Vascular Solutions' (VASC) CEO Howard Root on Q3 2016 Results - Earnings Call Transcript

| About: Vascular Solutions, (VASC)

Vascular Solutions, Inc. (NASDAQ:VASC)

Q3 2016 Earnings Conference Call

October 24, 2016 16:30 ET

Executives

Phil Nalbone - Vice President, Corporate Development

Howard Root - Chief Executive Officer

James Hennen - Chief Financial Officer

Analysts

Mike Matson - Needham & Company

Brooks West - Piper Jaffray

Jason Mills - Canaccord Genuity

Ben Haynor - Feltl & Company

Jim Sidoti - Sidoti & Company

Larry Haimovitch - HMTC

Operator

Ladies and gentlemen, thank you for standing by. Good afternoon and welcome to the Vascular Solutions Third Quarter Conference Call. [Operator Instructions] As a reminder, ladies and gentlemen, this conference is being recorded today, Monday, October 24, 2016. I would now like to turn the conference over to Phil Nalbone, Vice President of Corporate Development at Vascular Solutions. Mr. Nalbone, you may begin.

Phil Nalbone

Thank you, Denise. Good afternoon, everyone. Thank you for joining us for Vascular Solutions’ third quarter 2016 conference call. You will be hearing presentations today from our Chief Executive Officer, Howard Root and our Chief Financial Officer, James Hennen, and all 3 of us will be available later during the Q&A portion of this call, but first, the necessary preamble.

This conference call is being webcast to the public and is completely open to members of the media, Vascular Solutions’ shareholders and other interested parties. Today’s conference call is a proprietary Vascular Solutions presentation and is being recorded by Vascular Solutions. No other recording, reproduction, transmission or distribution of today’s call is permitted without Vascular Solutions consent. This call is being audio simulcast on the Internet via our company website at www.vasc.com. A replay of the conference call will be available on the Internet shortly after this call is concluded through Monday, October 31. To listen to the replay, visit the Investor Relations section of our website.

Forward-looking statements made in the course of this conference call and webcast are made pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. These statements can be identified by words used such as may, will, expect, continue or other similar expressions. There are certain important factors that could cause the company’s actual results to differ materially from those anticipated by the forward-looking statements as described in our annual report on Form 10-K and other recent filings with the Securities and Exchange Commission. Forward-looking statements are made based on our analysis as of today’s date and we undertake no duty to update the information provided on this call.

I will now turn the call over to Howard Root.

Howard Root

Thank you, Phil and good afternoon everyone. We are pleased to report another very strong quarter of sales and earnings growth for Vascular Solutions. As we enter the final quarter of 2016, we are proud to be completing our 13th consecutive year of double-digit percentage growth in product revenue. And with the preliminary guidance we issued today, we fully expect our double-digit revenue growth performance will continue for our 14th straight year in 2017. The underlying trends in our business remained strong and we believe our core business strategy of launching multiple clinical specialty products will drive our continued success. Our internal pipeline is full with around 40 projects at various stages of development. Last Friday, we announced 510(k) clearance for our internally developed and manufactured Fluent inflation device, which will be launched worldwide during the fourth quarter. Before year end, we anticipate FDA clearance of a couple more new products. And in 2017, we have 12 additional new internally developed medical devices slated for commercialization.

With our long track record of superior execution on this multiple product strategy and with the Short Kit legal distractions finally eliminated in 2016, we are very confident on the sustainability of our ascending revenue growth and operating leverage for the foreseeable future. On top of that, with a strong balance sheet and no debt, we are well positioned to acquire products that fit our niche strategy and our existing call points. And we are currently in active evaluations and discussions on opportunities to add to our growth potential through product acquisitions.

Longer term, we continue to make significant progress on our number one long-term priority, which is RePlas freeze-dried plasma in collaboration with the U.S. Army. The development of freeze-dried plasma to treat battlefield hemorrhage and save the lives of wounded soldiers has long been a top objective for the U.S. Army’s Combat Casualty Care Research Program. We have been working diligently with the U.S. Army toward achieving this goal since we signed a cooperative research and development agreement back in 2014.

As we have reported in our October 18th press release, the U.S. Army has now filed with the FDA the investigational new drug, or IND application for RePlas to start clinical studies. Pending FDA approval of the IND, we expect patient enrollment into the clinical study to get underway during December. Upon successful completion of the clinical studies, a biologics license application, or BLA is expected to be filed in the 2019 timeframe. As a reminder, the U.S. Army is managing and funding all of the expenses of the clinical studies and the FDA submission.

