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Haemonetics Corp (NYSE:HAE)

F3Q 2014 Earnings Call

January 27, 2014 8:00 a.m. ET

Executives

Gerard Gould - VP, IR

Brian Concannon - President and CEO

Chris Lindop - CFO, EVP Business Development

Analysts

Lawrence Solow - CJS Securities, Inc.

David Roman - Goldman Sachs

Steven Crowley - Craig-Hallum Capital

James Francescone - Morgan Stanley

Anthony Petrone - Jefferies & Company

Jim Sidoti - Sidoti & Co.

Larry Keusch - Raymond James

Raymond Myers - Alere Financial

Jan Wald - The Benchmark Company

Operator

Good morning. My name is Philistia, and I will be your conference operator today. At this time, I would like to welcome everyone to the Third Quarter Fiscal Year 2014 Earnings Release Conference Call. (Operator Instructions) I would now like to turn the call over to Mr. Gerry Gould, Vice President, Investor Relations. Please go ahead sir.

Gerard Gould

Thank you, and good morning. Thank you for joining Haemonetics' third quarter fiscal '14 conference call and webcast. I'm joined by Brian Concannon, President and CEO; and Chris Lindop, CFO and Executive Vice President of Business Development.

Please note that our remarks today will include forward-looking statements. Our actual results may differ materially from anticipated results. Additional information concerning factors that could cause the actual results to differ materially is available in the Form 8-K we filed this morning, as well as in our recent 10-K and 10-Qs.

On today's call, Brian will review the business highlights of the third quarter. Chris will review operating performance for the quarter and guidance for fiscal '14 in more detail. Then Brian will close with summary comments.

Before I turn the call over to Brian, I would like to mention the treatment in our adjusted results of certain items, which by their nature and size, affect the comparability of our financial results. Consistent with our past practice, we have excluded certain costs from the adjusted financial results we'll talk about today.

In total, we excluded $18 million of pretax transformation, integration, restructuring costs from our third quarter fiscal '14 adjusted results; and $25 million from the third quarter of fiscal '13. Additionally, the earnings information discussed within excludes deal-related amortization expense. Prior period amounts have been similarly presented to permit comparison. Deal-related amortization expense excluded from adjusted earnings totaled $7 million in the third quarter of fiscal '14 and $6 million in our third quarter of fiscal '13.

Further details, including comparison with fiscal '13 amounts excluded, are provided in our Form 8-K and have been posted to our Investor Relations website. Our press release and website also include a complete P&L and balance sheet, as well as reconciliation of our GAAP and adjusted results.

With that, I will turn the call over to Brian.

Brian Concannon

Thank you, Gerry and good morning everyone. This morning we released our third quarter results that showed a modest return to growth on our base business and we updated guidance for the rest of fiscal ’14. We said that revenue would remain challenged in international markets affected by currency weakness and in the U.S. where blood usage continues to decline at rates that exceed anything that was expected. However I was pleased with the strong performance in the areas we have identified as growth drivers.

Organic or base revenue, which we define as all but our whole blood business, increased 1% as reported and 4% on a constant currency basis. Profitability in the quarter included an adjusted operating margin of 17.5% and adjusted earnings per share of $0.61, up 5% over the prior year third quarter.

While recent blood collection declines continued to negatively affect some parts of our business, there was strong growth in the third quarter in other parts of our business, particularly Plasma, TEG diagnostics and emerging markets led by China and Russia.

Our Plasma business grew $9 million or 13% as reported and 15% in constant currency. Strong end market demand for plasma derived biopharmaceuticals continues to fuel collections and we also continue to benefit from the distribution change in Australia and New Zealand.

TEG continued its impressive growth trajectory, up $2 million or 27% in the quarter with double-digit growth expected again in the fourth quarter. And in the emerging markets of China and Russia, we had $4 million of disposables revenue growth. China and Russia continue to represent the largest growth potential of all emerging markets with 16% and 42% disposable growth respectively in the third quarter.

Three parts of our business: Plasma, TEG and the emerging markets represented 55% of our base business revenue in the third quarter, again defined as revenue other than from whole blood. That 55% of our base business enjoyed 13% growth in the quarter. These opportunities were identified as growth drivers over a year ago, and we invested in these areas to drive this growth. It’s important to recognize that again this quarter a substantial portion of our business portfolio is delivering solid growth and we remain encouraged with the prospects for continued growth there.

The other 45% of our base business is cell salvage and blood component collection, and declines in these parts of our business continue to be driven by protocol changes with our hospital customers and the corresponding impact on blood collections, primarily in the U.S. market.

Hospitals are increasingly implementing blood management techniques to reduce bloodshed during surgical procedures and changing protocols in order to decrease the frequency of transfusions. As a result, blood center revenue in the U.S. continues to be under pressure due to the rapid decline in demand for blood products. The prices hospitals pay for blood components are also under pressure resulting in increased competition amongst blood centers. This is causing changes for our blood center customers that weren’t even contemplated as little as one year ago.

Transfusions in the U.S. continued their downward trend, pressuring both our whole blood and double red cell products. The U.S. still compares unfavorably with best practice nations where the red cell transfusion rates are in the low 30s per 1000 of population. Average red cell transfusions in the U.S. population are likely to drop from approximately 40 per 1000 at the beginning of fiscal ‘14 to about 33 per 1000 by the end of our fiscal ’15. This decline particularly affects our whole blood and double red cell businesses which derive 65% and 85% of revenues from North American customers respectively.

