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Merit Medical Systems, Inc. (NASDAQ:MMSI)

Q2 2014 Earnings Conference Call

July 29, 2014 05:00 PM ET

Executives

Fred Lampropoulos – President and CEO

Anne-Marie Wright - VP, Corporate Communications

Kent Stanger - CFO

Martin Stephens – EVP, Sales and Marketing

Greg Barnett - Chief Accounting Officer

Analysts

Mike Petusky - Noble Financial

Jayson Bedford - Raymond James

Tom Gunderson - Piper Jaffray

Jim Sidoti - Sidoti & Company

Chris Cooley - Stephens

Operator

Good day, ladies and gentlemen. Welcome to MMSI Second Quarter 2014 Earnings Conference.

At this time, I would like to turn hand things over to Mr. Fred Lampropoulos. Please go ahead, sir.

Fred Lampropoulos

Thank you. Good afternoon, ladies and gentlemen. We are broadcasting from a rainy and thundery Salt Lake City, this afternoon. We will start the meeting today by having Anne-Marie Wright, read our Safe Harbor provision. Anne-Marie?

Anne-Marie Wright

Thank you. During our discussion today, reference maybe made to projections, anticipated events or other information which is not purely historical. Please be aware that statements made in this call which are not purely historical maybe considered forward-looking statements.

We caution you that all forward-looking statements involve risks, unanticipated events and uncertainties that could cause our actual results to differ materially from those anticipated in such statements. Many of these risks are discussed in our annual report on Form 10-K and other reports and filings with the Securities and Exchange Commission available on our website.

Any forward-looking statements made in this call, are made only as of today's date and we do not assume obligation to update such statements.

Although, Merit's financial statements are prepared in accordance with accounting principles, which are generally accepted in the United States, GAAP, Merit's management believes that certain non-GAAP financial measures provide investors with useful information regarding the underlying business trends and performance of Merit's ongoing operations and can be useful for period-over-period comparisons of such operations.

The table included in our release and discussed on this call, sets forth supplemental financial data and corresponding reconciliations to GAAP financial statements.

Investors should consider these non-GAAP measures in addition to, not as a substitute for, financial reporting measures prepared in accordance with GAAP. These non-GAAP financial measures exclude some, but not all items that affect net income. Finally, these calculations may not be comparable with similarly titled measures of other companies.

Fred Lampropoulos

Thank you, Anne-Marie. Good afternoon, ladies and gentlemen.

Well, we are going to have an interesting conversation today. As you can read from our release this afternoon, we reported our earnings for the quarter as well as our revenues. Let me start out with the revenues first.

As you can see, our revenues were a record $248 million. That's an increase of 17% over the year ago quarter. Just a quick note, that the core growth was 15% and that difference is really which will be a quarter in which the [McKay] acquisition is included, will be included in the second quarter and the third quarter and then it will be apples-to-apples going forward in the fourth quarter.

I think you would all agree that that is an outstanding effort in terms of the revenue side of things. You will also note on the final part of our press release that we are increasing our revenues expectations and guidance from the $495 million to $498 million range up to $511 million to $515 million, a pretty substantial increase which then works out to be on an annual basis about 14% to 15% overall.

Now, you will also notice that that's a little bit lower than the first quarter, but you remember last year we had a stellar third and fourth quarter. We had very, very good numbers on the sales side last year. The good news of all of this, I recognize that today that there is a maybe substantial disappointment on the earnings side, but I think if you’ll indulge us for a few minutes, we will talk you through that.

The good news is we expect to see substantial growth going forward. The investments that we have made in distribution and our systems whether it would be in China and Brazil, India, Europe, Russia and so on so forth are paying off and they will continue to pay off I think big time, so we expect that as we look forward to the balance of this year and very candidly looking into the next couple of years, we are going to see growth that is going to be extraordinary.

You can compare it against other companies and come to your own conclusions on it, but we think that our product pipeline - we think that a number of products that have already been approved in Europe and that are just getting started there that we expect it will be approved in the United States later on this year or in the late third early four quarter really set the stage for a extraordinary year as well as going forward for the next couple of years.

A little bit later on, on the call today, we are going to talk to you about some new products and some really different things for the company that we have not had a discussion about nor are they in this particular press release, but we will talk a little about some other products that we think down the road are going to bring substantial opportunities to the company and are a little bit of a departure for Merit's business as you have known it in the past.

Now, let's go to the earnings side, because that's where most of you and where we are spending a lot of our attention in trying to look at the earnings. We missed, I think, the Street consensus by a $0.02, but maybe more importantly what we have done is, as we have looked at the business, there were a couple of events that are taking a little more time and a little more money than we expected.

Let me talk about the split of the sales force. I think we are getting exactly what we had hoped for. We are getting a deeper sell into our bag by getting more focused from our sales reps and that's part of what we invested in and what we had hoped for. I think at this particular point both of the domestic groups have exceeded our expectations. We had to have discussions that we would see this thing start to kick in to place about six months following the implementation, but we have seen it in the numbers that has taking place sooner than that.

That being said, the other side of that coin is the expenses associated with that and the subsidies, let me just very briefly explain the subsidies to you. What we have done is, when we split the sales force and split it along product lines, there were some areas where people had a full bag and now they were going to a substantially smaller bag, so what we did is we wanted to hold those individuals harmless and wanted to make sure that we were able to maintain the sales force.

I think short of one performance termination, we've essentially kept our entire sales force intact. I think when you go through a transition like this that's an extraordinary accomplishment. I do think however that there were some things that we underestimated and that is some of the travel, because now we have much larger sales territories and more expenses in those areas.

That being said, we are committed. We believe it was the right thing to do, we think you are seeing the results of that and we believe you will see that going forward, so we do not have any second thoughts on this although you will have this short-term - so about another - this thing kind of trails off over the next 18 months from here. We are in this first six months.

Kent, I am going to let you comment on that.

Kent Stanger

Yes. I would like to add to that that the sales increases with costs bumped up both for reasons of leveling it out and making it fair that Fred has mentioned in the travel and so forth, larger territories. We have also seen some increases in some of the bonuses and things that we are doing to incentivize them to focus them in the products we want and that focus is working, but most of it’s going to be fixed, so I believe there is leverage coming as the sales grow, it should grow faster than the SG&A costs associated with the split sales force. Although it doesn't look like it right now at the beginning I believe that's in the future.

