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Exactech, Inc. (NASDAQ:EXAC)

Q1 2014 Earnings Conference Call

April 22, 2014 10:00 AM ET

Executives

Bill Petty - Executive Chairman

David Petty - CEO

Jody Phillips - CFO

Analysts

Jeff Johnson - Robert W. Baird

Mark Landy - Summer Street Research

Jim Sidoti - Sidoti & Company

Bob Sullivan - Satuit Funds

Operator

Ladies and gentlemen, thank you for standing by. Welcome to Exactech First Quarter 2014 Results Conference Call on Tuesday, April 22, 2014. Throughout today’s presentation, all participants will be in a listen-only mode. After the presentation, there will be an opportunity to ask questions. (Operator Instructions)

I will now hand the conference over to Executive Chairman, Bill Petty. Please go ahead, sir.

Bill Petty

Good morning from Exactech and thank you for joining us. I just wanted to take a brief moment to introduce our new Chief Executive Officer. I think it certainly applies in this case, David really needs no introduction. He’s been at Exactech almost as long as I have, done almost every job here, and we were certainly pleased when our Board of Directors chose David as a Chief Executive Officer and look forward to his leadership.

So I’m now going to turn the conference call over to David.

David Petty

Good morning, everyone, and thank you for your interest in Exactech. As always, we will begin with the disclaimer statement. This release contains various forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, which represent the Company’s expectations or beliefs concerning future events of the Company’s financial performance.

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

Now, I would like to make some comments about our quarter’s performance and then I will turn it over to Chief Financial Officer, Jody Phillips, who will also offer some prepared remarks and then each of the three of us will be available for a Q&A session.

Revenue for the first quarter of 2014 increased 7% to $63.3 million from $59.3 million in the first quarter of 2013. Diluted earnings per share for the quarter was $0.30 based on net income of $4.2 million, representing a 9% increase compared to net income of $3.9 million or $0.29 diluted earnings per share in the first quarter of 2013.

For the quarter, knee implant revenue was flat at $20.6 million. Extremity implant revenue increased 25% to $19.7 million. Hip implant revenue increased 3% to $10.8 million, and the biologic and spine segment revenue decreased 4% to $5.8 million. Other revenues decreased 3% to $6.4 million based on an intentional reduction of non-Exactech product sales and our global offices outside the United States.

Revenue growth was balanced between U.S. and international sales. U.S. growth was 7% up to $41.6 million compared to $39 million in the first quarter of 2013. This was driven by another quarter a very strong performance with our Equinoxe shoulder product line. International sales grew 6% to $21.7 million compared to $20.3 million in the first quarter of 2013. This growth was supported in part by debt performance of our hip product line and represents growth in each of our three international regions. International sales represented 34% of the worldwide total while U.S. sales represented 66% of total revenue for the first quarter of 2014.

Now, I’d like to turn it over to Jody Phillips to make some additional comments.

Jody Phillips

Good morning everyone and thank you for joining us for the first quarter 2014 conference call. The first quarter results were largely consistent with our expectation as we were within the range of our revenue guidance and as the high end of earnings guidance. With that being said, there were a few moving parts that were slightly different than our expectations. So I will touch base on those as I review our operating performance. In order to review our 1Q ’14 operating performance, I will review each of the operating line items from a percent of sales perspective.

Our gross margin increased to 70.5% versus 68.7% during the first quarter of last year. This was better than we anticipated due to the strength in the U.S. extremities business as well as the pricing impact of the euro during the quarter. On a go forward basis, we continue to expect gross margin increases although we are expecting those increases to be lower than they were in the first quarter, probably in the range 50 to 75 basis points on a comparative quarter basis.

Our total operating expenses for the quarter were slightly above our expectations at 60.1% of sales. This represented a 10% increase. Sales and marketing expenses totaled 37.5% of sales during the quarter. This compared to 36.3% in the first quarter of last year and as I referenced in the release, a component of this was due to the ongoing review and enhancement of our global compliance program, specifically in our direct offices outside of the United States. We expect the full year sales and marketing expenses to range from 36% to 37% of sales. So there is an implicit expectation there that as a percent of sales, sales and marketing cost will decrease for the balance of the year.

