Exactech CEO Discusses Q1 2011 Results - Earnings Call Transcript

May. 4.11 | About: Exactech, Inc. (EXAC)

Exactech, Inc. (NASDAQ:EXAC)

Q1 2011 Earnings Call

May 4, 2011 10:00 am ET

Executives

William Petty, M.D. – Chairman and Chief Executive Officer

Joel C. Phillips, CPA – Chief Financial Officer

David W. Petty – President

Analysts

William Plovanic – Canaccord Capital

James Terwilliger – Duncan Williams

James Sidoti – Sidoti & Company

Jason Bednar – Robert W. Baird

Operator

Good day, ladies and gentlemen, thank you for standing by. Welcome to the Exactech Incorporated First Quarter 2011 Earnings Conference Call. During today’s presentation, all parties will be in a listen-only mode. Following the presentation, the conference will be opened for questions. (Operator Instructions)

I would now like to turn the conference over to our host Mr. Dr. Bill Petty. Please go ahead, sir.

William Petty, M.D.

Thank you, Christina, and good moment to everyone. We apologize that we’re a couple of minutes late. We just still had people dialing in and wanted to be sure everyone was on the call. I will begin the conference call with 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 Act of 1934. They represent the company’s expectations or beliefs concerning future events in the company’s financial performance. These forward-looking statements are further qualified by important factors that could cause actual results to differ materially from those in the forward-looking statements. These factors include the effect of competitive pricing, the company’s dependence on the ability of third-party manufacturers to produce components on a basis, which is cost-effective to the company, market acceptance of the company’s products and potential effects of government regulation. Results actually achieved may differ materially from the expected results included in our statements in our discussion.

For the first quarter of 2011, Exactech had revenue of $53.4 million. That represents an increase of 9% over $49.1 million in the same quarter of 2010. Net income in 2011 was $3 million, which is $0.22 per diluted share and that’s compared to $3.3 million or $0.25 per share in Q1 of 2010. If we exclude the pre-tax expenses of $1.3 million, compliance and monitoring related to the Exactech settlement with government reached in December 2010, our net income would be $3.8 million or $0.28 per share for Q1 of 2011.

A little more detail on segment performance, our knee implant revenue was up 2% to $21.3 million. Extremity implant revenue increased 33% to $9.4 million. Hip implant revenue rose 21% to $8 million. Biologic and spine revenue was actually down from $7.4million to $7 million. Our other revenue which as you may remember includes our Cement business was $7.5 million, which is an increase of 6% from $7.1 million last year.

Sales in our largest product segment Knee implant maybe a reasonable result compared to overall industry growth in Knee replacement, it is not acceptable for Exactech and we are working to improve it further. We are pleased with the continued industry leading growth in our Extremity segment and the robust growth in Hip implant revenues.

Our internationals revenue rose from $16.3 million in 2010 to $18.4 million in the first quarter of 2011. This is an increase of 13% and results and approximately 34% of our overall revenues coming from the international market. Our U.S. sales were up 7% to $35 million compared to $32.8 million in the first quarter of 2010.

After those summary introductions, I'm going to turn it over to Jody Phillips, who will give us some more detail about the financial operational results. Jody?

Joel C. Phillips

Good morning, everyone, and thanks for joining us for the first quarter 2011 conference call. Our first quarter sale result was slightly ahead of our expectations, primarily due to Shoulder and Hip sales performance and the strength in our international revenue.

Our gross margin percentage expansion during the first quarter to 68.7% from 64% was consistent with our estimate and we expect the gross margins to remain in this range for the balance of 2011. The key driver for this increase in gross margin is the transition to direct sales operations in a few select markets that we’ve been discussing for the past year. This gross margin expansion is offset by the significant increase in operating expenses of the direct selling model which is the primary driver behind 31% increase in sales and marketing cost for the quarter. As we progressed through the balance of 2011 these year-over-year increases will be lower as the cost of operating the direct models begin to annualize.

As was referenced in the release, the primary driver behind the 28% increase in G&A expenses was $1.3 million in compliance cost which reflected $1.1 million increase versus the same cost in the first quarter of 2010. At this time, we are maintaining our estimate of $5 million in compliance cost for 2011. Although, again, we caution that this is a very rough estimate that can have significant variability.

R&D expenditures decreased to 5% during the quarter, I would not read too much into that number as we expect R&D spending to increase in the balance of the year and be in the neighborhood of 7.5% of sales as compared to 6.5% that we experienced in the first quarter.

Another item that reflected a significant increase is the depreciation and amortization cost of $3.4 million, which was a 42% increase. Going forward, we expect that number to increase from this $3.4 million as a base total likely in the neighborhood of around $100,000 per quarter. The large increases that we experienced in the D&A line during the first quarter are a function of the significant instrument deployment that we experienced in 2010 and through the first quarter of 2011 specifically related to our direct sales initiatives outside the U.S. and our new product rollout in the United States.