Fred Lampropoulos

Again, the good news is, we are getting the result that we had hoped for. Now, let's talk about the gross margins going forward, which I think that's one of the areas that as a business we are concerned about.

As you know, if we were to go back 18 months to two years, we set out a plan to grow the gross margins from 41% [and add] [ph] 360 basis points and most that we have accomplished. The challenges in this market environment that we are faced with, we are seeing more expenses in the areas of freight, simply put, with national accounts, the various things that we signed up for and with our international operations we have seen higher costs in some of those areas which we are monitoring and evaluating, but we have seen some higher costs in those areas.

We see some price pressure. I think that anybody that's in the device area across the border are seeing more and more hospitals, more players looking and wanting to have discounts and lower prices and more competition, so we see some of that.

What we are not seeing is the leverage going forward on the gross margin side at least as it is presently constituted. By that, I mean, we have a lot of new products, they are very high-margin products, but whenever you are starting those projects up, you're going to have just the start up cost. The launch packages, the training and all expenses associated with that.

If we look at labor, we also had very, very, very tight labor market here, at least in Utah. Although interestingly enough, labor isn't the issue, it is in the overhead and in the sales price. Here is what we are doing.

First of all, as we have mentioned previously, we've essentially frozen hiring in our businesses, so other than replacements that we think are necessary with essentially frozen hiring and I think that will have an effect as we go forward.

The other that we are doing as we are asking our research and development and our marketing department, our sales department to be able to operate short of ancillary expenses associated with sales. In other words if they sell something there's a commission to be paid, but we are not going to expand our sales force beyond where it is. We have plenty. I wish we had more, but we are simply not going to do it.

We are not hiring more people and we are holding the budgets on the research and development side going forward to the same expanse dollars of this year, so even though we would expect and this is a ballpark number, that as we look forward to next year that we could see revenues grow. Again, this is just please will get you a formal forecasting the future, but let's just say it went up $50 million.

Generally, we would take about 8% of that 7% to 8% and we would allocate that for research and development expenses going forward as a percentage of sales.

Well, where we are today is that we are going to freeze and have in fact frozen research and development expenses in these other areas to their current spend levels, so other than the cost of insurance and commissions it is essentially going to be flat, so that is going to give us substantial opportunity going forward.

We thought it was time as we looked at situations with our buildings which Kent explained to you now and some of those issues that it would be important kind of reset the number, at the same time we are still very optimistic about the revenue numbers as you can see. I suppose the criticism will be great sales numbers why can't you leverage and Kent, I am going to let you comment little bit on some of the factors that are affecting that lack of leverage that we are getting and that we see for the rest of this year as we look at to the start up some of these other facilities and absorption levels please.

Kent Stanger

Starting with the cost of sales, Fred, you covered many of them. One of them you haven't mentioned is that the amount of capacity we have added recently and the overheads that go with that, so both here in Salt Lake as well as the Pearland Texas facility and Ireland and not very long ago we added new businesses over there that are startup still and they have facility cost to them and overheads that aren't being absorbed yet, so you have the necessity to absorb fixed overhead costs that we loaded into. That's slowing down.

As part of that, we have the transition we spoken of before where right now in the first and second quarter, we have had heavy load nearly $1 million a quarter of cost involved within that facility that isn't in product yet. I am talking about the new one in Pearland as well as it transitioning out of the Angleton.

Those have been the SG&A costs. They are going to transition to cost of sales and therefore they are going to add overheads to the cost of sales margins that we have been concerned about Fred was mentioning. As we look at that, we will get some help in the SG&A area, but the other areas that we were looking at has to do with just mostly the split sales force has to do with some of the increased cost like the 401(k) plan that we put back into place through all the departments, higher healthcare increases, the legal costs, now those will be suspended a little bit, because it's been delayed to…

Fred Lampropoulos

The trial is going to be in January, so we are going to be able to see those slowdown a little bit, but we had some of those increases that we are behind this or they are fixed, so we believe we can start moving it forward and leveraging it. It's just been a little delayed more than we expected. We underestimated some of those costs in the transition periods and how long it would take.

Let me go onto some of the newer products and talk about what effect we think they will have. We alluded and have talked previously that we have introduced a number of new products. One of the big successes that we believe that we will see, so I suppose maybe that's somewhat premature, but we have just launched our PreludeEASE is a hydrophilic Radial Sheath, which is used not only in radial procedures, but in thermal as well. This particular product in its first week, we were able to convert one of the largest accounts in Great Britain.

We believe that in the next week, we will convert another even larger account in Britain, just so that you know what these things mean. These two accounts could account for up to 20% to 25% of our existing capacity on the product line. That's how large they are. It's not approved in the United States at this point. This is the PreludeEASE, but we expect that by the end of the year, we would receive notice from the FDA, they have comments, we will respond back to them.

What I'm trying to say to you is, we have great products and great growth opportunities and this absorption that Kent is talking about of these facilities will take place, because we are going to see substantial growth in the products that have potential margins. We are also going to redirect our thinking in terms of how we compensate our sales force and what products. I think that sort of thing.

Even though we do that, to some extent it will be a greater emphasis going forward about making sure that the efforts of our sales force will be in the products in the areas where we simply can make more money, so there will be some re-strategizing of that particular of the current strategy.

We have great products and we have a great opportunity. We didn't have the growth my goodness, it would be a tough conversation, so I know many of you are impatient, some of you are saying while we have heard this story before and perhaps you have, but I think as we look at our business today and say we have to capacity, we don't have to make any major capital expenditures. We have this absorption as Kent pointed out Angleton, some start stuff in Ireland and very candidly still have the absorption of the new facilities we have here.

We are very optimistic about the future, so although we will have some disappointment for the near-term, let me assure you that we haven't given up. In fact, quite to the contrary, we believe, that this is great opportunity for the company to go forward.

Let me hit a couple of other points that I hope will be of interest to you. One of the things that we have done in our research and development is that we had been transitioning for company for some time. Remember, I say sometime over the last couple of years to take a look about where is this company going to be five years from now? We have also started and directed some research and development projects that are longer-term projects.

