Exactech's (EXAC) CEO David Petty on Q4 2015 Results - Earnings Call Transcript

| About: Exactech, Inc. (EXAC)

Exactech Inc. (NASDAQ:EXAC)

Q4 2015 Earnings Conference Call

February 17, 2016 10:00 AM ET

Executives

David Petty - Chief Executive Officer

Jody Phillips - Chief Financial Officer

Analysts

Jeff Johnson - Robert Baird

Jim Sidoti - Sidoti & Company

Mark Landy - Northland Capital Markets

Jennie Tsai - Gabelli & Company

Operator

Good day ladies and gentlemen. Welcome to the Exactech Fourth Quarter Year End 2015 Results Conference Call. Today's call is being recorded. At this time, I’d like to turn the conference over to Mr. David Petty, Chief Executive Officer. Please go ahead sir.

David Petty

Good morning, everyone and welcome to our Q4 and full year results conference call. I will first, as always, begin with the disclosure statement and then we will move right into the business of the call.

This release contains various forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, which represent the Company's expectations or beliefs concerning future events of the Company's financial performance.

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

So I am here today with Jody Phillips and as usual, we will each make some prepared remarks and then we will open it for questions and normally, we have with us Executive Chairman and Founder, Bill Petty, but he will not be with us today because he is on an airplane flying to a medical education event to do some customer work on behalf of Exactech. So we will certainly have him back next time and Petty is meeting with customers.

Now I am going to continue with my remarks and then turn it over to Jody Phillips.

Revenue for 2015 decreased 3% to $241.8 million from $248.4 million in 2014. This was a 1% constant currency increase. Diluted earnings per share for the year was $1.04 based on net income of $14.8 million, representing a 10% decrease compared to net income of $16.5 million or $1.18 diluted earnings per share during 2014.

I will now highlight 2015 full year and fourth quarter performance by segment. Extremity implant revenue increased 7% to $84.4 million, up 8% in constant currency. Knee implant revenue decreased 10% to $70.9 million, down 6% in constant currency. Hip implant revenue decreased 2% to $42.7 million, a 3% constant currency increase. Biologics and spine revenues decreased 5% to $22.6 million, a 1% constant currency decrease. Other revenues decreased 9% to $21.3 million, down 7% in constant currency.

Revenue was $62.7 million for the fourth quarter of 2014, down 1% from $63.3 million for Q4 of 2014 and up 1% in constant currency. We were pleased with the domestic sales increase of 7% for the quarter.

Net income was down 19% to $4.1 million at $0.29 per diluted share, versus $5.1 million, or $0.36 per diluted share.

The fourth quarter segment revenues were as follows: Extremity implant revenue increased 5% to $22.9 million, up 6% in constant currency, Knee implant revenue decreased 4% to $18.2 million, down 1% in constant currency, Hip implant revenue decreased 4% to $10.8 million, down 1% in constant currency, Biologics and spine revenues decreased 3% to $5.9 million, flat in constant currency and Other revenues decreased 6% to $4.9 million, down 3% in constant currency.

In 2015, we invested in new product launches and also sales channel development. In the fourth quarter, domestic sales were modestly supported by pilot launches of revision, hip, knee and shoulder systems. These products will progressively contribute to revenue throughout 2016 as we transition from pilot to full launches for each during the four quarters of this year.

New sales teams resulting from our focus on domestic channel, development contributed meaningfully to good domestic sales growth in Q4 of 2015 and that’s in our knee, hip and shoulder product lines. Conversely, we had a difficult year in our OUS business because of the strong dollar. We expect that pressure to subside in 2016 on a prior period comparative basis. Last month, we executed the acquisition of our Australian distributor which gives us nine directly owned sales and marketing distribution companies outside the US.

2015 U.S. sales were up 2% to $168.1 million. International sales decreased 11% in 2015 to $73.7 million and were down 1% on a constant currency basis. For the fourth quarter of 2015, U.S. sales were up 7% to $44.9 million, and International sales decreased 17% to $17.9 million and decreased 10% in constant currency.

We expect our strong product pipeline and an improved sales force to produce revenue and bottom-line growth in 2016. Specifically, our revision knee, the humeral reconstruction prosthesis and advanced bearing ceramic gemisphere for reverse shoulder arthroplasty, a total ankle product, a revision hip stem as well as two new GPS applications will contribute to our results this year. We continue to make improvements to the sales channel and feel very positive about 2016.

Now I would like to turn it over to our Chief Financial Officer, Jody Phillips to make some additional prepared remarks and then we’ll take questions.