Transfusion reductions that we previously expected to occur over a 5 to 8 year period are now expected over a 2 year period -- fiscal years ‘14 and ’15. We are nearly through the first of these two years and the rate of decline in blood center collections has accelerated to the 8% to 10% decline rate that we identified previously. As a result, we are seeing dramatic changes in the U.S. blood collection market to include the rapid consolidation and the formation of affiliations as well as an increased focus on operational efficiency and direct supplier costs.

Two large customers, the American Red Cross and HemeXcel represent approximately 60% of all U.S. collections. They have both opted to pursue competitive single source supplier strategies for whole blood collection sets, utilizing tenders aimed at minimizing disposable costs.

Pricing has become one of the key drivers. Our Value Creation and Capture initiatives position us well to compete in this new environment and planned value engineering initiatives will allow us to further reduce manufacturing costs over the next three years. These customers recognize the growing importance of reducing the total cost of collection, improving the quality of the blood components collected, ensuring compliance and working with their hospital customers to improve logistics and enhance their patient blood management initiatives. This is their path to becoming more relevant in this rapidly changing blood management environment. We are very well-positioned to support our customers in each of these areas with our blood management solution.

We recently announced that HemeXcel completed its tender process and selected Haemonetics to supply its whole blood collection disposables for three years and the implementation is already well underway. In the surgical business, our 10% growth last year was influenced by the impact of a natural disaster on a competitor that later returned to the market with aggressive pricing. This resulted in the loss of much of the business that was gained in Europe and Japan as customers resumed using the competitive device. These comparisons will soon be behind us as we reach the anniversary of that event.

Our total organic revenue guidance is reaffirmed in the range of 0% to 2%, reflecting our continued expectation for 2 percentage points of currency headwinds. This represents an organic constant currency growth rate of 2% to 4%, consistent with prior guidance range. The mix will be a bit different with strength in our commercial plasma business, offsetting continued weakness in our hospital business both to somewhat greater extent than previously anticipated.

In summary, overall revenue growth continues to be muted by U.S. blood collection and hospital market dynamics. But our projection for organic constant currency growth of 2% to 4% in a soft market reflects the progress we are making in our identified growth drivers. Our $2.30 to $2.40 adjusted earnings per share guidance is unchanged. However pricing declines, currency headwinds and some variable compensation funding are expected and thus we note a bias toward lower end of that range.

I will now turn the call over to Chris Lindop to review the financial highlights of the quarter and our current thoughts on guidance. And then I will wrap up with some closing comments. Chris?

Chris Lindop

Thank you, Brian. In the third quarter, total revenue was $242 million, down 2% on our base business revenue. In other words, our legacy business aside from whole blood increased 1% as reported and 4% on a constant currency basis.

The weakness of the yen versus the U.S. dollar resulted in 170 basis point of headwind for our overall revenue growth rate in the quarter. Our hedges, which are designed to protect our operating income over a rolling 12 month period, leave a portion of our revenue unhedged and therefore susceptible to changes in foreign currency rates. This currency trend, which relates primarily to a major shift in the yen which began in our third fiscal quarter last year, is expected to impact growth rates in the fourth quarter of fiscal ’14 and into fiscal ‘15 as we’ve already locked in hedge rates for the majority of next fiscal year.

Plasma disposables revenue, which was $76.7 million in the quarter, increased by over $9 million or 13% as reported and 15% in constant currency. Importantly, North America plasma disposables revenue grew $7 million or 15% and our customers continue to be optimistic about end market demand.

In Australia and New Zealand, we benefited from the recent transition to a new direct selling approach, which contributed 4% to our overall revenue – plasma growth in the quarter. Our guidance range for plasma growth in fiscal ‘14 is raised to 8% to 10% from the previous 7% to 9%. Given the recent plasma extensions we reported in today's press release, we are well-positioned with customer agreements covering approximately 80% of our commercial plasma business for five years through Q3 of fiscal ’19.

Blood center disposables revenue, not including whole blood, declined 6% to $53 million with red cells down 16% and platelets down 4% in reported currency but flat in constant currency. The red cell disposables revenue decline was driven primarily by the U.S. market decline which Brian noted.

Strong platelet growth in Russia was more than offset by $1.5 million currency impact from the weakening yen. We expect our base blood center business to be down between 5% and 8% organically in fiscal ’14. Our Acrodose product which our customers recover a clinically equivalent platelet and whole blood and our universal platelet protocol product which improves the effectiveness of our existing platelet apheresis platform, both represent opportunities to achieve near-term blood center disposables growth.

Whole blood revenue declined 14% to $47 million with $32 million in North America, $10 million in Europe and European distribution markets and $5 million in the Asia-Pacific and Japan markets. North American whole blood revenue declined by $5 million, reflecting the trends and demand for red cells which Brian described and the impact of a transitional OEM supply contract which recently expired.

Whole blood revenue declined in Europe by $4 million due to the previously noted loss in the low margin tender. We’re encouraged that whole blood revenue grew by $2 million in emerging markets with strength in all four BRIC countries. We continue to expect approximately $190 million of whole blood revenue in fiscal ’14.

Hospital revenue declined 3% to $32 million in the quarter, and surgical disposals revenue was $17 million in the quarter, a decrease of 11%. And we know that currency cost us nearly 200 basis points of growth again this quarter. Additionally as Brian mentioned, a competitor returned to the market with aggressive pricing and this resulted in weak revenue performance in our surgical business. Soon we will anniversary the tough comparable relative to last year’s share gains.