Our first quarter G&A expenses represented 9.1% of sales during the first quarter and as we projected at the beginning of the year, we expect G&A expenses to remain in the 8.5% to 9.5% of sales for the full year. Our first quarter R&D expenses increased 9% to 6.6% of sales and was within our expectations for the quarter although we expect an increase in the growth of R&D spending and the full year range we are projecting to be roughly 7% to 8% of total sales. As a result of this gross margin and operating expense element, our first quarter operating profit increased 9% to $6.6 million and represented an operating margin improvement of 30 basis points to 10.5% of sales as compared to 10.2% in the first quarter of 2013. In our non-operating area, we experienced $300,000 currency exchange gain, primarily related to the receipt of large accounts receivable payments in the Spanish marketplace. I will talk about the impact of this payment on our balance sheet in a few moments.

Our first quarter effective tax rate was 36.4% versus 27.9% in the first quarter of last year. With this increase, this was primarily due to the expiration of the R&D tax credit for the tax year 2014 as well as the fact that on a comparative basis in the first quarter of last year there was a positive three penny impact from the reinstatement of the 2012 tax credit.

During the first quarter of this year, there also was a higher than expected mix of profits from higher tax jurisdictions including United States. As the year progresses, we expect that effective tax rate to come down, likely to a full year rate of 33% to 35%.

In summary, for the income statement, the resulting net income of $4.2 million and diluted EPS of $0.30 were at the top end of our expectations and we think we are off to a great start for the year from a P&L perspective. From a balance sheet perspective, we made some significant improvement during the first quarter. In February we received approximately $13 million in past due payments from the Spanish government. This payment, coupled with the traction that we are now experiencing from the supply chain improvement that we targeted during 2013 allowed us to reduce our total debt by $11.5 million and increase our cash position by $5.3 million during the first quarter. Our total operating cash flows for the first quarter were $19 million.

Based on our performance in the first quarter we are increasing the lower end of our full year revenue and EPS guidance with revenue guidance being $247 million to $254 million and the diluted EPS guidance being updated to $1.19 to $1.24 per share for the full year. Our second quarter revenue guidance of $62 million to $64 million represents a 3% to 6% increase and is expected to result in second quarter diluted EPS ranging from $0.29 to $0.31 and that would represent a 13% increase in net income.

This is all of the prepared comments that I have that time. So I’ll turn it back over to David.

David Petty

All right. Alex we are ready to receive questions.

Question-And-Answer Session

Operator

Thanks you sir. (Operator Instructions) The first question comes from Bill Plovanic from Canaccord Genuity. Please proceed with your question.

Unidentified Analyst

Good morning this is actually Kyle on for Bill. Just wanted to first start off -- we could talk about some of the market dynamics in hips and knees. Just wondering if you can break out how the U.S. knees business was in the quarter and then kind of talk about what the drivers are there on a U.S. - OUS basis for these?

David Petty

Well, we don’t’ typically breakout our segments by geography but I’ll try to give you my perspective on our knee business. First of all, we’ve been pleased to see our knee units up reasonably well. So we have good positive traction. I think part of that is coming from the interest in our GPS, Exactech GPS, which we’ve spoken about before. Though we’ve also observed that the new business that we’re bringing on has come to us at relatively lower pricing than our average selling prices. So on balance, we have seen some negative pressure on pricing in the 3% to 4% range and that goes for hip and knee but it has more to do with the mix and shift in customers than what we think we’re seeing for lack of better term same store or same hospital existing customer pricing and our instances remaining relatively stable. I don’t know if that’s helpful or not, but that’s what we’re observing.

Unidentified Analyst

It is helpful. Thank you. And then on the hip side, when you talk about hip strength OUS, can you kind of talk about what the biggest driver is there and what your prospects are on the U.S. side, especially with the new hips stem [ph] that you guys are preparing to push out?

David Petty

Sure. I think just getting our products registered in a few additional markets, our existing range of available hip products and introducing those and just further developing markets we’re already in, is basically what created the strength outside the U.S. But I think your question about the wedge stem is an important one as it relates to our global opportunity. Because we’re certainly expecting that to be very helpful in the United States. Our team observes that that philosophy of design comprises about 40% of the U.S. market and that segment of the market we’ve had unavailable to us until that product is launched, which will be in the second half of this year.

Likewise we also have a number of our managers in markets around the globe who are highly interested in that product. So our intention is get very quickly, as soon as we have all the available data into registrations in our major hip markets outside the U.S. so that we can enter those markets as soon as possible with the wedge design.