Jody Phillips

Thank you, David. Good morning, everyone and thank you for joining us for the fourth quarter and full year 2015 conference call. I will spend some time recapping the fourth quarter and full year 2015 performance and then give some background behind our 2016 guidance.

In order to review our full year operating performance, I will make specific comments about the major operating lines from a percent of sales perspective and comment on the full year where additional explanation is necessary.

Our fourth quarter gross margin percentage remained relatively flat at 70% during the fourth quarter of 2015. This can be attributed to a higher mix of U.S. business at higher margins, as compared to the fourth quarter of 2014, which was offset by consistent pricing pressure that we are experiencing on large joints.

This is pretty much the same story when we look at the full year of 2015 where the U.S. mix being at a higher growth rate than outside the U.S. business that carries higher margin, again, continued to offset consistent pricing decreases that we are experiencing.

During 2016, we are expecting gross margins to decrease between 20 to 50 basis points assuming that manufacturing cost reductions and the distribution model changes in Australia will offset ASP decreases.

During the fourth quarter, our operating expenses increased approximately 2% of sales to 61% of total sales, primarily due to U.S. sales organization expansion cost and increased R&D expenses.

For the full year, total operating expenses increased by roughly 1% to 60% of total sales. Again, there was significant expansion in our U.S. sales organization cost during the full year and that was somewhat offset by reduced outside the U.S. expenses as a result of currency changes.

During 2016, we are targeting to deliver 50 to 100 basis points of leverage through the operational expense line, largely through sales and marketing and G&A cost management. We expect the following operational expense elements during 2016: sales and marketing expenses, we expect to increase between 3% to 5% and range from 35% to 36% of sales.

G&A expenses, we expect to be between relatively flat and a 2% increase and range from 8% to 9% of sales and R&D expenses, we expect to increase between 6% to 8% and range from 7% to 8% of total sales.

Back to 2015 and the fourth quarter specifically, in the other income and expense section, there were a number of moving parts during the fourth quarter. We incurred approximately $380,000 in charges associated with a termination of our previous credit facility and unwinding of an interest rate swap.

That was an item that we did not planned for and anticipate coming into the quarter, but we are happy to have a new facility in place that gives us long-term flexibility.

Also, there was a $269,000 in foreign currency losses related to the movement of currency during the quarter. Those are two items that we did not particularly anticipate and that were not factored into our fourth quarter guidance.

During the fourth quarter, the R&D tax credit was reinstated for the full year of 2015 and resulted in a 21% effective tax rate for the quarter. The third quarter year-to-date catch-up element of this reinstatement reduced fourth quarter tax expense by roughly $450,000 and positively impacted earnings by roughly $0.03 per share.

Our 2015 full year effective tax rate was 27.4%, versus 31.7% in 2014 and this improvement was primarily due to capturing the tax benefit of historical losses in Spain due to increased profitability in that region.

As you guys know, the research and development tax credit has been permanently renewed. So our anticipated tax rate for 2016 is approximately 30%.

In summary, for 2015, from a P&L perspective, we had a difficult year on the top and bottom-line, most specifically due to the currency impacts which evaporated $8.1 million in sales in U.S. dollar terms.

As compared to earlier in the year, the fourth quarter largely ended up within our expectations as it was the last quarter of significant currency headwinds given where rates are today and we turned the corner with the momentum in U.S. sales that David has already referenced.

From a balance sheet perspective, we delivered solid performance by reducing our debt, net of cash during the year by approximately $10 million. The upgrade of our syndicated credit facility that already referenced to $150 million in capacity gives us great flexibility and will be something that we will use from time-to-time to execute upon the stock buyback that we announced in December.

Our full year accounts receivable DSO decreased to 77 days, as compared to 80 for the full year of 2014 and this was primarily due to improved terms in the Spanish marketplace.

Our total inventory levels increased by $3.5 million during the year as we commenced our new revision product launches, although we expect that increase more significant during 2016 as we transition to full launch of these major revision launch.

Our 2016 revenue guidance of $248 million to $256 million represents 3% to 6% top-line growth. The diluted EPS guidance of $1.12 to $1.18 implies 8% to 14% growth in net income.

Our first quarter revenue guidance of $62 million to $65 million represents a 1% to 6% increase in the top-line and this is expected to result in first quarter diluted GAAP EPS ranging from between $0.28 to $0.30 per diluted share.

So this is all about prepared comments that I have at this time. And again, thank you for joining us and we look forward to your questions.

David Petty

Thank you, Jody. So we are ready to open it up for questions.

Question-and-Answer Session

Operator

[Operator Instructions] We’ll go first to Jeff Johnson with Robert Baird.