OrthoPAT disposables revenue of $6 million was down 10% in the quarter. The increased use of tranexamic acid and lower transfusion triggers by hospital customers are the market challenges for OrthoPAT. We expect benefits from introducing the OrthoPAT Advance will be more than offset by these market declines and our expectations reflect this trend.

In diagnostics, TEG disposables revenue was $9 million, up 27% in the third quarter driven by increases in North America and emerging markets. We installed 506 TEG devices in the first nine months of fiscal ’14, 675 devices in fiscal ‘13 and 425 devices in fiscal ‘12. We fully expect strong TEG disposables growth to continue.

Taking into account the current surgical weakness and OrthoPAT market headwinds, we’re adjusting revenue guidance to a range of 0% to 4% decline in our hospital disposals business for fiscal ’14. Our prior guidance was 0% to 3% growth with the bias towards the lower end of that range.

Software solutions revenue was $18 million, up 10% and we previously referenced a strong pipeline of software opportunities that we expected would drive revenue growth for the remainder of this fiscal year and that remains the case.

Hospital [ph] customers increasingly recognize software’s importance in identifying and implementing blood management solutions. Equipment revenue was $15 million in the quarter, down $3 million or 18%. This reflects the timing of orders, tenders and capital budgets with certain recurring orders known to have been received in last year’s third quarter, which are expected instead in the fourth quarter of the current fiscal year.

Our install base of equipment, which is a combination of purchased and placed devices, increased 5% in the first nine months of fiscal ’14. This bodes well for growth in disposals in our base business. Third quarter fiscal ‘14 adjusted gross profit was $124 million flat with the prior year quarter. Adjusted gross margin was 51.3%, up 90 basis points year-over-year. Productivity improvements in the base business accounted for this improvement.

Adjusted operating expenses were $82 million in the third quarter, up $4 million or 5%. We continue our commitment to funding planned growth and infrastructure investments in emerging markets as well in R&D to support the development and introduction of new products.

Adjusted operating income was $42.5 million in the quarter, down $4.5 million. Operating margin of 17.5% was down [ph] 150 basis points. In addition to planned spending, the weak yen emerged as the headwind to profitability. As we began to anniversary the major devaluation of the yen, which began a year ago, we thought the headwind in our operating income growth rates of 6% or $3 million in the third quarter fiscal ’14. And this headwind is expected to continue to impact results into fiscal ’15.

Interest expense associated with our loans was $2.4 million in the quarter and our tax rate was quite favorable at 19.6% in the quarter. While we are benefiting from the ongoing implementation of our global TEG strategy, the overriding cause for the decrease was the expiration of TEG statutes and the resulting required reversal of reserves established for tax periods that they covered. For the full fiscal year ’14, we now expect our tax rate to normalize at around 24%. Adjusted earnings per share reached $0.61, an increase of 5%.

And summarizing our revenue guidance, we expect plasma disposables to grow approximately 8% to 10%; blood center disposables to decline 5% to 10% on an ex-whole blood basis; hospital disposables to decline 0% to 4% and software to grow 2% to 5%.

Overall we affirm base revenue growth of 2% to 4% in constant currency and 0% to 2% on a reported basis. And any expected whole blood revenue of approximately $190 million, we affirm total revenue growth guidance of 5% to 7%. On an adjusted basis, our gross margin is expected to approximate 51%, up 100% basis points over fiscal ’13 and operating margin, excluding deal amortization, is expected to be roughly 18%, also up approximately 100 basis points.

We are reaffirming our previously provided adjusted EPS range of between $2.30 and $2.40, excluding $0.38 of deal amortization but with the bias towards the low end of that range. As in the past, our website includes revenue and income statement scenarios which are based in the elements of guidance provided in my comments for the full year.

We ended the third quarter of fiscal ’14 with $178 million of cash, up $19 million in the quarter and down $1 million in the first nine months of the year. This reflects an investment of $23 million for the acquisition of the assets of Hemerus Medical and $29 million for debt repayment.

We generated $47 million of free cash flow before transformation costs in the third quarter. After making net investments of $16 million in capital expenditures and before funding $30 million of cash, restructuring and transformation costs and $4 million of VCC capital expenditures.

Year-to-date we generated $95 million of free cash flow before transformation costs, up $49 million, more than doubled the same period last year, in part due to working capital requirements in the prior year following the whole blood acquisition. In fiscal ’14, we continue to expect free cash flow generation of $120 million or $2.30 per share, before funding restructuring and capital investments related to our transformation activities. As detailed and scheduled on our website, we plan to utilize $100 million of free cash flow to fund $28 million of capital expenditures and $72 million of expenditures associated with our manufacturing, transformation and other VCC initiatives in fiscal ’14. Again we have included no net benefit in our fiscal ’14 guidance for our VCC initiatives and the manufacturing network transformation.

Current period activities will principally be capital investments and technology transfers associated with the transformation. We expect to realize $21 million in fiscal ’15 which will ramp up by fiscal ’18 to a targeted level of $40 million to $45 million in annual savings.

Finally, regarding the incremental business volume from HemeXcel. We indicated this will not have a material impact on fiscal ’14 revenue or earnings for the Corporation as a whole. There are some implementation costs that will be among the headwinds creating the bias towards the low end of the guidance range.