Vascular Solutions part in this collaboration is the manufacturer and commercialization of RePlas and we made a lot of progress in that area during the third quarter. As expected, we completed the installation of our commercial scale manufacturing equipment in our new RePlas manufacturing facility during the September and we are now able to manufacture human use product to be used in the clinical study when the study is approved by the FDA. We continue to believe our freeze-dried plasma product has an annual market opportunity of more than $100 million when we look at all the potential applications in the treatment of trauma in both military and private sector settings and we remain very excited about the clinical and commercial outlook for our RePlas freeze-dried plasma.

One other long-term product development program also with a very big market potential is our large bore closure device. We have a deep understanding of the market for sealing femoral artery punctures and our aim has been to develop a device that seals very large punctures that are associated with procedures such as transaortic valve replacement, endovascular aortic aneurysm stent graft placement, and the use of ventricular assist devices. We have been pleased with the preclinical results with our device and we are moving toward design-freeze during 2017. We expect our large-bore closure device to be commercialized in the U.S. also in that 2019 to 2020 timeframe.

I will now review our revenue performance and provide some perspective on our most significant current products and how they influenced our third quarter performance. Then I will turn the call over to James for details on the income statement and our future guidance. During the third quarter, we grew our revenue by 13% to a record quarterly level of $41.8 million. Our revenues came in towards the top end of our guidance range of $41 million to $42 million. Excluding for comparison purposes, the $1 million in GuideLiner launch inventory we sold to our Japanese distributor, Japan Lifeline, during the third quarter of 2015 our worldwide revenue increased 16% during the most recent third quarter. During the quarter, as we have previously reported, we initiated a voluntary recall of our Twin-Pass catheters. We estimate that recall cost us approximately $200,000 in delayed sales during the third quarter. No patient injuries have been reported in association with this issue and we resumed shipments of Twin-Pass on October 15.

Our geographic mix of product sales during the third quarter was 81% U.S. and 19% international. Our U.S. sales increased 15% to $33.7 million. International sales increased 4% to $8.1 million. However, excluding Japanese orders for GuideLiner from last year’s third quarter, our international sales grew by a healthy 24% in the third quarter of 2016. During the third quarter, our top 8 products combined represented 80% of our total worldwide revenue and grew by 17% on a year-over-year basis or by 22% when eliminating the impact of GuideLiner in Japan from last year’s revenue.

Our top selling product during the third quarter once again was our GuideLiner catheter, which had worldwide sales of $12.2 million, representing an increase of 7% from the third quarter of 2015. Again, excluding Japan, worldwide sales of GuideLiner now in its seventh year on the market grew by 21%, consistent with the strong underlying trends in our GuideLiner business that we have been demonstrating for some time. In the U.S., GuideLiner sales grew by 19%, as the number of complex coronary interventions continues to grow.

In international markets, sales of GuideLiner declined 10%, but excluding the Japan effect, GuideLiner international sales were up by a very solid 23%. With the Japanese launch inventory now substantially depleted, we expect our Japanese distribution will resume substantial orders of GuideLiner during the fourth quarter followed by a further substantial sales increase throughout 2017. While we are already – while we already offer multiple configurations of GuideLiner, our planned product launches for 2017 includes what we believe will be another significant expansion of our GuideLiner rapid exchange guide extension product portfolio.

Our second biggest source of revenue during the third quarter was micro-introducer kits, with sales of $3.9 million representing growth of 22%. Micro-introducer kits are one of the most widely used devices in the interventional suite. And during the past couple of years, we have focused on transitioning to internal manufacturing, cost reductions and product line expansion. Our strategy has worked very well, resulting in the combination of lower prices for our customers and increased market share at higher gross margins for Vascular Solutions.

Our third largest source of revenue during the third quarter was our reprocessing service for the ClosureFast radiofrequency varicose vein ablation catheter with revenue of $3.8 million, an increase of 20% on a year-over-year basis and a 27% increase sequentially. We had a substantial spike in the sales of off the shelf reprocess catheters in the third quarter as a result of a pricing promotion program, which grew sales but also reduced our gross margin, as James will detail. We continue to believe reprocessing of this vein treatment catheter is at least a $20 million revenue opportunity for us.