Jeff Johnson

Thank you. Good morning guys. Hey, David, maybe I can start with you. Just on the revision launches, I guess, just trying to figure out, it sounds like you are going to kind of move from pilot to full launch at the end of this year. Kind of what’s the time lag from getting these implanted kind of in the September, October time period of 2015 and moving from pilot to full launch at the end of 2016? What’s kind of that 12 to 15 month gap? Is that just building instrument sets and what have you?

David Petty

I think the gap is in – maybe how I communicated, because what we are doing is, progressively building up sets and rolling them out. So we are still and what we will call pilot in terms of inventory availability on the knee and the hip and we are continuing to build more sets and we’ve seen nothing from a clinical efficacy perspective that would have a pause or slowdown. So, it’s really a matter of the time it will take and sort of just managing the asset deployment from a physical perspective to get those systems out into the U.S. market. It will likely be into 2017 before we’ll be ramping up outside the U.S. So, that’s for the hip and the knee. So it’s happening faster than somehow you interpret it from what I said and for the humeral reconstruction prosthesis, we will be and what we will call a full launch mode sooner, simply because that prosthesis is used relatively less frequently than revision hips and knees and therefore you don’t need as much inventory to serve out of a loaner bank or broader potential customer base.

Jeff Johnson

All right. That’s helpful. And then, Jody, as I think about those revision systems ramping throughout this year and looking at your 3% to 6% revenue guidance and with what you did in the fourth quarter, is it fair to think about, I know you don’t guide by geography, but the U.S. kind of be in the - above that 3% to 6% range, maybe up or single to low double-digits and then the OUS business kind of staying in the low single-digit to flattish or can both of them grow inline to above kind of that range you’ve thrown out there?

Jody Phillips

I think we are probably in a situation now where both could grow in that range that we put out there. 2015 was quite, a challenge on the OUS front due to the currency situation. As you know where we are today that’s no longer a headwind and then it could even turnout to be a little bit of a tailwind. So I think there is equal opportunity for the two markets to grow at the top-line growth rates that we put out there.

Jeff Johnson

Okay, that’s helpful. And then, just last question from me, it’s more on modeling, I guess than anything. Jody, when you guys took the R&D tax credit out of guidance a couple quarters ago given the uncertainty that existed back then for 2015, I thought you quantified it at $0.05 to $0.06. It sounds like, when it went back and you are quantifying it $0.03, I just want to reconcile kind of a difference there and then as I think about 2016, obviously, the R&D tax credit won’t be a year-over-year tailwind, but it does help the 2016 number, because it probably, it wasn’t in my model anyway for 2016 either. But on the med tech tax, I think you guys sit on almost a year of inventory, so fair to think about that not really having much of an impact in 2016 and that being more of a 2017 and 2018 benefit on the two year moratorium there?

Jody Phillips

Sure, let me start with the last part of your question. First, you are exactly correct and I didn’t mention that in my comments, but the medical device tax has been factored into inventory and so there is probably roughly a year of that in inventory currently. So we are not anticipating any benefit in 2016 at this time from the moratorium and that should accrue to us in 2017 and 2018. And back to the questions on the R&D tax credit. You are correct, we did say that it was roughly 5% or 6% and I believe that was in the fourth quarter guidance when we took it out. It did turn out to be less than what we expected. The number that I referenced there in my prepared comments was the catch-up impact. So, it’s roughly a four penny total impact. The third quarter or the year-to-date catch-up of that was three pennies in the quarter. And really what moved as compared to our guidance was those items in the non-operating area specifically. The cost associated with the termination of the previous credit facility. So, if you try to do a bridge to our guidance, I think you will see we are kind of right there at that top-end.

Jeff Johnson

Yes, thanks. Go ahead, David. I am sorry.

David Petty

Just to follow-up, because you asked a question about U.S., and OUS revenues specifically around guidance and I agree with what Jody said, but I also want to make a point that we feel very good about what we’ve done with the US sales force and the new product launches and we feel confident about the U.S. sales today.

Jeff Johnson

Fair enough. All right. I think I’ll just leave it there. Thanks guys.

David Petty

Appreciated.

Operator

And we will continue on to Jim Sidoti with Sidoti & Company.

Jim Sidoti

Good morning. Can you hear me?

David Petty

Yes, sir. Good morning, Jim.

Jim Sidoti

Great. So just to follow it up on the U.S. sales force, I think it was the first quarter last year, you’ve pointed out that you would add some pretty material turnover or upgrades to the U.S. sales force and that some of those reps that you had brought on had agreements with their previous employers and they weren’t able to market in their normal territories. Has that situation now expired? Are these guys now back into normal territories by doing what they normally do?

