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Greatbatch Inc (NYSE:GB)

Q4 2013 Earnings Conference Call

February 25, 2014 8:30 AM ET

Executives

Betsy Cowell – VP, Finance & Treasurer

Tom Hook – President & CEO

Michael Dinkins – EVP & CFO

Analysts

Charles Haff – Craig-Hallum Capital Group

Dan Rutter – Paragon Investment Management

Operator

Welcome, everyone, to the total year 2013 Greatbatch, Inc., conference call. Before we begin I’d like to read the Safe Harbor statement. This presentation and our press release contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, involves a number of risks and uncertainties. These risks and uncertainties are described in the Company's annual report on Form 10-K.

The statements are based upon Greatbatch, Inc.'s, current expectations and actual results could differ materially from those stated or implied. The Company issues no obligations to update forward-looking information included in this conference call to reflect change in assumptions, the occurrence of unanticipated events, or changes in future operating results, financial conditions, or prospects.

I’d now like to turn the call over to today's host, Vice President of Finance and Treasurer, Betsy Cowell. Please go ahead.

Betsy Cowell

Hello, everyone, and thank you for joining us today for our 2013 earnings call. With us on the call are Thomas J. Hook, President and Chief Executive Officer; and Michael Dinkins, Executive Vice President and Chief Financial Officer.

In terms of today's agenda, Tom will start us off with an overview of the 2013 results and the strategic initiatives contributing to our financial performance, including remarks on our product lines. Michael will then provide initial comments on the 2013 financial results and discuss our 2014 guidance. We will then open the call up to Q&A.

As we have done in the past, we are including slide visuals to accompany this presentation, which you can access at our website, www.greatbatch.com. Now, let me turn your call over to Tom Hook.

Tom Hook

Thank you, Betsy, and good morning to all of you who are joining our call today.

Last evening we reported 2013 record total year revenue of $663.9 million, which represents organic constant currency growth of 5%. We saw continued momentum from our orthopedics and cardiac rhythm management neuromodulation product lines, which grew 20% and 6%, respectively, during 2013. I will talk more about the sales performance drivers later in the presentation.

Adjusted diluted earnings per share improved 19% to $2.10 for the year. Fourth-quarter sales totaled $176.6 million, a 13% organic constant currency increase over the prior year. Adjusted earnings per share were $0.55 for the fourth quarter and represented the sixth consecutive quarterly increase over the prior year.

Turning to other key metrics. Adjusted operating income improved 12% to $82.9 million and the adjusted operating margin increased 110 basis points to 12.5%. Adjusted cash flows from operations totaled $85.5 million, a 32% increase after taking into account the $29 million tax payment associated with the retirement of the convertible notes.

Our accomplishments in 2013 established a basis for continued progress in 2014. As expected, we filed the Algostim PMA in 2013 and the CE Mark in January of this year. The CE Mark quality check and ISO audits are underway, as is the review of the design dossier. We fully expect that as the year progresses we will continue to move smoothly through the required approval process steps.

We remain committed to maintaining a healthy intellectual property portfolio, which is the foundation of our business model. Our broad and deep intellectual property has enabled the securing of long-term customer contracts that deliver value to our customers. This positive trend continues to enhance the stability of Greatbatch.

During the last two years, we've expanded our medical device patent portfolio to 537 patents, now 36% of the total patent portfolio. Consistent with 2012, the Greatbatch Medical portfolio grew 18%, bringing our total patent and patent-pending portfolio to almost 1,500.

During 2013, we reorganized the Greatbatch executive team under one sales and marketing executive, consolidated our operations group, and streamlined other functions. This enhanced the quality of our decision-making and enables the Company to more effectively leverage resources.

Our investments in sales and marketing have allowed us greater insights into the diverse markets we serve, which enable us to drive greater adoption of our product lines by blue-chip global companies. Upgrading our salesforce and locating resources closer to our customers is an investment that we consider vital to sustain our commitment to 5% revenue growth. We believe these changes will aid us in delivering results consistent with our strategy and position Greatbatch for the future.

Now I would like to provide some comments relative to our various product offerings.