I am pleased to report to you today that Merit is developing a central venous, what we call a CVO stent. This is a vascular stent that is used in the upper extremities of these veins which are essentially destroyed or are malfunctioning due to various types of interventions. It comes from using pick lines, putting in central lines or putting in dialysis catheters and it is something that is a major problem and there is not currently a product on the market that we are aware of this approved for these types of procedures.

We started working on this about two years ago. We covered our spider project and it is a project that we believe they could generate $50 million $200 million a year in revenues. It's an exciting opportunity. Just this week, we finished our animal work in which we had results which were stellar. We had no information, we had full patency of these implementations and had great results, so now we will start moving down the road and this is a five-year project.

I announced it to you today so that you can see that as we view the future of the company, it's not a company that is necessary selling stopcocks and tubing kit. Although they will continue to be part of our business, Merit is still transitioning to what we believe are higher need, higher opportunity projects and I would also say, with that goes higher risk, because it has more effort and it has more regulatory scrutiny.

Another thing I think that's a highlight in it's just kind of getting started too and it will affect us positively is our embolic business.

Now, it if we take a look at various regions of the world and particularly Asia and Europe, we are just doing a great job. In fact, one of the challenges we are having is in some ways keeping up with the growth. We probably could have added another half to three quarters of $1 million of revenues if we could have shipped all the product that was on the order that we had hoped to ship for this quarter in the embolic business with higher margins and we are just simply out of our - I don't want to use the word struggling, because that's not maybe appropriately, but we are catching up. We have almost doubled our workforce in France to keep up with the capacity demand that is coming out of Japan and China coming out of the Middle East, coming out of Russia and other places for the demand for our embolic products which will have very high margin, but we have again had to hire and staff up to be able to meet that demand.

As you look at our business, there are a lot of positives on the side. Again, it depends on, I suppose, we can continue to talk about the disappointments on the earnings side. The issue of the containment of expenses is that the subject of topics here, programs are in place and there are more to come. We had, just before this call, we talked about more of the discretionary expenses and some of those things and will do more of that, so the bottom line is, we have a good business, we have a business that is growing and will continue to grow, but we have got to work through the next six months or so of absorption getting moved into the Texas facility.

I will say one other thing too, that I think that you can expect in the future, and that is we think that our consolidation of our facilities from 45th South, which is here in Utah to this facility was very positive and we would expect to look at how we can consolidate other facilities and to be able to get some financial advantage from that going forward, so it's a little too early to talk about that today, but it's on the horizon.

Another thing that we expect to do is to take a look at how we can expand our low-cost environment to be able to put more products in environment in which can lower cost, so there were a lot of things going on here, but we thought it would be appropriate and isn't it a paradox, isn't it interesting? We are sitting here raising this forecast by almost $15 million, yet we are not getting the financial performance, but I think if you look beyond where we are today, I hope you'll see where the opportunity lies and that's in this ability for us to be able to take and control these expenses and get the kinds of returns, so we probably haven't done that to this point, but I am not going to linger on it maybe longer.

I think it speaks for itself. Everybody in the room here and there are 40 people sitting here with me today, our staff, understand what we need to do, and I know you have heard it before. What we were saying that it's always darkest just before the storm. I think the strongest past, we have lot of work to do, but there's a lot of opportunity here, so Kent, you want to comment?

Kent Stanger

Yes. I do want to focus on a few things that I think are strength and momentum for the future, not only just the total revenue gains across - our international business is growing amazingly. We talked about China, although China is still 37%, the Europe is at 30% both, distributors and we have moved to what the month was 40% now as international 39% for the quarter is the ratio and a lot of the things that we are trying to focus on most are the ones growing the fastest.

If you look at the embolic, both the drug, QuadraSphere as well as the Embospheres are growing. That's some of our top product along with the radial projects, so we're seeing the things inflation devices have reinvigorated both from [iPhone] coming on stronger, but also our basics is reinvigorated too, so it's nice to see these higher-margin products starting to kick in or we would be having more problems with our gross margin, so the momentum in some of those areas is encouraging, the total revenues and so most of the stuff we are concerned about are pretty fixed, so I think there's a chance.

As we said, we predicted it all along in the year. It's just being a little slower. I think, we are saying still through the rest of the year we are going to see sequential momentum coming into the financial statements into our cash flows it bodes well for the future.

Fred Lampropoulos

Yes. I think as we look at the numbers, again, this is on an internal forecast, but sequentially the earnings go up quarter-by-quarter and they are sequential improvements in each, but there was a pretty high bar to reach in the second half of the year.

The programs are in place, so let me just finalized by summarize by saying that we expect to be in our Pearland facility and essentially fully buttoned up, but then a few little minor details by the 1st of September. That's significant.

It will cause a move from the SG&A into the cost of goods. SG&A will go down, cost of goods will be effective like that, but hopefully then again the volumes and the consolidation efficiencies of being there will start to come into effect.

Plenty of products, I think the good news is that even with our R&D flattening out in terms of this year's expenditures, we alluded we have everything we need, so there are no good no needs. We are full and we have a lot of new projects.

On acquisition side, we have absolutely no appetite for it. We are too busy with the things that we have. We don't see any need for it and we don't have any money to do it, so it kind of solves the problem all-in-one. It's not time to do those things until we get into a better position in the future, but we don't foresee any of those expenditures or disruptions.

I will say by the way that on the radial side, when we did the McKay deal last October, that it absolutely fit in perfectly and has been a fully integrated as I mentioned in my previous calls, seamlessly. The good news there is that as this PreludeEASE, this new project that this new Hydrophilic Sheath and comes onto the market worldwide, you are going to see that business improve business across the board.

On the revenue side, we see great things. On earning side, you will see sequential improvement. It just didn't move as quickly as we had hoped and thought it would and that's what we had report to you today.

I think, Kent, should you have any thoughts you want to add?

Kent Stanger

No.

Fred Lampropoulos

I think, we will go ahead and turn it back over to the operator and we will take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Mike Petusky, Noble Financial.

Mike Petusky - Noble Financial

Hey, good afternoon.

Fred Lampropoulos

Hi. How are you?