Unidentified Analyst

Great. And then just one last question I’ll hop back in the queue here. Obviously continued strengths in market share gains on the shoulders and extremities business, just wondered if you could comment on where you think some of those gains are coming from and any new products that you’ve launched that will continue to drive that -- growth of 30% in ‘11% and again in ‘12 and 25% -- you’re obviously taking big shares in the market. Just wondering what that looks like and whether or not you think that that can continue for the foreseeable future?

David Petty

Well, I’m going to answer the same way I have for the last 25 quarters, which I don’t think it will be -- we can sustain the kind of growth rates that we see now into the future and I’m just so proud of our team for continuing to prove me wrong. And to answer your question about what’s driving it, I think there are a number of things. In terms of product, certainly the augmenting glenoids and cage glenoid products are unique things that continue to have sophisticated shoulder specialists become interest in our Equinox shoulder and when they do, they discover the many advantages that we offer.

So we’re able to pick up some high volume customers and that helps move the needle on share a little bit. And I also just want to give credit to our team because in the process of having the fastest growing shoulder on the market now for a number of years we’ve just become really, really good at articulating our story and providing the very best medical education program to perspective customers to help them understand the value that we really have with the shoulder product. And I think our team has become really, really good at that and our sales organization, I would put their clinical competence up against in sales organization with shoulders. We’re smaller, there are fewer others but we’re very good.

Operator

Thank you. The next question comes from Jeff Johnson from Robert W. Baird. Please proceed with your question.

Jeff Johnson - Robert W. Baird

David, just want to reiterate the congrats to you as well on the new role. I think well deserved and something we all look forward to working with you more here going forward in the future. So, couple of questions, you mentioned down 3% to 4% pricing data. Is that -- was that an aggregated hip-knee number or did I miss hear that and maybe how does that compare to where pricing was maybe six months ago -- year ago?

David Petty

In terms of all in total compared to six months ago, it’s probably a little bit more of an effect. Again, the dynamics there have more to do with the new business coming at a lower price than implying any belief on our part that the market is down that much in terms of pricing. So, I don’t know if that answers your question.

Jeff Johnson - Robert W. Baird

Yes. No. I guess what I’m trying to get at it is that 3% to 4% number -- I thought I heard you say in the prior question was an aggregated number, then it would seem like the new business maybe is coming in and -- just purely swigging [ph] it but the new business coming in and like 10% below your typical ASP and then the other stuff -- the continuing business been flat to maybe down one or two is where the industry has been anyway. So I don’t know if that’s a way to try to size that or try to put numbers on that, if that’s accurate or not?

David Petty

I wouldn’t think that way, as that big difference generally, but we do have one really big new customer that came in pretty low. So that kind of skews probably what should be more stable macro picture then.

Jeff Johnson - Robert W. Baird

But I’m hearing that correctly, I mean, you are small size relative to the industry anyway. One customer can’t do that and we shouldn’t necessarily read that through a full market and it is that customer an international customer?

David Petty

No.

Jeff Johnson - Robert W. Baird

Okay, well, maybe we’ll talk about it little more offline but that’s helpful.

David Petty

Maybe.

Jeff Johnson - Robert W. Baird

That’s fine. And then just looking again at the hip and knee business, this was the quarter -- you guys definitely met our numbers on the hip and knee side, but frankly this was a quarter where we’re hoping there might be some upside or thinking there might be some upside on the hip and knee side. You did come up against your easiest comps of the year down 3% or 4% for both hips and knees. So did you flat or very little growth against those easy comps. Where do you feel like you are relative to the market at this point? It feels to me like you maybe lagging on the hip and knee side by a few points. Is that accurate? And what do you think it takes? Does it take the wedge design? Does it take GPS? Are those kind of drivers to get you back to the market if not above market over the next six to 12 months?

David Petty

We feel good about our hip and knee business. And I personally agree with you. I would have liked to see a little bit more in the first quarter and you hit the nail on the head with key drivers going forward for hip and for knee, and you said Exactech GPS for the knee is going well. And we continue to have surgeons who become aware of it or we show it to are enthusiastic and eager to use it. We’re approaching 2000 surgeries with it. So, we’ve gained a lot of experience and really what we’re doing is developing that competency in the capital equipment sale area because that’s not something we’ve done before.

And certainly, the folks who do that will tell you that can be 3 to 24 month cycle and so while we have a lot of interest and a number of new knee customers or potential knee customers based on that GPS, it will come more slowly because of the capital equipment sales process. And for hip, not only are we enthusiastic about the wedge and the potential that offers us, but we’ve also launched some other new products as you’re aware in the last several quarters and our team is very, very focused on getting the benefit of those products and setting the stage, setting the table for a really good opportunity with the wedge as we get into the second half of the year.

