Exactech's (EXAC) CEO David Petty on Q2 2016 Results - Earnings Call Transcript

| About: Exactech, Inc. (EXAC)

Exactech, Inc. (NASDAQ:EXAC)

Q2 2016 Earnings Conference Call

August 2, 2016 10:00 am ET

Executives

David W. Petty - CEO

Joel C. Phillips - CFO

Analysts

Jeffrey Johnson - Robert W. Baird

James Sidoti - Sidoti & Company

Jennie Tsai - Gabelli & Company

Operator

Good day and welcome to the Exactech Second Quarter 2016 Results Conference Call. Today's conference is being recorded. At this time, I would like to turn the conference over to David Petty, Chief Executive Officer. Please go ahead.

David W. Petty

Thank you, Ruth, and good morning, everyone, and thank you all for joining us for the second quarter results conference call. As we've said, my name is David Petty, I'm the CEO of Exactech, and I have with me here Jody Phillips, CFO, and also Executive Chairman, Bill Petty. And I will begin by making some prepared remarks, I will ask Jody to do the same, and then we will open it up for questions for the three of us. But as usual, I will start with the disclaimer statement.

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

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

Now, the second quarter revenue was $66.1 million, up 8% from $61.5 million in the second quarter of last year. Net income increased 20% to $4.4 million or $0.31 per diluted share, compared to $3.7 million or $0.26 per diluted share last year. For the quarter, Extremity implant revenue was up 18% to $24.2 million, Knee implant revenue increased 1% to $19.2 million, Hip implant revenue increased 13% to $12.4 million, Biologic and Spine revenue decreased 7% to $5.4 million, and Other revenue decreased 6% to $4.9 million.

First half of 2016 was $131.4 million, up 7%, compared to $122.9 million in the first half of last year. Net income for the first half of 2016 increased 13% to $8.8 million or $0.62 per diluted share, compared to $7.8 million or $0.55 per diluted share in the first half of last year. For the first half, Extremity implant revenue increased 16% to $48.4 million, Knee implant revenue increased 3% to $38.6 million, Hip implant revenue increased 8% to $23.7 million, Biologic and Spine revenue decreased 2% to $10.8 million, and Other revenue decreased 10% to $9.9 million.

We are pleased with the progress in our sales channel development, particularly in the U.S., which in combination with contributions from new product launches is creating revenue growth momentum for Exactech. We continue to build inventory for the revision hip, knee and shoulder systems that are being launched this year. Those products contributed modestly to growth in the first six months. We hope to accelerate that in the second half. We returned to industry leading growth with our Equinoxe shoulder product line and look forward to doing first cases with the Vantage Total Ankle in the second half of the year. Hip growth momentum is strong as we get traction with the Alteon Tapered Wedge Hip Stem and InteGrip porous metal acetabular component.

We are also pleased with our first half performance, which was led by our shoulder implant revenues as demand continues to be strong and we have good momentum heading into the second half of the year. Similarly, hip sales were up 8% for the first six months with a strong 13% gain in the second quarter, continuing to reflect the success of our revision hip stem release and success with new selling team. Knee revenue was up 3% for the first six months and rose 1% in the quarter. We are continuing to invest aggressively in R&D focused on both new products and innovative production capabilities.

U.S. sales were up 8% to $89.2 million, compared with $82.5 million in the first six months a year ago. International sales increased 5% to $42.2 million. U.S. sales for the second quarter of 2016 were up 8% to $44.6 million, compared with $41.3 million in the second quarter a year ago. International sales increased 7% to $21.5 million from $20.2 million in the second quarter of 2015. U.S. sales represented 67% of total sales and international represented 33% of total sales during the second quarter.

Now I'd like to ask Jody to make some further prepared remarks and then we will open it up for questions.

Joel C. Phillips

Thank you, David. Good morning, everyone, and thank you for joining us for the second quarter conference call. The second quarter results were at the high end of our expectations and continue to signal a very solid rebound compared to 2015 that we intend to continue for the second half of this year. As usual, to summarize the quarterly income state performance, I will review each of the operating line items from a change versus the second quarter of last year perspective and a percent of sales basis, and add some commentary about our expectations going forward for the second half of the year.

During the second quarter, our gross margin percentage increased to 69.3% versus 68.6% during the second quarter of last year. Despite continued pricing pressure in the U.S., this increase was slightly above our expectations due to the United States mix in our Extremity segment which carries higher gross margins. On a go-forward basis, we expect gross margins to decrease between 20 to 50 basis points for the second half of the year as we have higher gross margin comparables and we expect the pricing environment to continue.

Our total operating expenses increased 9% during the second quarter and were consistent with our expectations. As a percent of sales, total operating expenses increased slightly to 59.3% of sales versus 58.6% in the second quarter of 2015. Sales and marketing expenses increased 11% to 36.0% of sales during the second quarter, compared to 34.9% in the second quarter of last year, primarily due to costs associated with the new product launches and variable selling costs. We expect sales and marketing expenses in the second half of this year to remain in the range of 35.5% to 36.5% of sales.