The number four product during the third quarter was our Turnpike catheter line with sales of nearly $3.6 million, a 303% increase from the year ago quarter. We launched our first configuration of Turnpike in the first quarter of 2015 and have launched three additional configurations since then. Already, Turnpike is our most successful internally developed new product launch since we introduced GuideLiner in late 2009. Unlike GuideLiner, Turnpike fits into the growing segment for complex coronary interventions. Now at an annual run rate of more than $14 million, we believe Turnpike can become at least a $30 million product for us and we continue to expect Turnpike to be one of our major growth drivers over the next several years.

The number five product during the third quarter was our Pronto extraction catheters, which had sales of $3.2 million, representing a decline of 10% on a year-over-year basis. On a sequential basis, Pronto’s sales were relatively flat, which was consistent with our expectations given market and clinical practice trends. With now several consecutive quarters of relatively flat sales in 2016, we look at Pronto as being a relatively stable product for us going forward.

Our sixth largest product line was our hemostatic patches, with third quarter sales of $2.9 million, representing a decrease of 6% year-over-year, but once again stable performance sequentially. We launched our D-Stat Dry hemostatic patches in 2003. And the market for femoral artery hemostatic patches has been mature for some time now. The competitive and pricing pressures are compounded by the rapid shift from femoral access to radial access for performing catheterization procedures. Therefore, we are focusing our growth efforts on our newer products that address the rapidly rowing radial artery access market in the U.S.

Our collection of radial artery products represented our seventh largest sales category during the third quarter, with revenues growing 16% to $2.2 million. Vascular Solutions was early to identify the move towards radial artery access in the U.S. and our strategy of developing and assembling a variety of products to serve this market has paid off very well. We expect our radial products to be a significant source of growth during the next several years, particularly starting in 2017, with the expected full launch of our line of radial introducer sheaths.

The Langston dual lumen catheter was our eighth largest selling product during the third quarter, with revenues of approximately $1.8 million, representing growth of 9%. We expect sales of Langston to continue to grow as it is an increasingly important tool to measure aortic stenosis in percutaneous aortic valve replacement or TAVR procedures, a cath lab procedure that is growing substantially worldwide. Overall, our clinically based focus on niche devices within the area of complex interventions continued to drive our sales growth in the third quarter, as interventional physicians are spending more time to treat more patients effectively with minimally invasive catheter based procedures in order to prevent those patients from having to undergo open heart bypass surgery. Beyond GuideLiner and Turnpike, this complex interventions phenomenon is seen in several other products in our catalog, products that in the past we haven’t talked a lot about. For example, sales of our specialty guide wires grew by 29%, sales of our SuperCross microcatheters grew 28% and sales of our Guardian hemostasis valve grew 26% during the third quarter.

This is a very exciting time for Vascular Solutions. We have a full pipeline of internally developed products and a very strong balance sheet to support our efforts to bring in growth enhancing products from the outside in the form of distribution agreements and tuck-in acquisitions. Our core business model allows us to sustain superior financial performance, while we pursue the development of much larger, long-term product opportunities such as RePlas freeze-dried plasma and large-bore closure device. And as always, our number one force – focus remains the clinical benefits of our products providing useful medical devices to doctors so that they can improve the lives of our patients with vascular disease.

With that, I will turn the call over to James for the financial review.

James Hennen

Thank you, Howard. Our gross margin in the third quarter was 64.4% compared to 67.2% in the year ago quarter. Our gross margin is subject to variability from quarter-to-quarter based on the mix of products sold and the mix between U.S. sales to our direct sales force and international sales to our independent distributors at a lower transfer prices. The decrease in the gross margin during the most recent third quarter was primarily due to product mix. As sales of our lower-margin ClosureFast reprocessing service increased substantially, resulted in a 100 basis point drop in our overall gross margin. We also had approximately $100,000 in expenses associated with the Twin-Pass recall.

For the fourth quarter, we expect our gross margin to rebound to the 65% to 66% range. Our operating earnings in the third quarter were $7.2 million, representing an operating margin of 17% compared to the year earlier operating earnings of $4.4 million or 12%. The big jump reflects the absence of legal expenses associated with the Short Kit litigation, which were concluded in February. During the third quarter of last year, we incurred $2.8 million in legal expenses related to the Short Kit case.

General and administrative expenses in the third quarter were $2.4 million or 6% of revenue, compared to $5 million or 14% of revenue in the third quarter of 2015. Without any further Short Kit legal expenses, we expect our G&A spending to continue to be approximately 6% of revenue in the fourth quarter. Sales and marketing expenses were $9.2 million or 22% of revenue compared to $8.1 million or 22% of revenue in the year ago third quarter. For the fourth quarter, we expect our sales and marketing expenses to stay in the range of 22% of revenue and then to gradually decline in 2017. We remain committed to our goal of driving sales and marketing expenses as a percent of revenue down below the 20% revenue – level over the next few years, resulting in gains in operating margin to above the 25% level at $250 million in annual revenue.

