Exactech CEO Discusses Q3 2010 Results - Earnings Call Transcript

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

Exactech Inc. (NASDAQ:EXAC)

Q3 2010 Earnings Call

November 03, 2010 10:00 am ET

Executives

Bill Petty - Chairman, CEO

David Petty - President, Director

Jody Philips - CFO

Analysts

Jeff Johnson - Robert W. Baird

James Sidoti - Sidoti & Company

Robert Gold - Brigantine Advisors

Erica Selin - Noble Financial

Bill Plovanic - Canaccord

Jeff Johnson - Robert W. Baird

Operator

Ladies and Gentlemen Thank you for standing by and welcome to the Exactech Inc. third quarter 2010 earnings conference call. During today’s presentation all participants will be in a listen-only mode. Following the presentation the conference will be open for questions. (Operator Instructions). I would now like to turn the conference over to our host Bill Petty, company’s CEO. Please go ahead sir.

Bill Petty

Good morning from Exactech and thank you for joining us. This is Bill Petty and before we get into the discussion for this morning. I do want to do the disclaimer. This release contains various forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. They represent the company’s expectations or beliefs concerning future events of the company’s financial performance.

The 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, the effects of government regulations and other effects. Results actually achieved may differ materially from the expected results included in these statements.

Exactech revenue for the third quarter was 42 million, which is a 1% decrease compared to 42.4 million in the third quarter of 2009. Net income was 1.5 million compared to 2.7 million in Q3 of 2009 and this is a decrease of 46%. The 1.5 million represents $0.11 per diluted share compared to $0.21 in the same quarter last year.

Regarding specific product lines for the quarter our Knee implant revenue decreased in the quarter by 10% to 15.6 million, Extremity implant revenue grew 33% to 7.3 million. Hip implant revenue decreased 3% to 6.6 million. And Biologic and Spine revenue declined 3% to 6.3 million. Other product revenue slipped 1% to 6.2 million. Now I’m going to discuss the nine months performance.

For the first nine months of 2010, the overall company revenue was 138.7 million which is an increase of 8% over 129 million for the comparable period last year. Net income for the first nine months of 2010 was relatively flat decreasing 1% to 7.76 million or $0.59 per share compared to 7.83 million or $0.61 per share in the first nine months of 2009.

For the product breakdown for the first nine months, the knee implant revenue rose 2% to 55.9 million. Extremity implant revenue rose 31% to 21.5 million, hip revenue increased 2% to 20.5 million and Biologic and Spine revenues were flat at 20.5 million. Other product revenue rose 17% to 20.3 million. Certainly we had softness in several lines of our business and our performance was further exacerbated by the temporary negative impact of cost associated with entering into new markets and distribution channel change internationally. We do expect these investments to add positively to Exactech’s performance in 2011.

We are especially pleased with the continuing strong results from our Extremity’s business unit which increased over 30% for both the quarter and the first nine months. I’m now going to ask David to give a little more information about the relative performance of our domestic and international performance. David?

David Petty

For the third quarter we are pleased that domestic sales increased 6% to 31.9 million compared to 30.2 million in the prior year quarter while international sales were down to 10.2 million compared to 12.2 million in the same quarter last year. As a percent of sales international sales for the third quarter were 24% compared to 29% for the third quarter of last year.

And for the first nine months international sales were 30% of the total compared to 30% in 2009 for the first nine months and obviously with the decline in sales it’s evident that the international business has put some pressure on us in the current quarter and I just want to point and reiterate that we are very positive about the value the changes we are making will carry for us in the future. And then finally looking at the first nine months for domestic revenues, the sales are up 8% to 97.5 million compared to 90.2 million last year for the first nine months.

Now I would ask Jody Philips to make some comments on the details of the financial.

Jody Philips

Good morning everyone and thanks for joining us this morning. The third quarter financial results were below our original expectations for a number of reasons including the soft sales in a number of markets, the increase in our sales return allowance for international market transitions and higher than anticipate effective tax rate for the quarter. On the positive front, we expanded our gross margin percentage during the quarter to 67.4% from 64% primarily due to the mix of OUS versus US business and contributions from our global offices.

The domestic sales growth of 6% resulted in 76% of total sales versus 71% in the third quarter of last year and was a key factor in the increase in our gross margin percentage. As a result of this quarter’s performance at the gross margin level, we feel that we are on track to exceed our original 50 to 100 basis point gross margin improvement targets for 2010 and expect gross margin improvement of between 150 to 200 basis points for the full year.