Mike Petusky - Noble Financial

Great. When you are talking about the split of the sales force and some of the incremental cost associated with that, is there any way you guys could quantify the subsidies, the travel, and the bonuses? I mean, what are we talking about either if you could break those out by those three different factors that you identified or in total anything that would help?

Fred Lampropoulos

Yes. Let me hit it and try to answer all those and let me explain it. When we talk about the subsidies, let's say, we had a sales guy that was making $200,000 a year and that salesperson was going to a division that had less products and there was a gap there.

What we've done and since we certainly didn't want to lose that salesperson and take the risk of hiring somebody else, we essentially said to them that you will make no less than what you made during that period and will do this and it will decline, so you are talking about $400,000 a year or so. Marty am I right? I am just talking about the…

Martin Stephens

350.

Fred Lampropoulos

Okay - or so that you would have that would be to make up for those. Then you would have the - we hired some additional salespeople. I think they were four and we added I think one or two clinical, so we hired about six people. The reason that we did that, there were some big gaps as we looked at these particular areas, so if you can take six people, I am going to just add two managers, so you are going to have maybe a total of eight people. I am just going to take a number fully burdened of a $200,000 just for the sake of the discussion and that's $1.6 million plus the $400,000, so now we are at about $2 million a year.

Then on top of that, since they have larger territories, you are going to have a bump up in the expenses to travel into those particular areas, so I would add probably another $200,000 to $300,000 a year of additional expense, so about $2.3 million to be able to put all of that in place and that will eventually - I mean, the subsidies will go away, the travel won't go away. I mean, they are still going to have travel to various locations and that sort of it.

Now, that being said, if you take a look at the sales side of it, the reward side, that's expense side, Mike, what you are seeing is and I should say just the beginning, so I think that's another really important point that from a sales point of view the ability to focus on and have less products in these various groups has already made a difference, but it's just getting started.

You have to remember, we are only six months into the year and some of these people are still learning and getting comfortable with the new products. Kent?

Kent Stanger

Yes. Part of that the sales in the U.S. direct group was up 13.2% in the second quarter. You know the history that's a lot of expansion that's an acceleration, it's 11% basically for the year-to-date, so it's definitely making. Part of that has to be part of the difference if not most of it that we are seeing better focus. And then when you drill down a lot of the products you are growing the most are the ones we want to focus on, so it's nice that way.

Fred Lampropoulos

Anyway, that was conscious decision simply because as we developed more products, our sales force through just kind of the natural way things are would focus on the new products, but there were a lot of really good products and some of them very technical. If you take a look at our Worley coronary sinus guides, if you take a look at our peritoneal dialysis catheters and those catheter systems, these are complicated products that take more time and more understanding and more clinical support. Those are some of the very same areas now that are growing the fastest along with embolics.

I mean, Kent makes a very good point. Selling and my concern it's a long answer, but when you look at these embolics, you're sitting in there in an account, Merit has three embolic products that can be sold. And a fourth one that's being developed as we speak that will release next year. It takes a lot of time to do these things. We just weren't getting the time that we needed we thought, to grow the business. Well, I don't think there's any question that we were correct in our assessment of these opportunities, so the answer to your question about those are the buckets. That's a ballpark, but about $2.4 million was the additional incremental cost.

It was higher than we though, it's a little bit higher than we actually had thought it would be initially, but that being said, we are also getting the sales results that we want.

Mike Petusky - Noble Financial

Okay, just a real quick follow-up on that. In terms of the subsidies then you seem to indicate that that would trail off, but does that go down on a quarter-by-quarter basis or that's just kind of go down at some point late '15.

Fred Lampropoulos

Yes. It goes down each year - a portion of it falls off. At the end of 2015, Marty, is it '15? When does it totally go away?

Martin Stephens

About the end of '15.

Fred Lampropoulos

About 18 months or so that subsidy will be gone totally.

Mike Petusky - Noble Financial

Okay. Then I just want to make sure I understand, so the R&D this quarter was on a dollar figure, I think, about $9.7 million. Are you guys essentially saying and maybe I am misunderstanding, but are you essentially saying that that dollars figure no matter what the sales do that dollar figure of $9.7 million, $9.8 million-ish roughly won't go up and so essentially next year the R&D will be $40 million or a little bit under $40 million. No matter what sales does, I mean, is that fair or I am…?

Fred Lampropoulos

That's correct except for two items. One will be if their healthcare increases, we don't know what that is we will be working on that, but let's say in the R&D department we had $250,000 worth of healthcare increases. That would be we would allow that expenditure to be there, but we are not going to out and spend more money, so you are short of a couple of little issues. I mean little. I am talking about $250,000 on a relatively large number.

Short of that, we are going to freeze R&D spending and it is not we’re going to. It is done. That has already the directive that's already in place as we speak. So as a percentage of sales you would see if we added again I’ll just use this as the example if you added $50 million worth of new revenues next year than what you would do is if we were to spend let's say 8%, that would be $4 million then what we will do is whatever that healthcare those costs which they can't control will give them allowance for that, but short of that that is their expenditures for the year.

Now, if I could just add, we still will release even with that slowdown, we will still release at least 10 new products next year or more, so it will not affect. We still have a huge pipeline of products and we will still essentially release the same amount of new products and enter some new markets. When I say new markets, within our call points, so yes, that is correct. So we will freeze that amount. It is currently frozen and it's in place as we speak today.

Mike Petusky - Noble Financial

Okay. Great. Just last one, Kent, what I am hearing you say on the gross margins, to me it sounds like gross margin could actually back up even a little bit more even though SG&A and R&D will be coming down as a percentage, but it sounds like gross margin could probably even come in a little bit further before maybe it firms up. I mean, is that a fair way to look at it?

Fred Lampropoulos

No. We are just saying it's not going to grow as fast as we had hoped. We think it's still going to improve sequentially it had some headwinds. For example Texas facility coming into cost of sales, but it's just we are not going to be able to what we hoped for this year in the second half of the year, because we have seen it slowdown in this quarter.

You are actually are internally modeling that slightly up in the third quarter, because to me...