Margin headwinds from lower pricing will more than offset any benefit related to this share gain in fiscal ’15. As a result, this will pressure margins and earnings per share in fiscal ’15. In fiscal year beyond ’15, benefits of product volume engineering and other internal initiatives are expected to offset these margin headwinds.

With that, I will turn the call back over to Brian.

Brian Concannon

Thanks, Chris. We had encouraging growth in our commercial plasma business, TEG diagnostics and emerging markets -- areas that we identified as growth drivers over a year ago. Funding those growth initiatives was important and remains the priority for us going forward.

Partially offsetting this growth were declines in the collection market, primarily in the U.S., and the impact of currency on our overall results. The collection markets will stabilize and the work we are doing in both cost reductions and the development of blood management solutions allows us to compete more effectively in this new environment. We remain optimistic in our ability to capture share and better help our collection customers become more relevant with their hospital customers in the future.

We also had a number of important business developments in the third quarter that are especially noteworthy. First, we are pleased to report the multi-year extensions of supply agreements with several plasma customers, providing for continued use of our collection devices and disposables. This places nearly 80% of our current commercial plasma business under agreement for the next five years through the third quarter of fiscal ’19. This is an important validation of the value our products and services bring to these customers and assuring quality, automation and operational efficiency.

Second, we were selected by HemeXcel to supply the whole blood collection disposables covered by their single source tender for the next three years on an exclusive basis. This too was important validation. In this case of our ability and willingness to respond to their immediate needs for agreement pricing, while demonstrating business continuity capabilities, assuring continued best-in-class quality processes and committing to product advances which have the very real potential to provide value and competitive advantage for our customers.

As Chris mentioned, our aggressive pricing will pressure margins and earnings per share in fiscal ’15. But in fiscal ’16 and beyond, benefits of product value engineering and other internal initiatives are expected to offset these margin headwinds. We’ve identified specific product engineering and manufacturing changes that went [ph] implementing will lower the cost of our whole blood kit and return margins to their prior level. In this manner, we expect to continuously improve the profitability of this product line.

There is another important benefit that will accrue from this strategy. Reducing the cost of manufacturing for our whole blood product will enable us to be more competitive on tenders outside the U.S. where the market size is much larger and where our blood business – where our whole blood business has been challenged to effectively compete up to this point.

We intend to bring the elements of our in-process whole blood automation offering to market as previously discussed. And I am pleased to provide the following updates on this and other key projects.

Three important independent U.S. blood center customers recently became partners for our automated whole blood strategy, purchasing Donor Doc Phlebotomy, our paperless phlebotomy product that received 510(k) clearance last spring. We continue to make good progress with our BloodTrack software adding three large North American hospital customers in the quarter.

Our communications tower that will enable the use of Donor Doc Phlebotomy, the Donor flow tablet [ph] and other devices that mobile drives is now ready for commercialization. And plans for pursuing FDA approval of the SOLX solution for 24-hour storage of whole blood have been combined with work to qualify the SOLX feed [ph] solution for use with the filter technology acquired in last year’s whole blood acquisition. This is on track for submission to the FDA in fiscal ’15.

We’ve previously expected to leverage our new automated whole blood offering and SOLX solution to gain share in the U.S. market. However rapid changes in this market are driving share shifts based on pricing. And these new solutions will now allow us to demonstrate added value to a growing portion of the U.S. whole blood market and to gain share elsewhere.

Blood collectors must address their total cost structures to remain financially strong in the wake of declining prices paid by hospitals for blood components. But they must also become more relevant and helping their hospital customers reduce the total cost of transfusions as well. Haemonetics' suite of products, services and software are the logical choices to bring them the differentiation they need to compete successfully.

We remain focused on realizing the benefits of our VCC initiatives, including transformation of our manufacturing network. These activities are important to sustaining our quality, service and cost competitiveness for years to come. These VCC initiatives are separate from the whole blood value engineering process I discussed previously. In fact, it’s important to remember that our VCC initiatives will benefit our entire manufacturing network and not just our whole blood business. They are keys to enhancing our business capabilities, rationalizing our costs and in doing so, positioning us to pursue market share and growth.

We expect fiscal ’15 will be a year of transition, one in which we continue to advance VCC initiatives while transforming our manufacturing network, commence value engineering projects, complete R&D advances and secure important approvals in the whole blood arena, all the while ensuring that customers continue to benefit from best-in-class service and the highest quality products in the industry.

However in beginning in fiscal ’16, we will benefit from the lower cost structure allowing us to improve profitability and also growing markets where we had challenges competing previously. Fiscal ’16 will also see the full suite of whole blood automation come to market and the continued growth in plasma and emerging markets.

Our suite of blood management products and services increasingly will meet the needs of both our hospital and blood center customers. These product opportunities include utilization of our TEG products to monitor hemostatis, our SafeTrace TX and BloodTrack products to manage blood inventory and reduce waste, our cell salvage products to provide autologous autotransfusions, and our IMPACT Online software to measure blood usage and results from patient blood management programs. These are solutions our hospitals need and solutions our blood center customers are seeking as they better position themselves to meet the needs of their end customers.

The steps we've taken over the past several years have put us in a good position to react to the current marketing dynamics. We have a strong and expanding global footprint, differentiating new products in the R&D pipeline, acquisitions that support and strengthen our blood management solutions, an increasingly advantageous cost structure and the broadest array of products and services in the blood industry. As such, we are uniquely positioned to meet the needs of our customers in this rapidly changing market, capture market share and drive sustainable profitable growth.

The fundamentals of our business remain strong and we are determined to keep bringing new solutions to market that reduce costs and improve patient care.