The 11% increase in total operating expenses was consistent with our expectations and we continue to expect the 20 to 25% increase in sales and marketing expenses in the fourth quarter due to the start-off expenses in international operations.

G&A spending decreased by 12% to 3.9 million primarily due to the decrease in the compliance and the legal cost. The R&D expense increased during the quarter of 2% was below our plans but we expect these expenses to increase between 12 to 18% for the fourth quarter. Our total operating profit decreased 30% to 3.1 million and net income decreased 46% to 1.5 million or $0.11 per diluted EPS again primarily due to weaker than expected sales.

Two additional offsetting factors that impacted the P&L this quarter that are likely one time in nature as to their magnitude or the gain on foreign currency exchange and the effective income tax rate. The gain on currency exchange during the quarter of $850,000 was primarily due to accounts payable, denominated in US dollars that was owed by our global offices operating with euro as their functional currency.

We don’t expect the levels of these payables and currency fluctuations to be as material on a go forward basis. As to our effective tax rate for the quarter of 61%, this amount was significantly impacted by an increased valuation allowance on our deferred tax assets specifically related to the 2010 year-to-date net operating losses in our global offices that we could not determine with certainty that we would be able to realize.

To a large extent, we expect this fluctuation in the rate to be non-recurring and expect a rate of between 33 to 36% for the fourth quarter assuming that the research and development tax credit is reinstated in the fourth quarter. Our inventory total increased by approximately 5 million during the third quarter as we commenced significant international expansion primarily in the second half of the quarter. Our total credit line borrowing increased 8.1 million during the quarter as a result of the Silverbolt asset acquisition from VertiFlex and the inventory expansion.

Our accounts receivable decreased by $3.2 million during the third quarter and DSO calculated on year-to-date basis remained constant at 66 days. While there were significant expansion on the balance sheet during this last quarter, these changes were largely in line with our plans and expectations. As to our guidance we have adjusted the full year revenue range to 187 to 190 million which represents 6 to 7% top line growth for the full year and our revenue guidance for the fourth quarter of 48 to 51 million represents roughly flat revenues up to 6% increase.

From a net income standpoint we have updated our four GAAP guidance to $0.81 to $0.83 and released our fourth quarter guidance of GAAP diluted EPS of $0.22 to $0.24 assuming that the R&D credit is reinstated. The net income guidance for the fourth quarter is roughly flat and once again reflects the significant ramp up of expenses and distribution activities outside of the US. Those are our comments for the moment.

David Petty

Alicia we can open up for questions now.

Question-and-Answer Session

Operator

Thank you sir, ladies and gentlemen, we will now begin the question-and-answer session. (Operator Instructions). And our first question comes from the line of Jeff Johnson with Robert W. Baird.

Jeff Johnson - Robert W. Baird

David wondering if I could start with you please. I know you guys don’t always give a lot of detail on geographic breakout, but could you talk at least qualitatively and ideally with some numbers around US hip and knee performance versus international hip and knee performance?

David Petty

Sure, I'll just say that for the quarter, our domestic new performance was relatively flat basically. Units were flat there was very, very slight negative pressure on ASP. And for hip, domestically again relatively flat with units with a little bit more impact on price. We believe that because when we launched Novation Element in 2009 we were able to get good pricing, higher pricing with the launch of new technology and it’s just to sustain good pricing like that in that environment. So we’ve had a little bit of downward pressure on the domestic hip price.

Jeff Johnson - Robert W. Baird

And David has that pricing pressure accelerated just in the last quarter or is that something you have been facing for the last few quarters, any change?

David Petty

Well, for the knee it’s a huge change. Remember, we’ve been saying for about four quarters now while others have been experiencing ASP decline for a lot of reasons, we were holding our own. And I guess now here in the third quarter we are saying we had a little bit of impact on the knee and a little bit more impact on the hip for the reason that I have given.

So, we have reported I think now for at least three quarters that there is a lot of activity, meaning a lot of request at the local level and regional level for pricing, for discounts, et cetera, and I think I’ve reported that the sales administration here at Exactech has been very, very effective in maintaining our ASPs, but it’s a big battle and we are not immune to it. So, it had a little bit of an effect this quarter.

Jeff Johnson - Robert W. Baird

If the slope of that line turned a little bit south this quarter, do you expect that line to continue going in that direction or you think this was kind of a one-time step function and when we could hold at these levels over the next few quarters.