Kent Stanger

Yes. We are thinking it can still grow sequentially, but just not a lot, so it is going to be ramped down from what the expectation in most of the models out there, so we are trying to manage those expectations and say you know even in spite of our increased sales and production levels we need to be conservative a little bit in what is gross margin potential side.

I think there is still some upside depending on how the product mix goes, how our overhead management levels are and so forth, but we are trying to be conservative. I wouldn't say these are interesting. It's the hardest part of our statements to forecast. There are so many moving parts to it that can vary, but we are seeing some momentum for example in our variances at least in the U.S. production facility, so we think we can start to see some improvement, but it is going to be slow.

Fred Lampropoulos

Based on our model, Kent - make sure those improves, I think 60 basis points for the next quarter - , so we would go about 60 basis points in the third quarter. Then just because we didn't want to get too far ahead of ourselves in terms of this another 20 basis points, so almost 100 or 80 basis points improvement for the balance.

Now, this is in addition, so this is why I think it's positive. Mike, we appreciate the question. This is even though the cost of Texas is currently in SG&A, it will move up into the gross margin side of things.

Mike Petusky - Noble Financial

That why I actually thought you would back up a little bit. That's where that questions was coming from.

Kent Stanger

Yes. We will see, there is some risk of it being slower like that, but because of the volume of sales we expect we think it's going to be absorbing overheads proving somewhat.

Mike Petusky - Noble Financial

All right. Great. Thanks, everyone. That's all for me. Thank you.

Fred Lampropoulos

All right. Thanks, Mike.

Operator

Next, we will hear from Jayson Bedford, Raymond James.

Jayson Bedford - Raymond James

Good evening. Can you hear me okay?

Fred Lampropoulos

We can Jayson. Thank you.

Jayson Bedford - Raymond James

Just, I guess, to tag on the last question on gross margin. I am little surprised you said that most of the growth is coming from higher-margin products yet the gross margin is coming down. I guess, a couple questions on that. One can just quantify the impact of price. Two, other redundant costs I guess meaningfully redundant costs associated with the Pearland facility and just a truck in product back and forth from Angleton to Pearland?

Fred Lampropoulos

Yes. I am going to let Kent comment on that. Go ahead, Kent.

Kent Stanger

Right now, not only are we having a lot of overhead like utilities and things duplicated around [clearance] of both locations that we can slowdown somewhat. We do have that transportation issue in packaging we had to hone back and forth. We had to buy a track we got people involved in it, so yes that's part of it. I think those are significant in the big picture the entire global operation it's still small bips, but it does defer, so we do have some upside by the fourth quarter of shedding some of those costs. That was what else did you?

Fred Lampropoulos

…question he had and it's a really good one and that's the issue is. We have commented that we are seeing growth in the embolics and comments in those areas and the question is why aren't we seeing more of response in our gross margins due to those.

Let me comment a little bit. I'll go to our European situation, particularly in France. As you know, Jayson, we received some approvals in China and approvals in Japan.

We have also by the way received approvals in some other key areas just recently, bit I am going to reserve comment on those. That the problem was essentially that business is doubled.

If we take a look at the amount more than doubled in terms of some of these areas, so we've had to staff up. Very candidly, it's been a little bit of a struggle for us and our French facility to be able to respond. That's just those are the facts.

We've had to send a substantial amount of folks from here and from Ireland and we decided to come to the rescue there, because they simply were not prepared to be able to that meet that demand and sell those expenses most costs in that training and again they were just simply ill-equipped and it's just something we missed.

We thought they could respond and they couldn't. To the extent that we could even ship off those products, I could say that we probably had a $0.05 million or three quarters of $1 million that we had orders for a month or two that we couldn't ship and we have more in the future, so the pipeline is full there, but we have to kind of reinforce quite a bit of effort in France to be able to meet that demand going forward, so we have the expenses. We couldn't ship all the product and that's just one of the issues.

However, I think that's a short-term issue. We have put the resources there and we expected that will smooth out. If not, I mean, there is still some issues out. I don't want to understate the issues there, because whenever you have to double your business, then we also had some problems with some vendors, so the vendors couldn't respond. That created a number of other issues. Kent, you want to answer?

Kent Stanger

Yes. I wanted to add some things to the question you asked about why isn't that enough to make some more of the different. We have seen some increases - our top growing product is our trays, which is lower margin. We haven't mentioned that. That dilutes it a little bit the other direction.

The other thing is that we are having some, I mentioned it in the collar, but we had some startup businesses in Ireland that are running negative variances both the pack business and the pack business, so we are received seeing those negative variances.

Pretty high for like say dragging that down a little bit, so about $900,000, so those are kind of countering, if you will, the benefits you referred to honor mix.

Fred Lampropoulos

To be a little more specific, we started up kit business and tray business that's been operating now just a little over year. It's a it's a business that we felt strategically to be able to meet needs for products in the Middle East and very candidly adjacent to be able to offset competitive pressures of people would replace our products that weren't in the kit or tray. That was we worked on for about a year our business segment and that's up in operating.

Incidentally it will do about $5 million or so worth of business this year and it's business that we think strategically and in Europe was necessary, but we have got that new building and we have got large clean rooms and areas and it's taking a portion of that but we have the overheads associated with that building. I think it's good to remember this, so you have Pearland, you have Salt Lake's facility that's only been up on and operating three -year.

You've got the facility in Maastricht in which we added warehouse space, so that we could accept this product, we were running out of space to be able to ship these products and that you have received this one, the Ireland, so we have all of these expenses at the same time the good news is, there are all there, they are in these numbers and we if we didn't have them we couldn't meet this demand and this opportunity that we see in front of us

We are not out there selling product at any price, we are out there with these expenses, but the news, Jayson, is that there's a lot demand for Merit products all over the world and it won't take us very long to absorb these up, particularly when we take a look at, you can just see what the numbers are this year.

Again, I don't want to get into forecasting for next year, but I would expect that we would see something either similar to what we see this year or more on a going forward. There is a lot of stuff out there and we kind of loaded up.

Jayson Bedford - Raymond James

Okay. Just a couple of other quick ones here, what was the U.S. direct sales in the quarter and I just wanted to be clear that these are sales generated by those 120 U.S. reps.

Fred Lampropoulos

That's correct. Kent?