Cardiac rhythm management and neuromodulation annual growth aggregated 6% versus 2012 and 17% in the fourth quarter. During 2013, we experienced double-digit growth in capacitors and lead wires, along with high single-digit growth in batteries and shield assemblies.

The long-cycle nature of the CRMN product line projects necessitates the measurement of our results over a four-quarter rolling average. As you can see from the chart, Greatbatch sales continue to track with the market. This represents the long-standing partnerships with our customer to develop and design new component technologies, which can take over three years to bring to market.

Our orthopedic product line delivered another double-digit quarter of growth, ending the year at 20% organic constant currency growth. We enjoy a balanced growing portfolio of offerings from hip and shoulder implants to delivery systems and instruments backed by intellectual property. Through innovation, new market programs, and an expanded salesforce, we are confident we will be able to sustain our growth objectives and deliver quality innovative products to our expanding customer base.

While our portable medical product line results were disappointing, our primary battery pack applications, also known as single-use batteries, used in applications such as surgical tools, patient monitors, and defibrillators, remains strong and delivered almost 30% growth during 2013. Our rechargeable battery assembly applications fell short of expectations and significantly below last year given the cyclical nature of customer stocking levels and launch quantities.

As mentioned previously, after further analyzing this business, customers, and offerings, we made several strategic decisions to secure business with margins in line with our strategy. This has caused us to forgo selective competitively priced business opportunities. We believe this is the right strategy for both Greatbatch and its customers.

Our vascular business continued to be depressed by the late 2012 voluntary product recalls. We expect to regain our momentum in 2014 because of our commitment to product innovation with products that are distributed across all customers, the return of the steerable catheter product to market, product launches in both our introducer and catheter offerings, and a salesforce dedicated to deepened customer partnerships which will expand our customer base.

We saw continued stabilization in our energy business, which grew 3% in the fourth quarter. We are committed to reestablishing growth in line with the market with new management and a more focused, productive sales team. Our environmental, military, and other product line revenue showed signs of recovery in the second half of 2013, with 5% growth driven by a strong fourth-quarter performance.

Our offerings service a broad-spectrum of customers and applications which we remain committed to serve. Mike Dinkins will now take you through a more detailed look at our results for the year and our 2014 guidance before we take your questions.

Michael Dinkins

Thanks, Tom, and good morning, everyone. I'm very pleased to be on the call today to provide a brief overview on our 2013 results, fourth-quarter performance, and reconfirm our 2014 full-year guidance. For more specific details regarding our financial results, we refer you to our press release that was issued last evening.

In 2013, we delivered the following: 3% sales growth; 5% organic constant currency sales growth; gross margins of 33%, representing 180 basis point improvement from 2012; adjusted operating income was up 12% to $82.9 million; and the adjusted operating margin increased 110 basis points to 12.5% of sales. Adjusted diluted EPS increased 19% to $2.10 per share, adjusted EBITDA improved 6% to $118.9 million and adjusted operating cash flow totaled $85.5 million.

On slide 13 we provide EPS reconciliation for the year versus 2012. Our global operations performed well during the year and the decision to consolidate our orthopedic product line delivered positive results. Operating efficiencies and volume increases contributed approximately $0.55 improvement to our adjusted EPS.

Our 2013 performance based on compensation negatively impacted the year by approximately $0.20 primarily because of the lower 2012 payout of only 62% of target bonus. Our planned investments in sales and marketing were partially funded through reduced medical device initiative spending, we had lower customer cost reimbursements for engineering projects in comparison to last year, and we incurred add costs for intellectual property filings, primarily for Algostim at year-end. In total, these costs negatively impacted adjusted EPS by $0.10.

Our share price increased over 90% last year, which impacts the diluted shares outstanding because of the Treasury method of accounting, thus reducing our adjusted EPS by $0.12. Offsetting this was lower tax rate and lower interest expense, which added $0.15 and $0.05 to the adjusted EPS, respectively.

Slide 14, we turn our attention to cash flow. We generated $85.5 million of cash flow from operating activities during 2013, which excluded $28.8 million of tax payments made in connection with the retirement of the convertible notes.