Research and development expenses were $5.6 million or 13% of revenue compared to $4.9 million or 13% in the year ago third quarter. The increase in R&D spending in the third quarter reflects headcount additions to support our pipeline initiatives as well as additional product testing required to meet increasing regulatory requirements for new products. For the fourth quarter, we continued to expect R&D expense to be between 12% and 12.5% of revenue. Clinical and regulatory expenses were $2.1 million or 5% of revenue during the third quarter compared to $1.6 million or 4% in the year ago quarter. The increase on a percentage basis reflects additional headcount added to ensure compliance with the increasingly stringent quality and regulatory requirements for manufacturing medical devices. For the fourth quarter, we continue to expect our clinical and regulatory expenses to be approximately 5% of revenue. Amortization expense for the third quarter was $404,000 flat on a year-to-year basis and a number we expect to be repeated in the fourth quarter.

During the third quarter, our income tax expense was $1.8 million and pre-tax earnings of $7.3 million resulting in an effective tax rate of 25%. In the year ago third quarter, our income tax expense was $1.4 million on pre-tax income of $4.4 million, representing an effective tax rate of our more normal 33%. The low tax rate during the most recent third quarter reflected the adoption earlier this year of a new accounting standard that requires excess tax benefits from restricted share vesting and stock option exercise be recognized in earnings. That excess tax benefit was $477,000 during the third quarter. For the fourth quarter, we are modeling an effective income tax rate of approximately 33.5%, subject to variations as a result of tax benefits recognized related to equity compensation.

Our third quarter net income on a GAAP basis was $5.4 million and earnings per share was $0.31, which came in at the top end of our guidance range, which had been $0.29 to $0.31. This compares to net income of just under $3 million and earnings per share of $0.16 in the third quarter of last year. The total number of shares used in calculating fully diluted earnings per share was slightly down year-over-year due to our now expired stock repurchase plan, just under 18 million shares in third quarter 2016 compared to just over 18 million shares in the third quarter of 2015.

Turning to the balance sheet and cash flows, we ended the third quarter with $39.1 million in cash and cash equivalents compared to $35 million in the year end – or at the end of June quarter. We continued to have no long-term debt. During the quarter, we generated $7.6 million in net cash from operating activities and we used $4.1 million for capital expenditures related mostly to building improvements and to purchase of manufacturing equipment.

With our manufacturing facilities renovations to be substantially completed in the fourth quarter, we expect our capital expenditures to decrease substantially in 2017. Our days inventory on hand at September 30 was 148 compared to 154 at the end of June. We expect our days inventory on hand to remain at approximately the 150-day level as we maintained higher than usual levels of finished goods inventory through the completion of our facilities renovations. Account receivables days sales outstanding were 51 days at September 30 compared to 48 days at the end of the June quarter. We expect our DSO to remain at approximately these levels for the foreseeable future.

Now, I will turn to our financial guidance. For the fourth quarter of 2016, we are providing revenue guidance of between $43 million and $44 million. The midpoint of this range represents growth of 14% from the $38.1 million in the fourth quarter of 2015. Our GAAP earnings per share guidance for the fourth quarter of 2016 is between $0.34 and $0.36 and includes approximately $900,000 in non-cash stock-based compensation, $400,000 in amortization of intangibles and an assumed effective income tax rate of approximately 33.5%. In the year ago fourth quarter, our GAAP earnings per share totaled $0.09.

Finally, I will give you our preliminary thoughts on our outlook for 2017. I want to emphasize that we would not compete our formal budgeting process until December and therefore, we plan to update this 2017 guidance on our Q4 earnings call. But based on our current forecast for products already on the market and for the internally developed products currently in our pipeline that are scheduled for launch next year, our preliminary revenue guidance for 2017 is between $183 million and $187 million. At the midpoint of this range, growth will be 12% from the midpoint of our current revenue guidance range for 2016 of $165.8 million. Our preliminary guidance for 2017 GAAP earnings is between $1.44 and $1.48 per fully diluted share, which at the midpoint represents growth of 20% from the midpoint of our adjusted earnings guidance range for 2016.

With that, I will turn the call back to the operator for the question-and-answer portion of our call.