David Petty

If the thesis is correct about what happened with the launch of Novation Element, we would have to anniversary whenever we started having to take discounts on that spend to see that decline stabilize in hip. And with knee, the pressure is out there and we so far have been effective and I would characterize it as closer to flat than been a major impact on our number.

Jeff Johnson - Robert W. Baird

And Dr. Petty and Jody, a kind of bigger picture question if possible, you know as I look at your results still try to figure out kind of where the shortfall was. Obviously the Germany and Spain transition were one bucket softer or softening market trend were a bucket, maybe some slower uptake and maybe that’s not fair, but slower uptake on some new products was another. How would you qualify or quantify those three buckets where the shortfall fell into, to each of those.

David Petty

I think the biggest one and I would not limit it, and this is David by the way, sorry. I wouldn’t limit the first bucket the OUS transition to market. There are a lot of moving parts out there and there are other things going on. So I think the biggest impact on the current quarter which we were predicative about a year ago was the transition in our business outside the US. I think the second one is what you characterize as a softening of demand for elective procedure domestically. If we are flat with knee that puts pressure on it because it’s an important percent of our sales, and so those two things together I think has the biggest impact on Q3. The good news for us, the one that’s the biggest one is really an investment in our future.

Jeff Johnson - Robert W. Baird

And one last question, I’ll say Jody, but David that you can jump in here too, but Jody just on the costs on the international transition side and what have your F&M being up quite a bit this quarter and into Q4. Does cost structure stay elevated there or remind me how much of that elevated or heightened F&M spending over the Q3 and Q4 is kind of transitory in nature and falls out of the model as we go into 2011?

Jody Philips

Well, the cost structure stays there in terms of pure dollars. I think the key is hopefully if we get the sales uplift the differential between sales and marketing expense increased growth and the sales growth dissipate where it starts to remove pressure from the model.

Jeff Johnson - Robert W. Baird

So there is no real non-recurring cost in there, that weren’t Q3 or Q4 costs in there that had to be incurred just at their transition?

Jody Philips

There are not specific non-recurring costs in the operating expense line. There were some elements related to that sales returning allowance that I mentioned that in theory are non-recurring in nature.

Jeff Johnson - Robert W. Baird

And those hit where? I’m sorry.

Jody Philips

That’s at the top line.

Operator

Thank you. Our next question comes from the line of James Sidoti with Sidoti & Company. Please go ahead.

James Sidoti - Sidoti & Company

Can you just give us an update on what’s happening with the DOJ, I know right, I’m a little bearish, earlier in the quarter I expected you guys would be right behind them, obviously that hasn’t happened?

Bill Petty

Well Jim, this is Bill Petty. I guess I’ll answer the question. I’m embarrassed to answer it because I’ve said a year ago that we were near the end, and then speaking with our attorney, he said to me recently a number of times we are done, we are there, et cetera, but I’m reluctant to predict, we are still waiting on some final paperwork, whatever. That’s where we are.

James Sidoti - Sidoti & Company

So there is nothing that’s changed as far you know they would hold it up.

Bill Petty

No.

James Sidoti - Sidoti & Company

Any sense on how is the slowdown this quarter in the US compares to a couple of years ago when the recession hit?

David Petty

A double dip for orthopedics. Everybody is looking for a double dip. Actually I read that from, not you Jim, but from one of your colleague analyst that’s what they called it. Maybe it was Jeff who was just on the phone with us but someone used that term I read it last week.

James Sidoti - Sidoti & Company

Would you characterize that is about the same magnitude or is more severe than in 2008?

Bill Petty

You know the first dip was a severe problem for us and our domestic number was in Q2 of 2009. In Q3 of 2008 when we are saying we are flat in knees and slightly down in hips based on ASP meaning the units are still there. If the Q3 this year is better than what was a low point at least for our experience but again as I partly described overall market dynamics derived those from Exactech numbers because of our small market share. So and we are also sort of crossing our fingers and wondering what’s going to happen in the fourth quarter because we didn’t see a nice rebound in the fourth quarter what was perceived to be the so called pent-up demand of patients who did not show up in the first half of 2009 coming in fourth quarter of 2009. And we are not necessarily seeing that now.

James Sidoti - Sidoti & Company

It’s not unreasonable to think that maybe by the first or second quarter those patients will come back?

Bill Petty

I agree. If they come back on the same cycle that they came before, it would for first second quarter

James Sidoti - Sidoti & Company

2011?

Bill Petty

Yes sir.

Operator

Thank you, our next question comes from the line of Robert Gold with Brigantine Advisors.