While our working capital turnover remained constant when compared to 2012, we reduced customer receivables $7.4 million with improved collection activity. The higher inventory balance is attributable to the sales volume. Our capital expenditure totaled $18.6 million for the year.

Turning to 2014. 2014 is a year of staying the course, fully leveraging our sales and marketing investments, continuing to deliver productivity across all product lines, realizing the benefits of our medical device initiatives, and, where appropriate, entertaining inorganic growth opportunities.

On slide 17, we have our guidance. We are reaffirming our 2014 guidance. We are confirming the sales guidance of 3% to 6% provided last month. We expect our operating performance and to improve as we progress through the year because of timing of new product introductions, continued improvement of sales execution, and realizing the benefit of planned improvements in our global operations.

We expect to generate $90 million to $100 million of cash flow from operations and we estimate our capital expenditures for 2014 will be between $25 million and $35 million.

In closing, I would like to reiterate several key points. We have a strong core business because of intellectual property and long-term OEM relationships. We are targeting sustainable 5% organic growth or better and we believe we can leverage our organic growth at 2x to the bottom line. Our cash flow remains strong and we are working on commercializing Algostim as an upside.

With that, let me now turn the call back over to the moderator to take questions.

Question-and-Answer Session

Operator

(Operator Instructions) Please stand by for your first question.

The first question comes from the line of Charles Haff of Craig-Hallum. Please proceed.

Charles Haff – Craig-Hallum Capital Group

Hi. Thanks, good morning and thanks – good quarter. I had a couple things I wanted to ask you about. First on capital expenditures, what do you think you're going to be doing in capital expenditures in 2014? And if you could kind of describe maybe the maintenance CapEx versus the growth CapEx from that, that would be helpful.

Michael Dinkins

Our primary spend for 2014 in terms of CapEx is productivity-driven, but we have opportunities to introduce new equipment that we think will help sustain or improve our margins on various product lines where we are seeing volume growth. So the vast majority of it is driven from productivity.

I believe this CapEx – I don't have an exact breakdown on that, so I can send that you later. But on the maintenance side it is probably in the – I would guess around the $5 million range and that's predominantly IT-related as we, like most companies, on a regular basis upgrade our servers and other IT equipment. So it's an ongoing spend in that regard that we have every year.

But most of the stuff that we are doing in the plants are designed to give us greater productivity and a little bit over this for volume.

Charles Haff – Craig-Hallum Capital Group

So we have for 2014 about $30 million of total CapEx. Is that the right way – are we in the ballpark or is that a little bit high, do you think?

Michael Dinkins

No, you’re in the ballpark because you give guidance of $25 million and $35 million so you're taking the midpoint and that's probably a good thing to do.

Charles Haff – Craig-Hallum Capital Group

Okay, great. And then on the CRM neuromodulation line item, extremely good growth this quarter. I dialed in a little bit late, so I apologize if you already went through this, but you know you had a pretty easy comparison with a negative 5%. Should we still be thinking about low to mid single-digit for CRM market growth for 2014? If you could talk about any anomalies in the quarter, that would be great.

Tom Hook

Sure, Charles. I think the way to think of it is we are still fairly conservative. When we look at the CRM market as a company, consistent with the way we've looked at it over the past three-plus years, we think the market it has stabilized but it's still a low growth market, so we feel that the market growth will be fairly low.

As you know, we win business years ahead of time in product development. We've made a lot of investments in salesforce productivity to pick up business and new product designs, but that takes a little while for it to percolate into the revenue line item for us. So some of the growth we enjoyed was due to prior product wins, but the salesforce productivity investments we have made over the past two years are definitely paying off.

So I would expect that still we will be able to grow slightly faster than the underlying CRM and neuro markets based on those wins, but it's not going to be a large departure from how we've tracked historically. So we feel it's very predictable. All the customers we have are on long-term agreements and we have a very good understanding of the product lines that we are in and qualified in and qualifying. It's just a question of what the underlying market growth will drive us.

Charles Haff – Craig-Hallum Capital Group

Okay, great.