Jeff Johnson - Robert W. Baird

That’s helpful and then last question for me Jody, I guess just on the S&M side of the P&L, while you talked about those costs coming down through the year, as some of these new products ramp in that, I guess I’m just trying to figure out what’s the driver of S&M coming down during a period where some descent to good sized new products are kind of being pushed out the door?

Jody Phillips

Well, number one I guess is importantly some of that compliant development spends specifically related to the global offices that elements of that are in sales and marketing. So that’s an element that we would expect to come down and while we do have a number of new products that we’re launching this year and there will be spend with that, we launched a quite few last year as well. So they are comparative cost that were in there from a product launch perspective as well.

Operator

Thank you. The next question comes from Mark Landy from Summer Street Research. Please proceed with your question.

Mark Landy - Summer Street Research

I guess we’re all kind of looking at the same thing. Notably with some of the knee issues, maybe just a strategic question. Are you guys using GPS to garner interest and to get Exactech name as a customer that perhaps you went in before and perhaps not trying to get much more price increase of the knee product or are you still trying to get price increase towards the Exactech. Like everybody I guess we’re still trying to join the dots on the easy comp, the comment that the knee products drove a good fourth quarter review obviously with some benefit from the market and then now kind of -- maybe a sideways [indiscernible] in the first quarter?

David Petty

Mark, are you on a speaker phone? Okay, all right. So let me answer that question. First of all, we are using GPS absolutely to gain interest in potential customers in the Optetrak knee, the Optetrak Logic knee system. And then separate from that we are negotiating pricing on the sale of the knee itself and interestingly when Exactech GPS is used, there is a disposable implant kit that goes with it which gets added to the invoice of the sale of the knee. So that implies a potential at least procedure higher rate than if we do not use Exactech GPS, but I wouldn’t correlate the Exactech GPS use to specifically a higher price on the implant.

Mark Landy - Summer Street Research

These quarters to have settle down. What comments can you share with us in kind spine, also biologics that region that also kind of also on fourth quarter down almost 5%, also again a reasonably weak cost.

David Petty

I’m getting the feedback again Mark, are you on speaker? Okay. So that, probably there is a little bit more explanation and I’ll say first that we are happy with the performance in our spine business as it relates to revenue growth. Both for the fourth quarter and the first quarter we think we have turned the corner. Not only has that business stabilized but it is growing. And now when I say that, you then will very quickly deduce our biologics business is down and that is true. We think that mostly has to do with market dynamics and pricing pressure on the kinds of biologic products that we sell. We still feel very good about the efficacy of our products, the product lines, in both the DBM bone paste and platelet concentration systems in bone marrow concentration systems. And our teams are working very, very hard to continue to stabilize pricing and attract new customers.

Mark Landy - Summer Street Research

And then just last question for Jody, Jody, not that I want to get interesting ideas whether it’s just a product in your business but a lot of your competitors have pointed to weather as a potential [ph] on weaker sales this quarter. Were you impacted at all and if so, what was the impact that you it -- could be see a strong weather disruptions in the first quarter?

Joel Phillips

Our sales team has pointed out the fact that weather was an impact specifically in February. We’re not prepared to attempt to quantify that. We do think it was an impact but it’s -- can’t put your hands around exactly how much.

David Petty

Alex, do we have any additional questions.

Operator

Thank you sir. The next question comes from Jim Sidoti from Sidoti & Company. Please proceed with your question.

Jim Sidoti - Sidoti & Company

Just couple of questions, first on the compliance expenses, did you say that those are mostly onetime expenses or are those going to remain at this level for the next -- going forward?

David Petty

Jim, you are aware of the compliance issues of the industry over the last several years and certainly you’re aware that – or maybe you’re not aware, we’re still under a corporate integrity agreement I think for another couple of years and we have invested a lot in the compliance program domestically and also a lot outside the U.S. Our current emphasis, in addition to being sure that we are fully involved with the CIA is to be sure that our compliance programs around the world are what we want them to be. So just as we’ve done in the U.S., we’ve used an outside consultants as well as beefing up our internal team over the last few years.