Robert Gold - Brigantine Advisors

Just a quick question, you had given some color, coming late in the quarter post the quarter as it did with a lowered guidance, I was just wondering if you can comment on directionally throughout the quarter did you see a material drop off towards the later stages of Q3 in terms of demand trends.

Bill Petty

I think a better way to characterize it might be that certainly we saw the usual seasonal low and maybe the pickup in the early fall wasn’t as strong as we’ve seen in the past, that’s from Bill Petty. Jody?

Jody Philips

I would confirm that, I think our preannouncement theme late in the quarter was not reflective of when the pressure came. It was kind of consistent throughout the quarter.

Bill Petty

Was that consistent across categories and geographies?

Jody Philips

Largely yes, but so much categorically.

Jody Philips

Product wise remember we reported 33% growth with our extremities business. We had some other segments of our business that were quite positive and then as we’ve said a couple of times on this call, if the knees were flat domestically and with our OUS changes there was pressure specifically the knee outside the US. We brought some of that on ourselves with our changes outside the US.

Robert Gold - Brigantine Advisors

The 33% growth in extremity was in extremity was obviously very bullish, so within that category what are the dynamics you are seeing in terms of units and pricing.

Bill Petty

To grow at 33% we are growing units absolutely and I don’t have very specific details on ASPs. I know that ASPs for both primary and reverse shoulders at least in our experience over the last year and an half has come down. But I don’t know a perfect comparison quarter to quarter on those products from 2010 back to 2009.

Operator

Thank you our next question comes from the line of Erica Selin with Noble Financial

Erica Selin - Noble Financial

I have a question for you on the tax rate. I know that this year is a little bit unsettled. Do you have any guidance or direction whatever you can give us for next year so we can get a handle on this as best possible?

David Petty

I think let’s assume for a second the R&D credit will be reinstated like we have in our guidance. I think next year we would be back to that rate that we have been experiencing in prior years which is like 37 to 38%

Erica Selin - Noble Financial

Okay, very good to hear that it’s not a lasting change. Thank you very much.

Operator

Thank you. (Operator Instructions). And our next question comes from the line of Bill Plovanic with Canaccord. Please go ahead.

Bill Plovanic - Canaccord

Couple of questions here, you mentioned that returns from European distributor changes did impact the top line. Did you quantify what that impact was?

David Petty

We haven’t and we didn’t specify that it was turns from Europe, it was international in general.

Bill Plovanic - Canaccord

Can you provide quantification?

David Petty

It’s roughly 1.7 million during the quarter.

Bill Plovanic - Canaccord

Okay, would that equate on to the gross margin line as well?

Jody Philips

Absolutely because it shifted the OUS US mix so to the extent that OUS US mix moved as I referred Bill from 71 to 76% US, that is a factor on the gross margin percentage and there is two factors in the gross margin percentage. One, that pure mix plus the fact that some of our global office revenues continue to ramp up and those we're doing better on our gross margins in those market.

Bill Plovanic - Canaccord

Are there any more returns in the next couple of quarters we should be aware of?

Jody Philips

I mean it’s really tough to project this stuff. We think to a large extent the materiality of what happened in the third quarter was non recurring there can be amounts in the future but I think from a materiality standpoint that’s probably a little bit now hard.

Bill Plovanic - Canaccord

Is that from a distributor change you’ve made, what was the genesis of that?

Jody Philips

We don’t want to go into a lot of details that’s basically in different markets outside the US.

Bill Plovanic - Canaccord

And then to switch topics here, extremity was very strong. You continue to do a phenomenal job in that market segment. What is the driver today? You’ve launched several different kind of iterations of product, kind of what's kept that growth rate you reaccelerated your growth as we’ve gone into Q2. We're holding that in Q3, what is driving that now?

David Petty

It’s really just another chapter in the same story Bill, we’ve observed since we launched the Equinoxe primary shoulder and even a fracture system now five or six years ago. That we offered technology that gave surgeons advantages in the operating room and ultimately clinical advantages that are meaningful enough that we can move market share with the technology. So we developed momentum and got I think a little bit of ahead of our competition with the technology and so that’s why you'll note that we have a continued stream of new products coming out in the Equinoxe family of products because we feel like we are ahead of the curve and the name of the game here is to sustain that momentum is to stay ahead of the competition.

So, there is a modest contribution of some of the recent launches to the growth rate, but really it is the continued growth and market share which are reverse, which has now been out several years, that continues to improvise the bulk of that, but as we get into launching the platform fracture stem that we’ve just launched, the Proximal Fracture Plate the we are in process of launching and then in the first quarter of next year the CTA (inaudible) posterior augmented glenoid. This succession of new product will continue to help us sustain that momentum. We are not promising 33% growth forever, but on the other hand we think we are doing all the right things to sustain the momentum.