Michael Dinkins

We’d also encourage you to look at the rolling four quarters as the best way to look at that particular product line. Because we have such large customers and their timing of their quarter end and our quarter end doesn't match up we sometimes get large current quarter organic growth positive or negative. That's one of the reasons why we ask that people look at the rolling four quarters.

We were very pleased with the 17% growth in the fourth quarter, but when you look at on a rolling four quarters it says, hey, we are beating the market by a fair amount but not as indicative as the fourth-quarter results.

Charles Haff – Craig-Hallum Capital Group

Okay, great. Then my last question is on the orthopedic segment. You have had a lot of changes over the last couple of years in that segment and these last two quarters, while you had very – or easy comparisons year over year, you've had very strong growth.

Should we think about going forward for orthopedics that all of the changes have now been complete and this is more of a steady-state environment? Do you think that you are maintaining market share or be growing – gaining market share in 2014? Thank you.

Tom Hook

Those are great questions. I think that the orthopedic investments that we have made definitely have paid off to streamline our operations, as well as to enhance the sales and marketing teams so that we have better market information, we are addressing customer needs better. However, I would not characterize orthopedics as having made all the investments we need to make.

We have a strategy that progressively improves that business at each of the product lines, from implants to delivery systems to instruments, and I do see continued investment that for manufacturing it would be to continue to pick up cost advantages as well as maintain pace with the growth rate. For the innovation side of the business, I would like to see us continue to win business with customers that is underpinned by our intellectual property.

We have to, in orthopedics, reach service delivery levels that match our cardiac rhythm management and neuro platform level. So while there are – definitely orthopedics has had an exceptional year, the operating teams, as well as the sales and marketing and R&D teams have done a great job, there's a lot more work to do.

And while I think the growth rate on a percentage basis will come down and temper a little bit, and that's included in our guidance information, I still feel that that will be a healthy grower for us based on the investments that we've already made. And we will have room to be making a few continued investments as the years go out to keep that trajectory very positive.

Charles Haff – Craig-Hallum Capital Group

So when you think about the standard deviation around your guidance for the orthopedic segment, do you think that there's a wider standard deviation there, given the fact that you still have some puts and takes? And would you say that there's a bias that the business will be moving forward? We won't have any setbacks like you've had or the charges and kind of the big changes that you've made in the past.

Tom Hook

I think it's fair to say that we are not – we have made the really paradigm changes in orthopedics that we needed to. Now we are on more to the evolutionary investments, so less dynamics and more core performance. Clearly, also the orthopedic markets stabilizing and growing again are also favorable, but I think, to use your term, yes, the standard deviation will be lower. It's going to be less volatile as we move forward and more predictable.

Clearly as the business gets bigger we have more long-term agreements in place, more predictability that we can make investments under. And as we deepen the customer relationships, especially with new ones, we tend to win follow-on products based on our performance and that's the underpinnings of how we grow. So that all points to a less variable business and it allows us to be opportunistic to pick up business on the upside.

One very important clarification: orthopedics is a combination of a long-run business, which is implants, which takes multiple years to qualify, versus a short-run business that is more the delivery system side. So we do have the ability to pick up business faster in orthopedics, based on our performance in 2014 and into 2015, than we would in other areas that have long gestation periods because of FDA approvals. We intend to continue to take advantage of that using our operating capabilities to do products faster than our competition and that puts us in a position of being able to take share.

Charles Haff – Craig-Hallum Capital Group

One follow-up question if I could. So in the orthopedic segment, for the higher volume products, I believe that you have been moving some of those projects to your Tijuana facility from the Fort Wayne/Warsaw facility. Wondering if you still see quite a bit of opportunity to continue to do that or is that kind of stabilized now and there's not much – as much transition to the Tijuana facility, because I know you've had a lot of margin expansion by moving products down there?

Tom Hook

The wonderful thing about Greatbatch is now that we have built a very broad operating base and we've invested heavily in manufacturing, our ability to make product lines beyond the traditional location that they've been in is very good. And one of the reasons why we underscore our ability to grow the bottom line twice as fast as the top line is to take advantage of internal cost savings that you are referencing right now, Charles.