Again I will close by thanking our employees and congratulating on securing the plasma HemeXcel wins. They remain focused on ensuring that we take care of our customers’ needs throughout all of this change. And we and our customers are bringing differentiating solutions to the donors and patients we serve and patient care is the ultimate beneficiary.

With that, we are happy to take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Larry Solow with CJS Securities.

Lawrence Solow - CJS Securities, Inc.

Just quickly on the outlook for the gross margin adjustment, is that mostly higher mix or excuse me, higher plasma reducing the mix with lower hospital sales and also I guess a little bit of headwinds with the HemeXcel initiation?

Chris Lindop

Yes, that’s a good summary.

Lawrence Solow - CJS Securities, Inc.

And then as you look at into ’15, just to clarify there were whole blood, obviously the new HemeXcel deal lower pricing will certainly be a negative, but in the overall – I mean that’s just not on your overall, that’s just even looking at whole blood, you still expect at least some offsets from these VCC initiatives which will sort of kick in at that 20 million?

Chris Lindop

But you also have to consider the currency headwinds which will impact us as well – and profiability.

Lawrence Solow - CJS Securities, Inc.

And just on the currency, is that – so I realize you hedged somewhat but obviously the impact is hurting more than you’re hedged on the weaker yen?

Chris Lindop

Yes, there is two elements to that. We don’t hedge every yen, dollar revenue because we have some yen costs which means that we – even while we are hedged, we are exposed on the revenue line to some portion of the shift in the currency, that’s what we have seen in the current year. But we hedge 12 months essentially selling yen forward in increments each months forward for 12 months. Which means that we get a visibility in terms of the impact of the yen exchange rate on our earnings out for 12 months. We are now getting to that point where we are moving into the new – if you will, the new yen currency environment, which is obviously weaker.

Lawrence Solow - CJS Securities, Inc.

And then just on the plasma, the distribution change I guess benefiting you guys somewhat. Can you quantify that or just give us a ballpark what you think that -- how much that affected this quarter?

Chris Lindop

Yes, it’s about a little under $3 million.

Lawrence Solow - CJS Securities, Inc.

Okay, a positive, year-over-year I guess. Great, thank you very much.

Operator

Your next question comes from the line of David Roman with Goldman Sachs .

David Roman - Goldman Sachs

One strategic question and one financial question. Maybe starting on the financial side, you have been realizing quite a bit of SG&A leverage in the first half of the year, I think, to the tune of a few hundred basis points. And this quarter we saw negative SG&A leverage. Maybe, Chris, you could just talk about the moving parts on the discretionary expense line and to what extent that is a line over which you have control versus the tighter revenue?

Chris Lindop

Yes, well, as we pointed out, if you think about all-paying leverage we had a headwind in all-paying yen currency around $3 million, which cost us about 6% there. We are obviously investing in some R&D projects and we anticipate that these would ramp up in the back half of the year and that has happened as expected. But we continue to have a good control over spending in all areas of the business. And that does give us some leverage to pull.

Brian Concannon

And the other piece of that, I would add there David, is our variable compensation, which is obviously related to our performance. This is a year in which there’s certainly a performance element but a market shift element that has affected our results and I’ll continue to monitor what I can do, therefore the variable compensation for our employees lower down in the organization base off of that shift. And that’s part of the reason why we’ve guided the lower end of that earnings range.

Operator

And your next question comes from the line of Steven Crowley with Craig-Hallum Capital

Steven Crowley - Craig-Hallum Capital

A couple of questions for you. In terms of trying to get our legs underneath us about next year, there is clearly a bunch of discussion around some of the changes in the marketplace, some of the investments you are making to capitalize on those changes longer term. But should we be thinking about 2015 as a year in which we are not going to see much if any profit growth out of the company before things really start to accelerate based on these moves? Is that the right mindset because that’s a different mindset than we have had but there have been big changes here?

Brian Concannon

We’re going to give guidance at the end of the next quarter, Steve. But what we are clearly signalling is a year of transition. We’ve got a major tender that still is in the wings here. We do expect that to come to a decision as that customer said in the first half of this calendar year. We are hoping it’s going to be sooner than that, which will give us better visibility but certainly we want to see that play out. But there is a bunch of moving pieces.

The first being that, that we were doing a number of VCC initiatives which really put ourselves in a very, very good cost position. In some respects doing this, on the front end of where we felt we needed to be in whole blood, based on what we have learned on the back end of what we did on the plasma world, I mean think about business continuity and certainly cost quality. So we are already moving down that path. As we have looked at pricing that has played out in this first tender and we believe will play out in the second tender, we’ve also been successful in negotiating a focus on what we call value engineering to really address cost within this product and opportunity that exists in whole blood that wasn’t necessarily as large in plasma so a given point there.

What else is taking place? Certainly the declines that are taking place in the whole blood market from a collection standpoint. Those headwinds, currency declines that exist there, certainly we have to feel the compensation, pull on variable compensation as we go into fiscal ’15. So yes, we are signalling a lot of moving parts for fiscal ’15. We’ve signalled that it’s going to be growth but I would say very modest growth. We will give that guidance once all of these pieces are played out and we have better visibility to what that looks like.