As a result of these operating activities, our operating profit dropped to $4 million from $5.6 million in the first quarter of 2010. Again the large driver in this decrease was the $1.1 million increase in compliance expenses, as well as the cost associated with the direct selling operations. As we progress through the balance of 2011, the difficult comparative from this operating model transition should decrease.

In summary, while these have been some significant investment to manage from a quarterly financial comparison perspective, we feel like we are making substantial progress in these markets and we will be well positioned for the future.

In the other income and expense area, the most notable item was the $0.50 million foreign exchange gain, which was primarily related to payables from our global offices that were denominated in U.S. dollars and related to the euro appreciation relative to the U.S. dollar.

Our effective tax rate for the first quarter was 31% as it was positively impacted by the reinstatement of R&D credit as well as the impact of our O-U.S. sales and marketing restructuring that commenced on January 3 of 2011. Going forward to the balance of the year we are projecting a 32% to 34% effective tax rate for the remaining quarters in 2011.

As a result of the first quarter activity and changes that I’ve highlighted above, we have elected to maintain both our sales and our EPS guidance for the full year. From a balance sheet perspective, we increased our inventory levels by $3 million and our credit line borrowing by $5 million during the quarter, which was largely consistent with our expectations.

As we stated at the beginning of the year, we expect modest increases in inventory and the credit line through the second quarter of 2011 and expect to turn cash flow positive in the second half of the year.

Those are the prepared comments that I have at this time and again thanks for joining us.

William Petty M.D.

Christina, we’re ready for questions.

Question-and-Answer Session

Operator

Ladies and gentlemen, at this time we’ll begin the question-and-answer session. (Operator Instructions) And our first question comes from the line of Bill Plovanic with Canaccord Capital. Please go ahead.

William Plovanic – Canaccord Capital

Great. Thank you, good morning.

David W. Petty

Good morning, Bill.

William Petty, M.D.

Hi, Bill.

William Plovanic – Canaccord Capital

First of all, congratulations on a solid quarter, nice to see the revenue momentum. And on that topic just we watched the U.S. numbers come in and you had a pretty good U.S. number. I was wondering if you could characterize kind of the Knee and Hip business, what you’re seeing with surgeons and backlog, and just on your outlook on the domestic operations going forward?

David W. Petty

Okay. Bill, it’s David. We, I guess, I would say in general the Knee market is maybe a little softer. Currently a little bit softer based on what our competitors have reported, little softer than we anticipated. And in that environment that would mean then just looking at the market in general that our existing customer base in Knees is probably down slightly or very flat on a comparative basis. And so the good news for Exactech is that we are adding new customers and we believe we’ll continue to add new customers in Knees on a prospective basis. And with the products that we’ve launched, as well as our focus on the sales force development, we're confident that we can continue to add customers to our new base.

The question then become what is going to happen with the existing customer base and when will patients return in greater numbers through our existing customer base, and that's hard for us to predict. The Hip on the other hand were performed better. We are working on a smaller base. It’s hard for us to understand, on a relative basis, customers or patients are more reluctant to come in for Knee surgery rather than the Hip surgery. I don't know how to answer that question. But there is certainly a difference in our experience. And again, we do have product launches throughout the year in Hip business and we do feel good about the prospects for growth with Hip going forward. Our uncertainty about the market itself, notwithstanding.

William Plovanic – Canaccord Capital

Okay. And then, thank you, that’s helpful. And then in the Spine and Biologics business, the weakness I know you group it together, but is the weakness more on the Biologics side or the Spine implant side and kind of…

David W. Petty

It is, Bill, what I mentioned this that the confidence shows us – the Spine business is actually showing robust growth but it's on a very small base. And so the bigger piece of that number is Biologics which is down. Recall that last year, first quarter of 2010, we had I think a very strong growth in by biologics. And so we have all tough comps for the first quarter in the Biologics piece of that business. But that truth is we lost a few customers, most of them related to distribution channel changes, but may be system competitive pressure. And so we’re very aware of it and very focused on helping the sales organization turnaround that biologics performance prospectively.

William Plovanic – Canaccord Capital

And then lastly, I'll get back in the queue. You made some changes internationally, just kind of where are we in that process with traction being gained by those reps. Is that – are we are starting to see the beginning of that? And then is that something that will accelerate through the year or you would fall the full production at this point. How would you characterize it? Thank you.

David W. Petty

So, I would characterize it as about that we are more or less on plan. And of course you are talking about Spain and Germany which we’ve talked about in these conference calls throughout the year, last year. If we look at our top six dollar growth producers outside the U.S., Spain and Germany are both on that list. So what that means is we’re making progress on the top line. But of course we’ve made investments and hired a bunch of people. So we haven't delivered on the bottom line yet on those two opportunities and certainly that’s something we need to focus on throughout the course of this year.