So in specific answer to your question, as we continue to beef up our team internally, we think we will have less need for the outside consultants, which of course are pretty expensive. So we do believe that over time it will go down but certainly there will be a steady state of continued expenses in the compliance area, just as pretty much all companies in our industry have as well as many other industries. So yes, we do expect it to go down but we will have a significant spend in an ongoing fashion.

Jim Sidoti - Sidoti & Company

And then kind of leads into the second question. Can you talk about sales team? Were there any changes in the quarter and what direction you expect that to go in 2014?

David Petty

Yes, I’d be happy to talk about that. We have made a few changes in the fourth quarter, first quarter and even yet here in the current month. And those are all changes that we think are going to be good for the Company to get a higher level of focus in specific territories. I’ve mentioned that our new Vice President of Sales is very focused on the quality of the sales organization and specifically the ones doing the selling, the true selling. We have a lot of service people out there in the field but we want to increase the ratio of really good sales people that are out getting new business. He has also focused on increasing the number of sales people in the sales organization and I feel very, very good about the direction that we’re going with respect to improving the sales organization domestically.

Jim Sidoti - Sidoti & Company

And with the role at GPS, are you going to begin to build up a capital equipment sales force or will that be sold primarily by your knee and hip sales people?

David Petty

We already have hired one person, specifically with that coming from a major competitor selling navigation like capital equipment in orthopedics. And so we’re happy to have him on Board. And in addition to that, we do have experience in selling capital equipment on our sales management team at the regional Vice President level and also just with sales management internally at Exactech and we have invested in some refresher training courses to get those folks up to speed. So we’re supporting the capital equipment selling of the -- the field sales organization is identifying the targets and the getting along with our clinical sales specialist -- getting surgeons interested in Exactech GPS. And then we do have corporate teams that go in and articulate the value to the so called C-suites and the hospital customers for convincing them of the value of Exactech GSP in their respected institutions.

Operator

Thank you. The next question comes from the Bob Sullivan from Satuit Funds. Please proceed with your question.

Bob Sullivan - Satuit Funds

I hope you all can hear me well. So sometimes you’re kind of cutting in and out, but question for you and I’m rather new to the story, not quite sure if this is too relevant, but can you discuss or describe the volume of procedures that you’re seeing with your product? I can’t imagine there is a lot of inventory that’s kept at your customer base, but is there a way to kind of characterize the volume that you’ve seen in your products over the last year and maybe talk about what you think might be going on in volumes, maybe for the rest of the year?

David Petty

So, we think in terms of units and procedures and -- but I want to just clarify one thing that I understood you to say which is that you had an impression that we didn’t have a lot of inventory at our customer sites and in fact it’s quite the opposite to do a total hip or total knee or a shoulder replacement. There are many multiple dozens of components because we haven’t seen any. We have four sizes and those four sizes we have left and rights on the femoral component. And we have four components and with left and rights on the femoral components and then multiple sizes of each component. So you explore that all out and you have a lot of implants on hand in order to treat a single patient.

We also have instrumentation that’s specific to our implant designs in all three of those segments and those instruments must be on hand as well at the respected hospitals or locations where the procedures are done. And so that then, when you look at our numbers, you will see we have – we do carry a lot of inventory over the sales we have. It’s not unique to Exactech. That’s something that is common our industry. In terms of units, our units as I’ve said are up in all three of those segments I mentioned at least for this first quarter.

Operator

Thank you. Your next question is a follow-up from the line of Bill Plovanic from Canaccord Genuity. Please proceed with your question.

Unidentified Analyst

Just a few modeling questions. I wondered if you could breakout the impact of currency in the quarter and then also the impact of the med dev [ph] tax and that’s it.

David Petty

Okay. The constant currency did not move the needle in terms of the overall worldwide revenue. It was still 7%. It did impact international revenue and would have increased it from 6% to 7%. When we look at that by product group, the constant currency revenues on knee would been have up 1% and on hip would have been up 5%, and the others are as reported. And in terms of the impact of the medical device excise tax, pretty a consistent run rate with what we’ve experienced last year as the spend in the first quarter on the medical device tax was around $0.5 million.

Operator

(Operator Instructions). There are no further questions at this time. Please continue.

David Petty

Thank you, Alex, and thank you to everyone who participated in this call. We thank you for your continued interest in Exactech and we wish you a good rest of the day and week. Thank you for your interest in Exactech.

Operator

Thank you. This concludes the Exactech’s first quarter 2014 results conference call. Thank you for participating. You may now disconnect.

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