cost. We are just – we are very pleased with the performance of the product to date in terms of the speed of the tissue sealing function the non-stick performance, the use in fluid environment, its really performing very well in the field. So we’ll just continue to watch it and watch it grow.

Mike Matson – Needham & Company, LLC

All right. Thanks a lot.

Operator

Thank you. And your next question comes from the line of Dale Dutile of The Boston Company. You may proceed.

Dale Dutile – The Boston Company

Hello.

Joseph J. Corasanti

Hello Dale.

Dale Dutile – The Boston Company

Yes, sorry I was cut off. Just a couple of quick things, the tax benefit in the quarter, what was that related to.

Joseph J. Corasanti

Primarily – well first of all we completed the filing of our 2012 tax return in September, and when that occurs that it allows us to be more confident about some of the tax positions that we’ve taken and most of that benefit relates to our foreign tax position with our subsidiaries outside of the United States where we have income at rate which are lower than the united states federal tax rate, so with the filing of that return and the conversations that we’ve had with the IRS, we feel comfortable with reducing the tax provision in this third quarter by approximately $800,000 related to those items.

Dale Dutile – The Boston Company

Okay and so for the fourth quarter we are back to kind of 33 to 34 and should we assume that for our next year as well?

Robert D. Shallish

Well for this fourth quarter we’re assuming 33% to 34% and I think for next year our assumption is that it might be closer to the 33% range, rather than the 34%. But we can give more guidance on that as we go into the next few months.

Dale Dutile – The Boston Company

Okay and then the patent dispute you had mentioned a few times, can you give us any color on what’s in that and is that kind of upside or downside, depending upon how it goes?

Robert D. Shallish

Well the patent dispute involves an allegation made by the owner of patents associated with should anchors. So this is part of our sports medicine business. And we believe that we do not infringe these patents and our strongly opposing any action by this firm. So the costs that we’re incurring are legal costs associated with the defending ourselves. And unfortunately these thing take sometime to resolve and we will continue this on extra legal costs for a period of time.

Dale Dutile – The Boston Company

As we go to quarter at some point so there’s kind of date at which we’ll know something?

Robert D. Shallish

There’s an no date to my knowledge at this point and eventually I guess it could go to court. Yes.

Dale Dutile – The Boston Company

Reasonably small revenue item for you, or is it more broad?

Robert D. Shallish

Well shoulder anchors are a strong part of our sports medicine portfolio. And so it is a major part of our product line in that group.

Dale Dutile – The Boston Company

Okay. Then just a last thing that just make sure I head the number right, the product you’re discontinuing endotracheal tube a $100,000 in revenue, but it was $2.1 million to close it down is that, am I thinking about that right?

Robert D. Shallish

Yeah you’re right. We had our projections from two or three years ago when we launched this particular product were aggressive. And we had built inventory of about over $2 million. And so we’re basically adjusting for that. Plus there are intangibles associated with this particular product line from the purchase of the product lines some eight or nine years ago. And so that’s being written off as well.

Dale Dutile – The Boston Company

Right that’s all I had thank you.

Operator

As there no any more questions, I like now to turn the call over to Bob Yedid for closing remarks.

Bob Yedid

Thank you everyone for your time today and we look forward to speak to you on future conference calls and on our investor meetings coming up in the fourth quarter. Thanks very much.

Operator

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

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