William Plovanic – Canaccord Capital

Great. Thank you.

David W. Petty

Thank you, Bill.

Operator

Thank you. And our next question comes from the line of James Terwilliger with Duncan Williams. Please go ahead.

James Terwilliger – Duncan Williams

Hi, guys. Thanks.

David W. Petty

Good morning.

James Terwilliger – Duncan Williams

My first question is on the Hip growth. When I look at your competitors, I know you’re dealing with smaller number but you had about 20% this quarter, 20% last quarter. What are the drivers? What are the drivers in this environment behind this type of 20% growth in your Hip business? I know you did an acquisition in Germany, is it a metal on metal issue? Is it a U.S. versus International issue? Just could you provide additional information on what's driving this significant growth in the Hip business?

David W. Petty

Sure. This is David again. We’ve announced in the second half of last year that we had clearance for one of our key products in the Hip segment in Japan. And so we had the benefit of having that product available for the full first quarter and the number was supported significantly by growth in Japan. We’ve a little bit of meaningful Hip growth in a few other international markets. And so certainly international help drive that very high growth rate, but we also are going at a good rate domestically and still benefiting from the effects of having launched some good new products in 2010.

James Terwilliger – Duncan Williams

Okay. And then my next question you kind of alluded to already. How are things going in Japan for you? I know you went direct, and I know you had a terrible tragedy, so again how is your Japanese operations doing? What’s going on over there?

William Petty M.D.

Actually we feel good about it. Of course the crisis has been a major impact in Japan in general. We did better than we expected during the first quarter in Japan, in general. And we continue to observe that our business is holding up well. So we are cautiously optimistic that Japan will still deliver both important top line growth as well as bottom line growth for Exactech throughout the course of this year.

James Terwilliger – Duncan Williams

Okay, great. And then the last question, I wondered if you could talk on the Extremity business about the recent launch of the shoulder fracture system and what that means for Exactech as a company out in the field?

William Petty M.D.

So, at the very highest level that product line is – the revenue contributions of that product line is baked into our guidance, and it’s a product that we plan to launch this year. It does give us the ability to prevent competitive salespeople from being in the operating room for certain indication because without that fracture plate a surgeon might go into a operative case with a particular intention to treat the patient. When we didn't have it they had to have a competitive rep available or perhaps they would not even call us. And now, we have a much more suite offerings that give us the ability to box the competition out a little bit more effectively.

I would also point out that we believe we’ve been growing so well with shoulders for a number of years now because we’re ahead of what I call the technology. We’ve provided a better product and primarily Total Shoulder Arthroplasty, Reverse Total Shoulder Arthroplasty and also fracture treatment for patients with (inaudible) fracture. And this plate will help us stay ahead of the curve, the technology curve and sustain our momentum in our Shoulder business.

James Terwilliger – Duncan Williams

Great, thanks for taking my questions, and congratulations on a nice quarter. Thanks guys.

William Petty M.D.

Thank you.

Operator

(Operator Instructions) And our next question comes from the line of James Sidoti with Sidoti & Company. Please go ahead.

James Sidoti – Sidoti & Company

Good morning, can you hear me?

William Petty M.D.

Yes, Jim. Loud and clear.

James Sidoti – Sidoti & Company

Great. Now Joel, you mentioned that the depreciation and amortization is going to pick up because of the increase in instruments that you have out there, is that primarily knees?

Joel C. Phillips CPA

It's a combination of knees as far as the largest piece but there is also been Hip and Extremity set deployment in some of these International markets and as well as the U.S. So it's a combination of all. Knee is the largest segment. It’s probably pro rata to the sales mix.

James Sidoti – Sidoti & Company

Okay. I mean is that what you think helps get the knee growth back on track is getting these instruments sets out there?

Joel C. Phillips CPA

It certainly should lead to knee growth at some point in time. The international market transitionary we have to deploy a lot of these assets as you know. And with the transition in sales in that market, we haven’t necessarily benefited from a large sales increase as of yet. And that wasn't our plan. So we do think in the coming quarters we certainly deploy enough net assets to expect higher sales growth in Knee.

William Petty M.D.

Jim, this is Bill Petty speaking. If it is true that the per surgeon number of knees cases is down or soft and way for us to provide business obviously in this environment is to add new Knee customers. We believe we have the inventories of implants and instruments available to make that happen.

James Sidoti – Sidoti & Company

Great. And Joel, can you just repeat what you said about the tax rate for the rest of the year?

Joel C. Phillips CPA

Basically, we are projecting 32% to 34% for the second to the fourth quarter.

James Sidoti – Sidoti & Company

Okay. Great. All right. Thank you.

Joel C. Phillips CPA

No problem.