G&A expenses decreased 2% during the second quarter to 8.5% of sales, primarily due to lower legal expenses. We expect G&A expenses to remain in the 8% to 9% of sales for the second half of the year. R&D expenses increased 16% to 8.1% of sales, consistent with our expectations for the quarter, and we expect R&D spending to continue in the range of 8% to 9% of total sales for the second half of this year and that will be at a rate that increased as higher than our sales growth.

As a result of these operating items, our second quarter operating profit increased 8% to $6.6 million and represented an operating margin of 10.0%, which was consistent with the second quarter of 2015. In our non-operating area, we experienced a $98,000 currency gain due to strength in the Japanese yen and the impact of effective hedges on the British pound as well as the Japanese yen.

Our second quarter effective tax rate was approximately 33% versus 31% in the second quarter of last year, and that increase was due to a slight increase in our mix of profitability in the United States. On a going forward basis, we expect the tax rate to be in the 31% of 33% for the balance of this year.

In summary, for the P&L, the resulting net income increase of 20% to $4.4 million and diluted EPS of $0.31 was at the upper end of our expectations, primarily due to the sales performance and the gross margin percentage.

From a balance sheet perspective, our cash position increased by roughly $1 million during the quarter as we increased our credit borrowings by $4 million to fund inventory and instrumentation expansion with our revision products and our sales channel expansions. Accounts receivable days sales outstanding for the first six months of 2016 improved to 73 days versus 76 days in the first six months of last year. Total inventory increased by $1.4 million during the second quarter, as we are in the process of significant set builds for some of our newly launched products as well as our existing product lines.

Based on the second quarter performance, we increased our full year revenue and EPS guidance to $253 million to $258 million in revenue and diluted earnings per share of $1.15 to $1.19. Our third quarter revenue guidance of $58 million to $60 million represents roughly a 3% to 7% top line sales increase versus the third quarter of 2015, and is expected to result in third quarter diluted EPS ranging from $0.21 to $0.23, which roughly translates to a 5% to 15% increase in net income for the third quarter.

These are all of the prepared comments that I have at this time, and again, thank you for joining us all.

David W. Petty

Thank you, Jody. So now, Ruth, we're ready to open it up for questions, and as I mentioned earlier, both Jody and I are here as is Executive Chairman, Bill Petty. So we will be happy to take your questions now.

Question-and-Answer Session

Operator

[Operator Instructions] We will go first to Jeff Johnson with Robert W. Baird.

Jeffrey Johnson

So David, let me start with you, just the hip number obviously is one of the better numbers we've seen here in quite a while. You've mentioned some products that are helping there. I guess my question is, is it mainly the Alteon, the Tapered Wedge at this point, the porous acetabular, are those the main drivers at this point, how much is the revision hip contributing, and if the revision hip is contributing, maybe why are we seeing it in hips and we're not seeing it yet on the revision side on the knee business being flat this quarter?

David W. Petty

So there's a lot going on there, and to start with the first part of your question, yes on the Alteon Tapered Wedge as a contributor as well as the InteGrip porous acetabular component, and that is, specifically those products and sales teams are important drivers of the hip growth. And the revision hip stem, we've been able to build inventory there faster than we have on the knee, I'll come back to that in a moment, and there's also, if you look at U.S. and OUS and you know we don't break that out, OUS was a contributor to growth in hip and detractor to growth in knee. And so those dynamics are also in the background in the quarter.

And as far as the knee goes, when you have capacity challenges and a lot of new demand, the first thing you do is continue to supply what you have before you add the new thing. And so we've been dealing with putting, with responding to demand from existing customers and new customers on existing products and that capacity has been used, and we were unable to build the knee as fast as we would have liked, which was not as great a challenge, so it was somewhat of a challenge, it was not as great a challenge on the revision hip. So, obviously we've been working on that now for months, and so that's getting better, and we expect to be able to ramp up the revision knee in the second half.

Jeffrey Johnson

Okay, that's helpful. And then any challenges I guess, David, as we think about, I know you guys have been trying to build the inventory sets on both the revision hip and knee side, but any challenges I guess in maintaining new customers? I know you brought some new customers on over the past couple of quarters. Any frustrations coming up with those customers or any risk that you're losing any of those new customers who then can't get access to your product, just how do we think about that?

David W. Petty

No, we've been very careful not to overextend ourselves. And so, when we take on new customer, we're able to supply them. What we're not doing is taking on new customers at a rate that we think we could if our capacity were greater.

Jeffrey Johnson

Okay. And then, Jody, just maybe two quick follow-up questions for you on the model. One just on R&D continuing to grow above sales, I mean you guys have launched a lot of new products here, what are the drivers from here of R&D continuing to grow above sales? I mean it's a good problem to have, I don't have an issue with it, just want to understand the drivers given all the new stuff that has recently launched.