Kent Stanger

For the three-month it was $59.1 million, so you want the quarter?

Fred Lampropoulos

Year-to-date.

Kent Stanger

Up 13% over 52 year ago.

Jayson Bedford - Raymond James

Okay. It seems like those reps are very productive?

Fred Lampropoulos

Yes. I think, Jayson, as we look at again I said this earlier, but if w look at the split and then take a look at both divisions and how we split it up, they are all operating well above their forecast, so they are beating the internal forecast that we had which leads us to believe that those products that weren't getting attention. In fact what, I think, this is fair, Marty, you will have to and Kent, I believe the interventional division as a percentage is actually outperforming the diagnostic, so the interventional these are snares, these are electrophysiology, this is embolics, this is peritoneal dialysis.

These are very complicated area is operating at 126% of forecast, so we are getting the result we want and get and I think we are doing it a little earlier, but again we have to understand that there is costs associated with getting that training up, getting these things going, but I am not disappointed in any way with the sales effort to me that these guys are out there doing a terrific job.

Kent Stanger

The only thing that - they actually exceeded our expectations as they sell more in the compensation they receive, so as part of that expense side. It's a tradeoff I guess you get for that, not only commissions, but there are bonuses. We didn't expect everyone to make them and that's what happening.

Jayson Bedford - Raymond James

It frankly just helps sort of understand the cost and it seems like that the cost of the business is not being weighed down by the sales force. I guess, just lastly for me and then I will drop. Just given the erosion in earnings, can you talk about the impact on your debt covenants?

Kent Stanger

Our ratio right now is 3.36 and is well below the 3.75 level, so good right now.

Jayson Bedford - Raymond James

Okay. I impact. All right. Thanks. I will get back in queue.

Kent Stanger

Okay. Thanks.

Operator

Next we will hear from Tom Gunderson, Piper Jaffray.

Fred Lampropoulos

Hey, Tom. How are you?

Tom Gunderson - Piper Jaffray

I am good. Thanks. Fred, you've been doing this longer than I have, so I want to get into some of the delta here. I think you captured the paradoxes. You called that with the higher revenues and the higher expenses, lower earnings, but if we look, you went through in quite a bit of detail on the first question with the subsidies and travel with larger territories, but it didn't hear anything - this is hindsight, but I didn't hear anything that wasn't unpredictable.

The subsidies you probably knew in late April when you were talking to us, the travel in a bigger territory seems obvious once you hear it. The gross margin on the variances pricing, pressure isn't that surprise to you from your customers. Maybe some freight thrown in there a little bit. The variances, I think, would have been mollified by the higher revenues.

Then also on the last question, I realize this is multi-level, but you get my basic question here. On the last question, you want your sales guys to be beat forecast, don't you? You don't want that to be - I would hope that if they all get paid bonuses then you make even more money to the bottom line than you expected, because you got so much higher revenue, so all that together with the short question is, what was the surprise in the last three months? What was something that fogged the visibility?

Fred Lampropoulos

I think it was the gross margins. If we take a look that was the area that was the biggest surprise to us is the costs, labor, materials and overhead, so we are seeing some inflationary cost in materials. There is some effect in some of this effectiveness, but I mean there are a lot of factors, but it was clearly in the gross margins.

There are some on that SG&A side too, you can talk about splitting the sales force and you can talk about that, but the reality of the travel and some of those things not think that you can clearly anticipate, because you can anticipate I think clearly enough, Tom, where they're going to go.

I will give you an hunting example. This is one of the interesting downsides to the split. I have talked about positives, we've got some territories they become so large that some people can't get and I want to disclose where they are, but let me just say that there's is two or three areas in which some people are covering three or four states.

We have not had that in the past, they are so busy in some areas and you would think that without offset expense, but we have got some holes and some various things, so I would say to answer your question there are some areas and clearly the gross margins some new things that we didn't that we had some national accounts and we saw some takeout for instance on products which give us the sales. You have got a 3%.

Then you've got to go and you are also on these national accounts you are providing shipping, so you get those higher costs, you get the higher costs. As Kent pointed out, we had growth in some of these areas. In fact they were still the fastest growing areas of the business, so I think I didn't anticipate or we didn't anticipate, because we all look at these numbers, we didn't anticipate some of those expenses and I don't think we anticipated the gross margins would be.

I thought they would be very candidly, I thought they would be 100 basis points higher, but they weren't. Kent?

Kent Stanger

Just on that point, I think we expected the travel expenses to go up, but they were almost twice the growth rate, nearly 45% 50% they are running at instead of the 25 we forecasted. It's not that huge, but it all adds up.

The other part of it is really it fits - over the gross margin issues. There is pricing in there and it's a mixed bag and worldwide effect on pricing issues and declines and some of the product lines are more impacted than others, so that's of course in fixed price [gross margins]

Tom Gunderson - Piper Jaffray

Got it. Thanks. Then I will ask what I think is a short question and that is on the embolics, where you could have sold more, but you didn't have it. Is that a capacity problem or you are going to have issues a year from selling 10%, 15% 20% more than you are selling now? How does that get resolved? Can you raise price?

Fred Lampropoulos

You always ask really good questions Tom. One of the things that we are doing in France is, in order to meet this demand and also a new product that's going to be coming online that's in research right now, but should rollout sometime in the May 1st [22nd] next year is in our facility in France in Roissy, what we've done is we have taken some additional space right next door to us, so we don't own those buildings. We lease those buildings, but in order to meet this demand there is two things we have done. We have taken additional space and we have added an additional sterilizer.

In order to meet the demand, we are having to put some more capacity in place to be able to be able to meet that demand, so you hit the nail right on the head. You can't do in same space. We have been and I think and how many square feet is it like? How big is that facility, Georgia?

Kent Stanger

19,000.

Fred Lampropoulos

We are 19,000 square feet and we are going to be adding I think another 10,000 square feet 15,000 square feet for the demand that we see coming forward.

One other thing I should say, I am going to be careful how I say this, but one of the most difficult areas to sell to in the world because of the very high standards are some of the Asian countries. That's another thing I think it has been.

As I said that a bunch of buys rolled in the [Rome], but about 80% of our product complaints come from about 5% of our sales and that's just a cultural issue. It's something that we've been dealing with in all medical device companies that are in certain Asian countries I have to deal.