So we are very deliberate and aggressive at where we manufacture for cost advantages, whether those are neighbor or, in many cases, energy related, because many of our operations work in areas that have cost advantages from an electricity standpoint. It's our objective to look at where we have the best capabilities, where we have the best partners from a supply chain perspective and to leverage those with more volume.

That includes the orthopedic product line, but it also includes every other product line. We will continue to highlight those in the future as we see opportunities for cost reduction projects. We will provide more information on those initiatives and how they drive the margin expansion for us as a company. I think they are vital to the growth strategy that we are presenting to the investors.

Charles Haff – Craig-Hallum Capital Group

Okay, great. Nice quarter, guys. Thanks.

Tom Hook

Thanks.

Operator

(Operator Instructions) The next question comes from the line of Dan Rutter of Paragon Investment Management. Please go ahead.

Dan Rutter – Paragon Investment Management

Yes. Good morning.

Tom Hook

Good morning.

Michael Dinkins

Good morning.

Dan Rutter – Paragon Investment Management

Would you provide a little bit more color maybe on the orthopedic sales growth in the quarter? The press release said that some of that was release backlog that had built up. Could you quantify that or give us a feel for the percentage contribution to growth?

Tom Hook

Certainly; this is Tom Hook. Where I think you look at our project to relocate our Swiss facilities to our North American operations in 2012, resulted in some qualification delays throughout 2013 for certain product lines. That resulted in a backlog being built up in our system that we have worked off over the course of 2013, but it's only a few million dollars, $2 million to $3 million, in terms of backlog.

So overwhelmingly the growth that we saw is not so much backlog-related as it is just we have done a very good job of engaging customers, driving business volume. And, as obviously our guidance suggests, is that we continue to see that as the fundamental driver for our growth in 2014 and beyond. We are just leveraging our manufacturing capabilities and the sales and marketing team is doing a very good job of engaging customers on new projects.

What is yet to be seen is investments that we will make in the orthopedic side and the innovations to help continue that momentum and get some margin expansion as we move beyond 2014. We will be making those investments in 2014 to continue that trajectory, so it is a backlog affect but it's relatively modest.

Dan Rutter – Paragon Investment Management

Great. And if I could follow up, could you talk a little bit about the implied QiG losses that are in 2014 guidance and maybe speak a little bit to the DVT expenses going forward?

Tom Hook

For QiG, investments that we are making in 2014, which is slightly lower based on the completion of the Algostim platform in 2013 which we obviously filed with the FDA in December, late in the year. There are as we move forward in 2014 expenses for continuing engineering related to that platform as we prepare commercialization with partners and as we also do new platform work.

We are not specific, for confidentiality reasons, and competitive reasons as to what those platforms would be. We've only noted that we have two neurostimulation platforms that are dramatically simpler than the Algostim platform in development. There are expenses associated with those.

Because the design verification testing for these various systems are much lower than Algostim, we are not breaking out the design verification testing information as granular as we have before. We will periodically provide that to give some direction, but for the most part, we expect that number to be manageable. And we will be, along with those new platforms, being very careful of those investments in preparation for the commercialization of Algostim, which we expect in Europe in the second half of this year to have the CE Mark approval that will allow us to work with partners for commercialization.

We would expect in 2015, early 2015, to have that in the US. And, of course, we will provide guidance at that time what we feel those would be.

Michael Dinkins

So I think it's important to note that for our 2014 guidance, when we give you adjusted operating income, it does not include any adjustment for design verification testing. But as Tom indicates, obviously we've got the new platform and we continue to do work on that product and other products that would be characterized as design verification testing. But we are no longer making any adjustments to our earnings for them, because we view it now as ongoing business as opposed to creating that first platform in PMA filings.

Dan Rutter – Paragon Investment Management

Great. Okay, thank you.

Operator

Thank you. I would now like to turn the call back over to Betsy Cowell for any closing remarks.

Betsy Cowell

Thank you. I would like to remind all of you that both the audio portion of this call, as well as the visual slides, will be archived on our website at www.Greatbatch.com and will be accessible for the next 30 days. Thank you again, everyone, for joining us, and have a wonderful week.

Operator

Thank you for your participation. That concludes today's conference call. Thank you.

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