Operator

Thank you. And our next question comes from the line of Jason Bednar with Robert W. Baird. Please go ahead.

Jason Bednar – Robert W. Baird

Good morning, guys.

William Petty M.D.

Good morning.

Jason Bednar – Robert W. Baird

Most of my questions has already been answered. So I guess I will start with some of the line items, which seem to add a few pennies based on our model. Just wondering how we should be thinking about some of these items for the rest of 2011 considering the benefit you have in Q1 particularly as it relates to FX gains?

Joel C. Phillips CPA

Hi, Jason, it’s Jody. Clearly, your guess is as good as mine in terms of what the euro versus the dollar is going to do in coming quarters. We did kind of anticipate in our guidance a couple of hundred thousand dollars benefit from the current to over a couple hundred thousand dollars higher than we expected. But that's the number that could continue to be positive if the euro appreciate. At some point we may consider some hedging strategy to lock it in. But at this point it certainly a function of the euro to U.S. dollar exchange rate. That's kind of tough for us. Your guess is good as good as mine I guess.

Jason Bednar – Robert W. Baird

Okay. That’s helpful. Then kind of building on (inaudible) question, considering the currency has moved favor at the top line given the benefits in the lower tax rate you just mentioned. Just assume that the operating outlook today may not be as high as it was may be coming out of last quarter. I guess I’m just trying to figure out if anything may have changed this last quarter?

Joel C. Phillips CPA

I don’t think anything has moved too much. You know we did kind of project of the $5 million in compliance spend, a little bit of that was planted towards the first half of the year. So that is a contributing factor. And also there are a number of kind of start up expenses that we’re still incurring in some of those direct market transition while the sales growth is not where we expect it to be by the end of the year, we were still incurring those costs. But I think some of our operating margin targets are still in tact at this point.

Jason Bednar – Robert W. Baird

Thanks for that Jody. And the last couple of question from me, first one, if you can provide what the currency impact at the top line was in the quarter? And then just hope you can provide an update on kind of where your pipeline stands today?

William Petty M.D.

Got you. The currency impact on the top line was very negligible. I think it was no more than a 0.5% in terms of growth. There were a couple of offsets in there that compares to what happened with the euro, so it wasn’t significant enough that we felt to breakout in this quarter. And then I will let David comment on the pipeline.

David W. Petty

Okay, as far as the pipeline goes starting with Knee, we continue with the ongoing launch of our Logic, PS and CR Slope knee products. We have a new logic fit to Optetrak that had a pilot launched in the first quarter and we will commence a launch in the second quarter and beyond. We have the new Logic PS Tibial insert that we’ll pilot in the current quarter and launch in the fourth. We have the Optetrak Logics Total Knee System that we’ll pilot in the third quarter and launch in the first quarter of 2012. And we also have Logic RBK Knee System that we’ll pilot in third quarter and launch in the fourth, and Logic’s PRC Tibial Inserts which we’ll launch in the first half of 2012.

For Hip, the Novation Tapered line extension is ongoing. The Novation Crown Cup ceramic is available outside the U.S. and potentially depending on regulatory pathways and (inaudible) in U.S. We have ongoing launches at the (inaudible) and Crown Cup line extension.

Our LPI prime project is currently on hold as it relates to FDA clearance. Provision for us at the tabular system we will have a pilot launch in the third quarter of this year. We are just starting to launch the German products that we acquired last year in limited international markets. And then we have a couple of more projects launched in the first quarter of next year.

For the Shoulder pilot release of the Proximal Fracture Plate is just concluded. We are going into full launch as I discussed earlier. Pilot release CTA Femoral heads in the third quarter was launched in the fourth (inaudible) augment Equinoxe Glenoids piloting now with the launch in the third quarter. And the pilot release of reverse shoulder line extensions in the second quarter and for launch in the fourth.

And then there is another project that sort of subject to FDA which I won’t mention right now. And we do have a bone graft delivery system and biologic launching in the second half of this year. And in the Spine division, pedicle screw system launching in the second quarter under the trade name Proliant. The Octane PEEK cervical interbody system that’s is pending 510k clearance. The Gibralt posterior cervical system will initiate launch in the third quarter and the Proliant (inaudible) system in Q1 of 2012.

William Petty M.D.

That’s all we have Jason.

Jason Bednar – Robert W. Baird

Thanks a lot. Thank you, and perfect. Thanks, guys. That's all I have.

Operator

(Operator Instructions) I am showing no further audio questions at this time, I’ll now turn the call back over to management for any closing remarks you may have.

William Petty M.D.

Thank you, Christiana, and thanks to all of you for joining in. We appreciate your interest in Exactech and we hope to reward that interest. Have a great day. Bye-bye.

Operator

Ladies and gentlemen, this does conclude our conference call for today. You may now disconnect.

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