One of the issues on the start up and we didn't address that, so I am glad you asked this question. I would say that our input and our re-work and all the work we put into getting up to those demands was substantial. I would say we put into it three times more effort than we would have. Of course the question is, why isn't all the products that way?

There's just some places that have higher requirements I mean to including a label, a box these are things, so I don't want to maybe over do this, but I will tell you it has been a struggle.

We have sent and hired some new production management, we have sent teams to support this and to be able to meet this demand. Maybe even more important question is, the demand is there and we expect it to continue to grow at you can see the numbers in here. We expect growth rates to continue at this or higher going forward in this business.

Tom Gunderson - Piper Jaffray

Got it. Thanks, guys.

Fred Lampropoulos

Tom, going back to anticipation, I don't know that we anticipated all that. I mean, as I mentioned during the call, we thought our guys can handle it and we had to send them in Calgary.

Tom Gunderson - Piper Jaffray

Thanks, Fred.

Fred Lampropoulos

Okay.

Operator

Next we will hear from Jim Sidoti, Sidoti & Company.

Jim Sidoti - Sidoti & Company

Good afternoon, Fred. Can you hear me?

Fred Lampropoulos

I can, Jim. It's good to hear your voice.

Jim Sidoti - Sidoti & Company

Great. If we go back about a year or maybe five quarters ago after comments that major customer you had a big cutback on selling expenses tradeshows and that kind of thing. Based on what we've heard today, should we assume that you have kind of reversed that and it's kind of full speed ahead with all those expenditures?

Fred Lampropoulos

No. I don't think you can. In fact, one of the things that we did Jim is that we pulled back the size of almost every one of our major shows. However, when we added the Thomas deal, there were a couple of shows that came on like Heart Rhythm Show and some of the other things that we felt that we needed to go to, to be able to show our products.

Incidentally, since you have asked, we have a another major product introduction that we expect in the late first quarter in this particular area, so this is a debate we are having and this debate is we have cut down dramatically on the people to go to these shows, the size of the (Inaudible) at these shows.

On a discretionary basis, these are things that we spent at least an hour today or longer talking about what shows do we go to, do we not go to these shows and there were so many things that happened, so I would say that from 18 months ago we are doing less in terms of size and people, but we are doing a couple of more shows, but let me give you an example of something we did this year at MD&M. This a big OEM meeting.

Normally, we would go to the tradeshow which is the Javits Center in New York. What we did this year is we met with our customers I am going to call like a rooftop type of social, not dinner but a social and it cut cost of that show by $150,000, and so we are looking at different ways to do things Jim that are less expensive, but still allow us to have visibility with our customers without maybe having those huge expenditures that you have by attending and having people on the floor shipping booth.

I think that was an example that I think of thinking out-of-the-box and it was very, very successful. I think, as we go forward, we will look at alternative ways that represents to be visible but to look at how do we take maybe a hospitality suite versus a booth or something like this so we still meet with customer, but we will still be on the floor the conventions, but that we would look at how we can cut costs and I think that's the best way to answer it. That's a real-life case of something that we did that cost dramatically.

Another thing, I will give another one since you brought it up. Next year, the decision is already made that we will not attend the PCR, so we are not going to go to the PCR Meeting in France next year. That's a $0.25 million that decision has already been made and we have cut that show, so I think that your comment is if we made it sound like it's full speed ahead and that we are back on and the answer is that's not the case whatsoever.

Jim Sidoti - Sidoti & Company

All right. Then you talked about the sales force quite a bit. I am not sure if you actually gave hard numbers. What was the headcount at the beginning of 2014 and where do you think it will be at the end of 2014?

Fred Lampropoulos

You are talk about the sales force?

Jim Sidoti - Sidoti & Company

Right. Direct sales.

Fred Lampropoulos

Okay. Marty, do you want to go ahead and -

Martin Stephens

Just in the U.S.?

Fred Lampropoulos

Just in the U.S. and then we will move…

Martin Stephens

There is only a difference, as Fred explained we had four reps, two managers, a clinical specialist and an IDN person, so we had what's that, eight or nine people could have been added over the end of last year.

Jim Sidoti - Sidoti & Company

Total number of…

Martin Stephens

It's about 125. That includes our clinical specialist, the managers and others.

Kent Stanger

42.

Jim Sidoti - Sidoti & Company

You had about 100?

Martin Stephens

Right, Jim.

Jim Sidoti - Sidoti & Company

Okay. It sounds like you went from around 150 at the beginning of the year and you will add another 125?

Kent Stanger

Give or take. Yes.

Jim Sidoti - Sidoti & Company

Okay. Outside the U.S., can you just give us some rough numbers on where you started.

Kent Stanger

Yes. I can give you exact numbers. For the six months, for positions in sales and marketing, national accounts, customer service that's China everywhere in the world is 42 people increase 11% in accounts 380 to 422 and that's a worldwide number of your a lot of people in Brazil, there is people in, China there's people in Russia, there is people in the Middle East, Turkey and Australia, we added one person in Australia. Yes.

Jim Sidoti - Sidoti & Company

All right, that includes 225 people in the U.S.

Fred Lampropoulos

That includes the extra 10 or so, yes. That's a 422 obviously, includes everybody including U.S. people. The 42 increase includes the once Marty has been talking about yes.

Jim Sidoti - Sidoti & Company

Okay.

Fred Lampropoulos

Just as a point of interest though if I could, when we are talking about adding let's say somebody in China, you would be talking about the cost that's probably I must say a third or 25% don't yet be about $50,000 a year versus let's say so in the U.S. at about $200,000 a year, so I think that's important to note and that's where - how many people did had there, Kent?

Kent Stanger

I think, we have had is four or five sales people.

Fred Lampropoulos

Okay. We added four or five sales people…

Jim Sidoti - Sidoti & Company

Yes. Those sales people three more in Hong Kong, one in (Inaudible) one in Australia…

Fred Lampropoulos

On the international side, we have added 9 or 10, so this would be Asia. Again, now remember these are areas that are growing at 36% and that sort of thing so at a much lower cost than you would see if you added the U.S.