Steven Crowley - Craig-Hallum Capital

In terms of my follow-up, it relates to the new product strategies that you have laid out and been executing for automated whole blood. It sounds like given the changes in the market landscape, those enhancements are really geared towards building back the margin, keeping the business at the end of these contracts and maybe some international growth. But given the change in purpose of some of the new capabilities you are bringing to the marketplace like SOLX, did that guide your decision to bundle the development of the 24-hour hold with the new filter technology? Or was it something with the regulatory process of SOLX that you needed more time anyway? Help us understand that change in strategy.

Brian Concannon

So a couple of pieces here that you’ve talked about, Steve. I want to be very, very clear is that SOLX, automated whole blood, those are not going to be needed to get our profitability back to levels that we expect to get them back to equal to where we were prior to this shift. That’s our value engineering initiatives. We see SOLX and automated whole blood, once as an opportunity to capture share aggressively in a market now to be premium products that will certainly provide for price premiums but importantly, not unlike what we did in plasma, be leveraged to retain that business as we go through the next round of tenders that will take place going forward, keeping that business.

When we look at SOLX, remember what we said. We had initially wanted to see a 24-hour hold that would have been on the Hemerus filter. That’s not going to take place. We found that, that was something that’s not worth spending our time on. We’ve moved forward – remember what we said, even though if we get 24 hour hold on Hemerus filter, we wouldn’t be able to generate revenue with SOLX solution until it was approved on the Haemonetics filters – the filters we acquired as a part of the acquisition over a year ago. So that remains on track. We were doing those in PAC ALL [ph]. We simply have put our entire focus on the SOLX solution being approved on the Haemonetics filters, and we expect to submit to the FDA before the end of fiscal ’15.

Operator

And your next question comes from the line of James Francescone with Morgan Stanley.

James Francescone - Morgan Stanley

I wanted to talk about a little bit more about the financial profile of the whole blood contracts. As you said, the net impacts will be dilutive in ‘15 but there is room to improve on that over time. Can you talk a little bit more about the magnitude of transition costs with respect to that initial dilution? And beyond that, your comments on cost improvement through value engineering mean those contracts become accretive beyond ‘15 or simply less dilutive and can you reach the free cash flow targets you previously announced?

Brian Concannon

Okay. So a lot of questions in there. First of all, we are not going to give visibility to the pricing as you might expect for two reasons – a) the confidentiality of those agreements with those customers, but b) we remain in a very competitive environment going forward in this space. We have certainly signalled that we would be aggressive on pricing and we have been aggressive on pricing. But what we have also been able to do as a part of that aggressiveness working with those customers is work with them to target real opportunities to take costs out of the product. That will be something that affects us in fiscal ’15.

But what we are saying is beginning in fiscal ’16, you will see that rebound that we believe that within three years we will have margins that will be back up to the original margins that we enjoyed in this product prior to this market shift. So I think ’16 and beyond growth and profitability we expect will outpace revenue growth.

James Francescone - Morgan Stanley

Okay. On the hospital business or more particularly the surgical line, is there some way you would be able to give us a sense of what underlying growth in that business was if you were to back out the impact of renewed competition from the competitor situation there?

Chris Lindop

Well, year-to-date last year, I guess, we grew 10%. So that’s sort of a tough comparable that you could isolate that effect and the balance would be underlying trend.

Brian Concannon

The answer really there, James, is no, we don’t have a tremendous feel for that. What we are trying to understand is what are protocol changes, how are those protocol changes that our customers are making in transfusion triggers, the measurement of haemoglobin, is that affecting transfusions of autologous transfusion rates. In other words, even though they are salvaging blood, are they connecting and processing it to transfuse back to the patient, we are trying to understand that impact and recognize whether or not that continues to affect that part of our business as well. Little more work to do there, we hope there’s some visibility here and there in the next quarter or two.

Operator

And your next question comes from the line of Anthony Petrone with Jefferies Group.

Anthony Petrone - Jefferies & Company

A couple on HemeXcel and then maybe some numbers questions for Chris. Brian, first on the HemeXcel contract, my understanding is that it will take some time for that contract to reach critical level in terms of actually getting equipment into all of those blood centers within that network. So maybe a little bit on timing when you will actually begin to see revenue flow out of that contract? And then heading into that, will you be incurring setup costs and the like as you reach critical mass on that contract?

Brian Concannon

So the first part, let me answer the last part of your question which is, is there a cost to transition? Of course, there is. There always is that cash. It won’t be as significant in the sense of the equipment pieces. There is no equipment here. It is a disposable piece but it will be significant in the sense that you have to convert mobile drives, not just blood centers. And so we’ve got our people going out in each of the mobile drives to train people. These are not just challenging trainings but each blood center must train on our products versus the competitive products that they were using to get up to speed quickly. That’s already begun.

You will see that happen in the HemeXcel transition fairly rapidly just by the nature of where the business was at the time. We had some blood centers that were a 100% with Haemonetics, others that had a partial, still others that had zero. So the focus in the transition schedule was set as a part of the contract and that’s being executed. So you are already starting to see that happen in our results.

Anthony Petrone - Jefferies & Company

And then maybe just a little bit on whole blood gross margins and profitability on that. Can you just maybe walk us through timing on key milestones through the end of fiscal ‘15? This is a disposable business, so as you move along in this transition phase, should we begin to see margins improve incrementally or is it all going to come after fiscal ‘15?

Chris Lindop

It will happen sort of ratably over a three year period. It will happen – the first part, that the first offsetting effect – this is the effect of volume on our absorption. The next phase, which happens over an 18 month period, is related to what we call value engineering. And that’s about half of the improvement that we are looking for. And then the last phase, which will continue – it will start now and will continue, is a strategic in-sourcing phase and that will conclude within the three year period. So you will see a bolus of improvement in ’16 and it will continue into ’17.