David Petty

Generally speaking, yes, we then made more changes subsequent to that time period and so there are others that are perhaps subject to some obligations that obviously we all honor. So, yes, we are expecting to see real contributions from some of the ones that we put on that we were talking about in the second quarter of last year. And we’ve made additional changes and one thing that we’ve been happy about is that, that first round we did we lost couple million dollars in revenue. And the ones that we have done since we brought it up on a call in the second quarter, we’ve been more methodical and more careful about the process and therefore we’ve made what we think are very positive changes without losing sales. And so that’s also going to help us in 2016.

Jim Sidoti

Okay then, just, Jody, have you bought back any shares from the stock buyback program you announced few weeks ago?

Jody Phillips

So, we will put the specifics in our filing I believe at the end of the first quarter. But one way to think of that is, we approved 1 million total in shares over a two year period. And just one way to think of that is, we are probably going to target to do somewhere between 100,000 to 150,000 shares per quarter depending on the pricing and we did execute on some activity so far in the first quarter.

Jim Sidoti

All right. Thank you.

Operator

Thank you. Our next question comes from Mark Landy with Northland Capital Markets.

Mark Landy

Good morning guys and thank you for taking my questions.

David Petty

Hi Mark.

Mark Landy

Good morning guys. Just perhaps looking and taking a step back and just looking at the business over a decade or so, specifically focusing on the operating margins, you’ve done a really good job of growing revenues if I go back to – if we go back to 2003 to around $70 million, in 2007, call it $125 million. But the operating margin has kind of gone in the opposite direction from the mid-teens down into the single-digits and not kind of bouncing around the 9.5% to 10.5% range. What do you need to do to be able to start marching that forward on a regular basis? Is your scale just too small right now and is that the costs are higher relative to what they used to be if they stuff in the business that you can look at that you can consistently grow that operating margin? How should one try and get the arms around this?

David Petty

Good question, Mark, there is a long story there over that ten years, a number of different things transpired between 2008 and 2012, we made some major expansions in Europe and other markets where we took a hit at the operating margin line to put us in a better position long-term. And so that was kind of expected. So that is one of the reason for the ups and downs during that period. We endured the financial crisis during that period as you know. And then, really in 2012 to 2014, I think, we did a pretty good job of delivering on the 50 to 100 basis points of operating margin that we targeted and we felt like we were on track with that program. And then, the currency challenges hit us last year. So, I think you are bringing up a good point. We are certainly committed to expand that operating margin by 50 to 100 basis points per year and that continues to be in our targets. We didn’t do that last year. We got hit a little bit by pricing and currency more so than we expected. But, given where we are today, the pricing environment, what we are doing to reduce our cost, if we hit these type of top-line growth rates that we are projecting, we are confident we can deliver that margin and feel that there is not any structural reasons that we cannot deliver that type of operating margin expansion over the long-term.

Mark Landy

Okay. So, just a couple of follow-on questions on that: should one think more about the operating margin as a function of top-line growth versus the ability to manage the P&L or is that unfair?

Jody Phillips

It is, I think, you are on to something there. We say, when we can grow in that mid-single-digit area, we can deliver the operating margin expansion that we have targeted and I think we did that in 2013 and 2014 and in last year, when we regressed primarily due to the currency that was not reasonable for us to do. So, it’s kind of contingent on being at least to that mid single-digit type growth rate and then we can deliver that operating margin expansion.

Mark Landy

Okay, so then just, I know this is a tough one, putting on binoculars in the queue forward, but, just looking at the rearview mirror in 2015, and then looking at the 2016 guidance, I mean, obviously some of the benefit that you get from the med tech tax in 2017 and 2018, is it probably fair to assume that perhaps 2015, perhaps represented a lot of points and that’s the expectation should be that all things being equal, this should be that solid kind of pick up in growth of that 50% to 100% going – 100 basis points going forward?

Jody Phillips

So, I agree with the first thing you said, and we are glad that 2015 is in the rearview mirror, because it was challenging. Some of it was – where things that we couldn’t control. During that time, we continued to make investments in products and channel in spite of the financial pressure and we did that for the purpose of getting a strong future. And so, we – knowing that we’ve done that, and we feel good about those things and we see positive results from those things that that does give us optimism about 2016.