One of the thing I think Marty pointed out, Marty Stephens our VP sales, US and marketing is that we added IDN guy. One of the things that these are small selling groups. We have a national accounts group here, Jim, in which we're calling more on administration and that sort of thing. We have added how many people, so we have added people to that three people there in the U.S. to support the sales force.

By the way, that's another reason we get sales growth is because we have people that negotiate these contracts with hospital's best-selling groups or buying groups.

Jim Sidoti - Sidoti & Company

Okay. Then can you just touch a little bit about what you are you are targeting for cash flow for this year and maybe next? How long you think it will be before you cannot pay down a significant portion of the debt?

Fred Lampropoulos

Well, we did $21 million just historically now for cash flow from operations and we actually had positive cash flow we haven't for while $1.4 million. That has now accelerated somewhat as our earnings increased as we forecasted, so I don't have a '15 number for it off the top of my head but we should see some increases in the cash flow from operations and that I will direct us to paying down debt then we need to accomplished both, the EBITDA ratio for earnings to debt.

Kent Stanger

…to have any flexibility and opportunity in the future, It's something that we know we need to do and we will. I think their point, Jim, is that sort or some of the smaller profits we don't really have other than maintenance and bringing on new products and stuff like we don't have any major projects ongoing that we have had in the last three-four years.

Jim Sidoti - Sidoti & Company

Okay. The expansion in France , is that relatively materials?

Fred Lampropoulos

Yes. It's a lease. It's a lease, so it is immaterial. Yes.

Jim Sidoti - Sidoti & Company

Okay. All right. Thank you.

Fred Lampropoulos

Okay. Thank you, Jim.

Operator

The next question is Chris Cooley, Stephens.

Fred Lampropoulos

Chris, good afternoon.

Chris Cooley - Stephens

Hello. Can you guys hear me okay?

Fred Lampropoulos

Yes. We can hear you fine. Go ahead.

Chris Cooley - Stephens

I apologize I am traveling today. Just two quick ones for me at this point the call. I apologize, but could you go back over the sequential gross margin expansion that you expect in second year of the year. Secondly, you talked about the changes to the sales force compensation structure. Just a little bit curious there, when that will be implemented? I realize that they actually have their guarantees here that trail off over the next 18 months, but help me think about when the new sales comp system goes into play.

Then one other quick question, sort of housekeeping item, just in terms of the pricing pressure that you saw during the quarter, was it across the board or were there select products that really kind of (Inaudible). Thanks a lot.

Fred Lampropoulos

Chris, let me answer the first one pricing pressure. Interestingly enough, on some of our products like some of our snares and some of those products, we actually saw the average sales price go up.

Where we see the most pressure are actually in the lower-margin products. Interestingly enough, if you take a look at kits and you take a look at some of those kinds of areas, areas where people can compete with you, those are the areas where we are seeing most the price pressure. Gregg is that a fair statement or you want to add to that?

Greg Barnett

Inflation devices were pretty high in catheters.

Fred Lampropoulos

Okay. In catheters, but basically in those areas and I don't have a number, but as Kent pointed out earlier, our inflation device business is growing at the highest levels we have seen in years, so that's doing fine.

On the gross margins, I will let Kent address that one. Kent, go ahead.

Kent Stanger

Yes. We're just talking about 0.5%, may be growth in the next quarter total of 80 bips we are hoping sequentially when you look at it by quarters. Average is somewhere in the upper 43s 43.7 something like is that what you want to know?

Chris Cooley - Stephens

Yes. Thank you.

Fred Lampropoulos

Okay. Then let me go to the issue of the sales force. This is a little bit, as you can imagine a little sensitive, but I think I will frame it this way. First of all, we wouldn't do anything this year in the middle of the sales year. We have programs out there, we have the incentives. We do all those things are in place and we don't think it's wise to ever switch people in the middle of the year and change the rules, so what I will say is that going forward. I'm and I'm actually very pleased to say this, I think what we will look at is how to better align the interest of the company and the sales force, so that it's just not about sales numbers. It's about something in which we make money, the sales guys make money.

We have to better align the interests of the company and the sales force to get the result that we want, so that's the best way to say that. I think that's what everybody wants to do is align the interests, so that both parties. It's not just a matter of how many dollars you can add and what your commission is. It is how many dollars that you can add to that benefits of the company and the salesperson, so I think philosophically it's very easy to say that and that's what we need to do and we need to do a better job of it than we have done in the past.

I think that's the best way to answer that one is that that realignment will be done to make sure that our interests are aligned and that there are more factors in that compensation that the benefits of the company, so essence of it is we want to incent those higher-margin products, those higher things that give us a better benefit and not just going in terms of sales dollars themselves. I mean, I think that's what every company wants to do.

At the same time, the good news, Chris, is we have the products and we have the things to do that. I think with the split that we have put in place at the beginning of the year, we get we get the opportunity because people can spend more time and have better training and we put more support to support those sales.

As I mentioned, PD catheters and in CMR area when you're taking a look at that coronary guides and things like that, those things are complicated products. Kent, you want to add?

Kent Stanger

I just wanted to clarify answering question that is a GAAP basis by the way, Chris.

Chris Cooley - Stephens

Can you repeat that?

Kent Stanger

I don't want confusion on that.

Fred Lampropoulos

Those GAAP numbers and gross margins are GAAP and non-GAAP…

Kent Stanger

Non-GAAP are roughly 2% higher.

Chris Cooley - Stephens

Okay. Got it. Thank you very much.

Fred Lampropoulos

Okay. Thanks, Chris.

Operator

At this time, there are no further questions. I will hand the conference back over for any additional or closing remarks.

Fred Lampropoulos

Well, ladies and gentlemen, we certainly appreciate indulging us and taking the time to ask, what I think were great questions. Kent and I will be here for the next hour or so to take your questions or clarify other things that you may need.

We again appreciate you take the time to visit with us today and we will then now signoff from Salt Lake City, wishing you all a very good evening. Good night.

Operator

Ladies and gentlemen, that does conclude today's conference. Thank you all for your participation.

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Source: Merit Medical Systems' (MMSI) CEO Fred Lampropoulos on Q2 2014 Results - Earnings Call Transcript
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