Question-and-Answer Session

Operator

Thank you. [Operator Instructions] And we will take our first question from Mike Matson of Needham & Company. Please go ahead, sir.

Howard Root

Mike, are you there?

Mike Matson

I am here.

Howard Root

Can you hear me?

Mike Matson

Yes, sorry about that. I had the phone muted sorry. So, I guess I just wanted to start with the reprocessing promotion that you guys ran. I understand that dragged down the gross margin a little. So, can you maybe give us the rationale for doing that?

Howard Root

Well, as you know, our reprocessing has two components. We have a service part and an off-the-shelf part. The service is we will reprocess the customers’ catheters and send them back to that same customer. The off-the-shelf one is we acquired the used catheters, have them reprocessed and then sell those reprocessed catheters to customers. And we manage our inventory as to how many used catheters we get in and then to determine how many that we are selling. So, our inventory was getting a little high in terms of the off-the-shelf reprocessed catheters as we are getting into the summer months, which normally summer months, the utilization of varicose vein treatments goes down. So, we thought it was a good time to do a promotion. We did a promotion. And then part of it is to test the market on the price elasticity and this as you know is a pretty price elastic business. And we hit a good price then really that the month of September with that promotion we did better than we thought we were going to do in selling those reprocessed catheters. Now, we still have a healthy inventory. So, it’s not like we put ourselves into a problem situation on the other side, but it resulted in quite a few sales of reprocessed catheters at that time and quite a few of those were actually to new accounts, who wasn’t just existing customers, but some of the larger vein clinics if you hit a certain price point, they will consider reprocessing to be a useful alternative. So, we had a good pricing promotion program. We got a good receipt for that. It drove sales up. And as a result, gross margin got affected by about 100 basis points in the quarter.

Mike Matson

Okay, thanks. And then just with regard to the gross margin, I am curious what your guidance sort of implies for next year. This year, by my math, it looks like depending on where it settles on the fourth quarter but it could be down around 150 basis points or so from last year. So, do you think that’s going to flatten out next year and the decline will kind of slowdown?

Howard Root

Yes. For next year, we have gross margin right around the same levels as this year, as where we think we are going to end this year. So Q4, we think we are going to rebound. Gross margins should improve to 65% to 66%. So, we expect the full year gross margin to be in that range of 65.0% to 65.5% for this year and we are projecting next year to be right around that same gross margin level.

Mike Matson

Okay. And then just my final question just on the new product pipeline, so you mentioned, you have 12 new products that you are planning for next year. So, are any of these potentially as big as GuideLiner or Turnpike?

Howard Root

I would say they are more in the area of Turnpike. There is not a GuideLiner, but then keep in mind as I – keep in mind that in every conference call, when we launched the GuideLiner, I thought it was a $20 million potential product and now it’s already at $50 million going it’s way probably to $100 million full in. So, you never really know the potential for a product until it gets out there. We do have one version that’s expansion on our GuideLiner portfolio that we are pretty excited about. We have some other products in that complex intervention area that addressed larger markets than what Turnpike would be, but with competition. So, there is a plus and a minus. It’s in existing market, but it’s also – so there is a market established, but you have a competitor you have to beat out. And then we have some things that are more unique products where it’s kind of the first time anyone has tried this, we think it’s got a good opportunity, but we are unsure of how big that could get. So, that’s what I would characterize as a GuideLiner type product is a good thing to get started with and we will see what it grows to. But they are all in that, I would call clinical niche strategy all in that Turnpike kind of category. Maybe there is a GuideLiner in there, but I wouldn’t bet on it at this time.

Mike Matson

Thank you.

Howard Root

Thanks Mike.

Operator

We will take our next question from Brooks West of Piper Jaffray.

Brooks West

Hi, can you hear me?

Howard Root

Hi, Brooks, can hear you fine.

Brooks West

Great. Thanks guys. Howard, I want to start with 2017 guidance, you are talking about 12% growth at the midpoint, but as you said, Japan comps are easier, you are getting back on a more normalized new product cadence, I am just wondering where you are being cautious or conservative in the guidance as you built that out for next year?