Brian Concannon

And I realize again right here just to jump in, I realize that I didn’t completely answer a question previously, I think it was James, which talked about the cash flow of this business. The way I would answer that which is kind of an extension of what Chris just talked about is that we are putting together what that’s going to look like. We believe that the endpoint is not going to change. We believe how we are going to get there is going to change just because of the nature of the decisions we are making in a market that’s changing rapidly. And that’s why at the JP Morgan conference we did not have that slide as a part of our presentation. Until we see how this market is going to play out especially with this very large tender, that is outstanding, we wanted to be responsible but that’s a question that’s been asked before. And that’s how we have answered that question, so to provide that clarity, I realized I hadn’t answered it previously.

Operator

And your next question comes from the line of Jim Sidoti with Sidoti & Co.

Jim Sidoti - Sidoti & Co.

I know you have said a couple of times you expect this SOLX to be submitted to the FDA in fiscal ‘15. Can you give us a little more color? Is that first part, second part? I guess what I am asking is do you expect that to be approved by fiscal ‘16?

Chris Lindop

Yes, we do. I mean obviously that’s to say, subject to any questions FDA has. But we believe that’s a reasonable expectation at this point.

Jim Sidoti - Sidoti & Co.

In the past you’ve always considered yourself a double digit grower on the bottom. It sounds to me like next year because of all of the transitions going on you may not get there. But do you think by ‘16 and ‘17 you will be back to that double-digit bottom line growth rate?

Brian Concannon

The way I would answer that question, Jim, is really two fold. First of all, we look at growth rates over periods of time and the answer initially to ’16 is yes. But the way I would answer further is to say, recognizing that ’15 is going to be a year of transition, you can probably expect at our May investor conference that we are going to give a little bit more of a peek into the future that we have done in years past. I think that’s important.

So again what you hear is my caution in just letting this market play out a little bit. As I said I hope that we will have that larger tender determined by that point in time, that will allow us to give you visibility and it’s my expectation that we will give you visibility beyond just fiscal ’15, so we can answer those questions for you.

Operator

And your next question comes from the line of Larry Keusch with Raymond James.

Larry Keusch - Raymond James

Brian, in the past in some of your SEC disclosures you have given some qualitative comments around some of your plasma contracts as those have been signed. And I know you have mentioned that you’ve gotten some extensions year. But I am wondering if you can again talk a little bit about sort of directionality of pricing on those?

Brian Concannon

Yes, pricing as we’ve always said, Larry, is a part of every negotiation. But it’s not an overriding element of the plasma contracts. It’s not what we are seeing in the whole blood contracts, if that’s your concern. Our plasma business is a pretty stable business. The focus with those customers is very stable. We are looking at things well beyond just simply pricing to include collaboration around some of the research and development of how we approach those markets. So things like we’ve talked about before, so you can see these contract extensions as being as positive as those we have talked about in the past both in terms of the puts and takes.

Larry Keusch - Raymond James

And then just on the financial side, I am wondering, Chris, if you can again remind us which parts of the business specifically are most exposed to the movements in the yen? And also I think I noticed this correctly that you now are looking to invest about $100 million of your free cash flow to fund the CapEx and cash transformation expenditures with the VCC in this quarter's press release and I think that at prior had been $109 million, so I was just wondering what the differential was?

Chris Lindop

Yes sure. So yen impact for us is obviously a Japanese business, which is a little right around 10% of our total business. And in terms of the VCC spending, Larry, it’s really just timing. And it hasn’t changed our timetable but it’s the quarter in which cash will leave the organization and it’s primarily related to Malaysia and the rather large capital project we have going on there. We broke ground there in October. We are in this phase of piling just now sort of land improvement part of it. And we continue to feel good about our endpoint. But it’s just timing of when the cash leaves the Corporation.

Operator

And your next question comes from the line of Brian Weinstein with William Blair.

Unidentified Analyst

This is Matt in for Brian this morning. You mentioned one of the offset to some of the lower cost initiatives for whole blood. Would it make you a little more competitive OUS? Could you maybe speak about any tenders that might be coming out or what the timing or length of some of those tenders might be?

Brian Concannon

There are no tenders that I would speak about that are of any significance in the OUS market. There is a number of different pieces that are puts and takes. Unlike the large tenders that you see here in the U.S. which involve about 12 million collections in total, these two tenders representing about 60% of that 12 million collection market. Most of the tenders outside the U.S. are country driven in quasi-governmental structure that exists around the world. So those will be coming up. We know when those are coming up. But there is none in the horizon here in the near term to speak of that would have any meaningful influence.

Unidentified Analyst

And then just back here into the U.S. whole blood market, we have seen, in your commentary, about 5% decline, then 8% decline and now 8% to 10% decline. You are still kind of sticking with this anniversarying or ending at the end of fiscal ‘15. I mean what’s the chance that we see that maybe go to 10% to 15%, or do you feel like you have a little better visibility to get you through the end of this downturn in collections?

Brian Concannon

I think we have a pretty decent understanding and appreciation of this trend at this point in time. I think we are going to see the dramatic decreases take place throughout the remainder of this fiscal year, throughout the remainder of fiscal ’15. The question is whether or not we will see it totally bottomed out in fiscal ’16 but we will continue to see some moderate declines because you see changes happening not only dramatically here in the U.S. but to a lesser extent elsewhere around the world. But that’s just simply fluctuations.