Joel C. Phillips

Sure. Good question. We have very active development projects on many fronts in our knee product line, some pretty significant developments for products that will largely launch next year. And then on the shoulder front, we continue to invest very heavily in that area. So those are two areas where the spending continues to be very robust. In our hip product lines, we're continuing to invest there as well. We are currently working on a modular hip component. I think you realize that. So that's the current activity.

Jeffrey Johnson

Okay, that's helpful. And then lastly just, I think last quarter you were talking pretty confidently about having some operating margin expansion over the rest of the year. Didn't see it come through this quarter, S&M higher. How much of that maybe is some of the Australian distributor buyout I think you did, and other than that, just any other impact there on the S&M side?

Joel C. Phillips

So the Australian distributor impact was a contributor to the total operating expense increase, and as you know, we had a little bit of lift in the Japanese yen, so that carried with it an increase in the operating expenses there. But there are some costs there in our U.S. sales and marketing organization that are increasing slightly higher than sales, and that's where we think we have an area of a little bit of leverage going forward.

Jeffrey Johnson

All right, very helpful. Thanks, guys.

Operator

We'll go to our next question from Jim Sidoti with Sidoti & Company.

James Sidoti

So it sounds like you are well on your way to launching the revision systems. Can you give us an update on where you are with the RBK knee system?

David W. Petty

So that application, an IDE was submitted I think on Halloween last year, if I remember correctly. So obviously we've had a couple of rounds of questions back and forth with the FDA, and I guess if we follow average timelines, we're hopeful that we'll get a clearance late this year or early next year. And then from there, and just so everybody understands, that was the classic Optetrak design with a Hi-Flex femoral component and we now have as our sort of mainstream product in the U.S. under the Logic system. So even if we have clearance with that, we are going to want to then bridge to the knee systems that are our main systems on the market. So we expect to have revenue from that product immediately when it's cleared, but then it will ramp up slowly from there.

Joel C. Phillips

Jim, it's Jody. I'll add related to the revision products that we're launching. We're really in the early stages of that. We're pretty much operating now with a first wave of those launches, and so there's a lot of runway left there, probably a couple of years of continued rollout of additional sets and quantities from all three of those systems.

James Sidoti

Okay. How about an update on the ankle implant?

David W. Petty

So we got regulatory clearance during the quarter, during the second quarter, and we had not built inventory at risk and our team did a really good job with the application. And so we've been building inventory anticipating doing first surgeries as soon as possible with our design team. And as you know, when you start out with a new system, those initial cases, you don't do as many until you're really confident that you have what you think you have with respect to the efficacy of the design. So we are confident that we are going to be doing surgeries with the ankle in the second half and hopeful we'll be doing cases in the second or third quarter.

James Sidoti

Got it. And then the last question on the reps, the acquisitions continue in your space, are you still adding reps and are you adding reps that were with previous device makers?

David W. Petty

We are but I would not specifically correlate that to mergers and acquisitions. It's a broader base of [people who] [ph] joins our selling teams, I mean from essentially competitors.

James Sidoti

Okay. Can you give us an update on where you are now size-wise?

David W. Petty

I don't have the information in front of me. What I would say about that is roughly 300 people but what I would say about that is the numbers are less important than the quality and I think what we've been doing is making qualitative improvements that are making a bigger difference than simply adding numbers, because we can add salespeople, we pay commissions, right, so it doesn't cost us anything until they sell something. We can add a dozen tomorrow. If they don't sell anything, it doesn't matter. What really matters is getting high-quality people who are competent and know how to approach surgeons and service complex total joint replacement systems [they sell] [ph].

James Sidoti

Okay, understood. Thank you.

Operator

We'll go next to Jennie Tsai with Gabelli.

Jennie Tsai

I just have two quick questions, because I think most of them were covered pretty well. So when I look at how was pricing for the quarter, is there a range you could provide us?

Joel C. Phillips

It's pretty broad, Jennie. So the way I'd look at it is on a worldwide basis. We're looking anywhere from 2% to 5% per product line and there are some pretty significant ranges in there, both across the product line as well as individual markets. So it's pretty significant.

Jennie Tsai

And also, did you see some FX benefit this quarter?

Joel C. Phillips

We picked up that little bit of gain in the operating income that I referenced, which is roughly $98,000. And then from a top line perspective, currencies were a slight tailwind that added basically somewhere between 50 basis points to 1% to the growth for the quarter.

Jennie Tsai

It seems like going forward, FX is going to be okay?

Joel C. Phillips

Where we have it right now, if rates stay where they are currently, it's not necessarily a tailwind but it's not working against us. So where things are right now, we're projecting it to be roughly flat with the third quarter of last year.

Jennie Tsai

Okay, great. Thank you.

Operator

[Operator Instructions] There are no questions at this time. I will take this time to turn the call back over to management for any closing remarks.

David W. Petty

Thank you, Ruth, and thank you everyone for taking the time to join us for this call and for your trust and interest in Exactech, and we look forward to talking to you again at the third quarter results conference call in October. Have a great day. Goodbye.

Operator

This does conclude today's conference call. Thank you for your participation. You may now disconnect.

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