Mark Landy

Okay. The last question, sorry for beating the dead horse, if I look at the growth - of the driver of revenue growth, how much of that driver will be based on, kind of economic condition global markets, et cetera versus how much can you drive internally with the new products that you are bringing to market? So I know there each plays a little bit of the other. But I am trying to get a sense of can we bank on a decent amount of growth coming from the new products than the product portfolio that’s hitting the market, because you would be working on that? Or is it more related towards the global environment, which obviously nobody really has a good control of it?

Jody Phillips

So, I don’t – we are certainly not counting on any huge improvement, I would say, in the global environment. We are counting on no further meltdowns outside the U.S. And certainly, a significant part of our growth is based on new products, but we’ve got significant market and penetration expectation activities with the products that we have currently as well and have launched over the last two or three years.

David Petty

Meaning that we can take those products that are already on the market and put them into an expanding channel and that gives us some real opportunity and then when you add on top of that, the new products that you are specifically asking about, particularly in the U.S. market with the revision system, then that’s just additional potential for us.

Mark Landy

Bit if I want to get a little bit more granular, that if the global environment continues to struggle flatly, given what you have put in place with the expansion of the sales force and the products that are going through that sales force and to come through that sales force, do you think that you will be able to make-up from that global weakness with what you have in place, currently organically?

David Petty

To the extent that that happens, that would be a mitigating strategy. Though – we – as Jody said earlier, we – the way we are thinking about it is and that’s why there is a range in the top-line growth is, after our experience in 2015, we are not going to expect high single-digit growth outside the U.S. and yet, that potential to be mid single-digits outside the U.S. is there, but, reticent to declare that that will happen.

Mark Landy

Okay, thanks for your patience on that topic guys. I appreciate it. That’s all I had.

David Petty

We appreciate your questions.

Operator

Thank you. [Operator Instructions] We will go to Jennie Tsai with Gabelli & Company.

Jennie Tsai

Hi, guys. Thanks for taking my questions.

David Petty

Hey, Jennie.

Jennie Tsai

Hi. It’s good to see your knee franchise stable in the fourth quarter. I just wanted to make sure that it, it was primarily due to revision and maybe GPS, just new products in general and just better sales force execution?

David Petty

So, yes, the – particularly, the revision knee was a little short in the arm, but that, I think was the minimum that we can expect from that product line, because that was the first quarter it was available. We didn’t have a lot of inventory. So, probably the sales force expansion was a more meaningful contributor to the nice knee numbers that we experienced in the fourth quarter domestically.

Jennie Tsai

Okay, great. And you also mentioned that, FX shouldn’t be that strong of a headwind this year, but just wanted to make sure, what – do you expect any impact on EPS with FX in 2016?

Jody Phillips

With where rates are currently today, we do not.

Jennie Tsai

Okay.

Jody Phillips

We expect it to be comparable to where we were in the prior year.

Jennie Tsai

Okay, great. Are you comfortable in disclosing any disclosures on the acquisition of your Australian distributor in terms of sales contribution or is it di minimus at this point?

Jody Phillips

We will have some certainly detailed disclosure in our first quarter filing. Just to give you a sense of the scope, it’s not as certainly as not as large as some of our larger markets including Spain and Japan. And it’s a modest contributor to that growth that we just guided to.

David Petty

It’s a reasonably good pricing environment, which is nice if the market that has been very receptive to the Exactech GPS technology and general surgeons there are more – it’s more prevalent to use computer-assisted techniques. And as we said before, we feel very good about the capability of our technology. And so our strategy there is to operate in a higher pricing environment and be able to deliver a more sophisticated technology to a market that demands it.

Jennie Tsai

It sounds like it’s going to contribute to your sales growth over the next few years here. Just one last question, can you talk about working capital needs this year with all your numerous full product rollouts?

David Petty

It’s a good question. They are going to be significant. Both the two next stages of the rollout of the three revision systems that David referenced will be very material numbers, plus there is new equipment with existing products, with the sales force expansion that we spoke about. So, we certainly are not anticipating as positive of a cash flow performance in 2016 as we enjoyed in 2015. And so I think of 2016, kind of as a transition year, where we will take a step backwards in terms of cash flow and then we should get back to significant cash flow generation after 2016.

Jennie Tsai

Okay, great. Thank you.

Operator

Thank you. [Operator Instructions] And with no additional questions in the queue, I would like to turn the conference back over to management for any additional or closing remarks.

David Petty

Thank you very much. And once again, we just want to express our appreciation for your interest in Exactech and thank you for your time and joining our results conference call. And we look forward to speaking with you again for the first quarter call in a couple of months. Have a good day.

Operator

Thank you. And ladies and gentlemen, once again, that does conclude today's conference. Thank you all again for your participation.

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