Bill Plovanic - Canaccord Adams

You haven’t promised the script before and you continue to hit, so congratulation on that.

David Petty

There was a time when it was 95 and there was a time when it was 76 and now it’s down 33.

Bill Plovanic - Canaccord Adams

And it is also your second largest business.

David Petty

It now is our second largest business and that’s wonderful. I think we are really making a good contribution to patients who have problems with the shoulder.

Bill Plovanic - Canaccord Adams

If you look at your international infrastructure at this point in time and you’ve taken a couple of areas direct Germany and Spain specifically, are there other geographies that you are targeting in the near term? Is this going to be a continued strategy where that becomes the strong direct footprint overseas?

David Petty

That’s a great question and I want to be clear about what we have done. The distributor model works well for Exactech and there is not an ongoing systematic effort to change to a direct model. We have been very careful and very opportunistic about when and where to look at a direct model when it makes strategic sense to our business whether that’s for another strategic reasons or whether that’s for improving the financial model. And so, to answer your question, almost certainly there will additional direct operations for Exactech outside the United States. But we will be chose the base on strategic considerations and when the timing makes sense. And I can tell you right now that with everything that we have on our plate for direct operations outside of the United States or model changes or distribution changes outside the United States. I don’t think it would be prudent for us to jump into another one in the near future.

Bill Plovanic - Canaccord Adams

And just remind me David, were you direct these days?

David Petty

We are direct in China, Japan, Canada, UK, Germany, France and Spain.

Operator

Thank you. Our next question is a follow-up from the line of Jeff Johnson with Robert W. Baird.

Jeff Johnson - Robert W. Baird

David, you started updating some of the shoulder expected launches here over the next quarter or two. It made me remember to ask a couple of other things. Are you still expecting 50 to 60% in the second half here on the PS Logic instrument side?

David Petty

Yes, we are.

Jeff Johnson - Robert W. Baird

And how would you qualify that launch at this point?

David Petty

I think it’s going well. It’s certainly making a positive impact on acquisition of new customers and we are putting instruments back on the shelf and now we need to match those up with target new customers and grow the business.

Jeff Johnson - Robert W. Baird

And I think you were talking about some line extensions on the Novation stem somewhere in Q4?

Bill Petty

Yes there was some larger sizes on the Novation tapered stem in the current quarter, still plan to launch the Novation Ceramic Crown cup for this quarter and then first quarter we’ve got (inaudible) domestic launch and a Novation Crown Cup line extension also in the first quarter. The LPI Prime, that’s a short stem. That actually I think may have slipped by the quarter from when we last reported.

We have the revision for this cup which we call it Intergrip which we will launch or pilot in the first quarter of 2011. And don’t forget that we also acquired the German hip assets back in April and throughout 2011 one of the things we will need to do with that is take advantage of opportunities outside the US with those products.

Jeff Johnson - Robert W. Baird

Okay, and on the LPI Prime the last update I had was the potential Q4 10 launch. When you say slip is that where would you think?

Bill Petty

Q1 2011, I’m sorry if I didn’t say that.

Jeff Johnson - Robert W. Baird

Q1 11 and did you guys launch a peek interbody cage I didn’t see you on there I don’t think and anything on the posterior cervical side?

Bill Petty

No, we didn’t but we are intending is a pedicle screw system and peek interbody in Q1 of 11 and then a posterior cervical system in Q2-Q3 of 2011. Those are the three in the pipeline and then of course we have the Silverbolt product that we acquired from VertiFlex during the third quarter.

Jeff Johnson - Robert W. Baird

There is not much integration if I remember right, that was just taken on the product itself?

Bill Petty

That’s right but I guess the point is between the third quarter of this year and the third quarter of next year is effectively four new product lines for our spine business which is what we have said we need to do in order to build a good sales force and start to drive the business.

Operator

Thank you. And as there are no further questions in the queue at this time I would like to turn the conference back to management for closing remarks.

Bill Petty

Thank you Alicia. We appreciate everybody joining me in this morning and your interest and I appreciate your continued confidence in Exactech. Thank you and have a great day. And Alicia would you stay on the phone for a moment?

Operator

Yes sir. Ladies and gentlemen this concludes the Exactech Inc. third quarter 2010 earnings conference call. Thank you for your participation, you may now disconnect.

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