Our biggest focus is going to be on capturing share. It’s a shrinking piece and we want a bigger piece of that. And we expect that we can be successful on that focus.

Operator

And your next question comes from the line of Raymond Myers with Alere Financial.

Raymond Myers - Alere Financial

I was hoping you might give us some visibility to what market share Haemonetics has currently with the one large blood center that is in the tender process currently?

Brian Concannon

Yes, we have said both for HemeXcel which we won, we were less than half, and for the one that is outstanding, we are less than half.

Raymond Myers - Alere Financial

That helps. Next, I thought you might touch on the automated blood collection device development. When do we expect that development to be complete and when do you expect to file for FDA approval on that?

Brian Concannon

Well, remember we have already received some 510(k) approvals for that. So we are in the process – the comments that I made about these three large blood centers that have signed up and purchased Donor Doc Phlebotomy, those are three targeted centers that we are going to be working with to truly understand how to bring that to market rapidly, effectively, efficiently with minimal impact to our customers but importantly understanding what does that mean for them financially, and how do we bring on the follow-on elements of that like the tower which is now ready for commercialization, and then ultimately the collector.

So that’s important milestones and important pieces to understand. I have said before and I say it again, we hope to be able to provide some visibility to that at our May investor conference. That will all be dependent upon how rapidly we can manage the implementation of those three important blood centers.

Operator

And your next question comes from the line of Jan Wald with Benchmark.

Jan Wald - The Benchmark Company

A couple of questions. Back to the European tenders, I guess it is as you said, country specific but it also sounded as if they were very price sensitive and maybe too price-sensitive right now for you to compete in. So how do you see your ability to enter into those tenders? And when do you think you’re going to be cost efficient enough really to win them now or sometime in the future?

Brian Concannon

Yes, and of course, that price sensitivity played out, Jan, in the beginning of this fiscal year when we lost a large European tender, that we had the business at and the margins were single digits. So it speaks to that point. But I believe we will be in a cost position to begin competing in those markets increasingly beginning in fiscal ’16 and beyond.

Jan Wald - The Benchmark Company

And I guess back to the whole blood market again, it sounds as if you are going to witness this decline in pricing over time. You have a bunch of value initiatives and things like that going on that will help you compete. But are there pieces of -- you lose the tender, but are there other parts of the business that you can still sell into those blood centers or into the hospitals or wherever you're trying to sell? In other words, do you lose 100% of the business or is there some business that remains because you have other products that you could sell into them?

Brian Concannon

Two pieces. To answer your question, first of all, going to the front part, which talked about the declines, the pricing declines won’t be over time, those will be pretty much in the early part of the implementation of that contract. The recapturing of the profitability through the value engineering will take place over time. That’s what I said there. So important to understand that piece there.

But your other question really relates to our broader product portfolio and no, there is a broad number of products that we continue to sell to those collection customers, such as Acrodose, such as platelets, such as double red cells, such as SafeTrace TX and BloodTrack on the software side. So there is a number of other products and those were not part of the HemeXcel tender, nor are they part of the American Red Cross tender.

Operator

Your next question is a follow-up from the line of Steven Crowley with Craig-Hallum Capital.

Steven Crowley - Craig-Hallum Capital

Just one quick follow-up. Given the role of a lower tax rate how it helped you make up for some shifts in the sands so far this year, I am wondering where you think that tax rate is in the wake of recapturing those reserves for 2015 and beyond. Maybe you could just update that for us. That’s probably something that’s more certain relative to these other variables, so hopefully you can help us there.

Chris Lindop

Sure. We are looking at between 26% and 27%. Some of the pressure there is related to the fact that our – we have a very efficient tax rate in our Japanese business by virtue of our tax structure outside the United States. And if the profitability is compressed in the Japanese business, it affects our ability to leverage that. But that’s a good number for next year, Steve.

Operator

And at this time, there are no further questions. I would like to hand the conference over to Brian Concannon for any closing remarks.

Brian Concannon

Thanks, Felicia. The success we see in our growth drivers should not be ignored and the fact that we grew base business 4% in constant currency in the quarter is proof that these efforts are paying off. Plasma, TEG diagnostics and emerging markets will remain areas of focus for us in the future. It is different for the other areas of our business. There is no question that the blood collection industry has seen tremendous change this past year and these changes come more rapidly than anyone expected. Change is inevitable.

But I believe we will be judged less on how these changes affected us and more on how we react and help our customers respond going forward. We saw this less than a decade ago in the plasma industry. It was the success we enjoyed there that helped us appreciate what could be in the blood collection industry. These past several years we took steps to capitalize on this opportunity by extending our product portfolio through acquisitions, innovating through R&D, improving with quality initiatives and becoming more cost competitive through value engineering and transforming our global manufacturing footprint. This latter initiative addressing the important issue of business continuity as well.

Our efforts are paying off as we continue to meet and exceed the needs of our plasma customers as evidenced by these important extensions and the HemeXcel win is a strong indication that we are beginning to do the same for our blood collection customers. Fiscal ’15 will be a year of further transition for our industry and for Haemonetics as well. But if we are right, then we position ourselves to win by capturing market share and fiscal ’16 will be the beginning of several years of profitable growth. It is often said that time will tell. I agree and that time is now.

Thank you for your attention this morning.

Operator

Thank you. This concludes today’s third quarter fiscal year 2014 earnings release conference call. You may now disconnect.

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