Howard Root

Well, we are always cautious on new products, because you really don’t know what you have got. So even though we are launching 12 new products next year, it’s – I would say almost immaterial part of our sales forecast. So something catches fire like Turnpike did this year that would be an out-performance. We are counting on GuideLiner to continue to grow, but in it’s I think 8th year – next year it will be end of its 8th year. You don’t expect it to grow as much. But I was surprised by how it grew last year, surprised outperformed this year as well. So couple of years in a row, I have been surprised on the plus side there. We are pretty cautious on that. Turnpike, there is this growth in complex coronary interventions as continuing throughout the world and we are getting a lot of the benefit of that as the market for Turnpike grows because of that opportunity growing. We think, it will continue to grow and we are pretty confident in that. But we are not forecasting any up-tick in the curve more stable growth in complex coronary interventions rather than inflection point in anyway. And then we have things like the Fluent inflation device. And the Guardian that goes with it, we have got very little in there. Inflation device market is a big opportunity. We are looking at that as an accessory product. So there is upside in that. And then finally, we have got absolutely nothing in there for any acquisitions or distribution deals. And as we have said on the prepared remarks, we are in active discussions and evaluations on deals to acquire products that fit into our portfolio to the existing call plan. So there is a lot of potential upside in that as we always like to do. Not all of it will come to bear, but we want to have more upside than downside in our forecast.

Brooks West

That’s helpful. Thanks for that. And then one more forward-looking, you mentioned on the large bore closure device going to design freeze and potentially launching that products in ‘19 or ‘20, you have never talked about scale of that opportunity, I mean should we think about that along the size of the St. Jude and Abbott businesses, can you help us just kind of quantify the annual opportunities you see for that product?

Howard Root

Sure. It isn’t like an Angio-Seal or Perclose, those are $200 million, $300 million, $400 million products, but they also engage and have substantial price competition. Those products that are used for the standard femoral artery stick like 8 French or a 6 French. Now there is a lot of those $8 million a year across the world. So we are looking at things that are more in that 12 French, 14 French, 18 French and that TAVR market, which is really the big opportunity has about 50,000 procedures a year, U.S. alone, right now, growing substantially with zero, 5 years ago, Edwards and Medtronic with the core valve are the two big opportunities there. Then there is also the thoracic stent graft, the aortic stent grafts and there is ventricular assist devices, which are smaller numbers, but they add to that whole market. So we are in a range, we are looking at 100,000, 200,000, 300,000 procedures, potentially U.S., internationally, you are going to double that. But this device would be selling at a higher ASP, substantially higher ASP than an Angio-Seal, which could go as low as $100 or even less. This is more like a $400 to $500 device. The competitive device out there right now is the Perclose two device systems, we have to buy two of them to do one closure. And it really was never designed intentionally for this just being used for this preclose technique in order to have something to avoid a surgical cut down or repair after implanting a TAVR procedure. So ours is a much simpler concept. It’s a fully resolvable concept. We haven’t gone into all of the details of it because our patents are – some of them are filed and others are coming. But when we get into the clinical mode then we will do a full disclosure of the product, the technology and where we see it. But it’s safe to say, this is north of $100 million opportunity realistically. But I would say it’s certainly south of $500 million, $100 million to $200 million is kind of where I would ballpark it as an opportunity for us.

Brooks West

Great, that’s very helpful. Thanks guys. I appreciate the comments.

Howard Root

Thanks Brooks.

Operator

We will take our next question from Jason Mills of Canaccord Genuity. Please go ahead sir.

Jason Mills

Well, thank you very much. And good afternoon gentlemen, how are you, can you hear me okay?

Howard Root

Hi Jason. Yes, can hear you fine. Great. Thanks.

Jason Mills

Congratulations on another fantastic quarter first of all Howard. I had a couple of questions, I wanted to start with operating margins and just looking back for last couple of quarters, you delivered very, very well on the top and bottom lines with components, you are getting from top to bottom are a little different than what we had seen over the last couple of years, where you are bit higher in OpEx, but you are able to make it up and then some on the tax line and James walked through a little bit of that, but in the fourth quarter, the guidance at least is for the model to sort of work as it has historically. And actually, at the midpoint of your range, unless I am doing our math wrong, it would suggest fairly significant operating margin expansion not only on the year-over-year basis, but sequentially to a level that I don’t think, the company has seen ever over 20%, in fact, maybe even something like 21%, could you talk about operating margins both historically and what it seems to be an inflection point here. And then next year again, given your tax guidance, your gross margin guidance, etcetera, you are guiding for a full year at the midpoint well about 20%, so it seems like we are – you are sort of in the midst of the leverage that you have often talked about that you are now guiding to?

James Hennen

Yes. I think I will take that one Jason. So this quarter Q3, we achieved 17% operating margin and then included kind of some of the one-time events of Twin-Pass recall, we had $100,000 in our gross margin. We did the promotion on the reprocessing, which lowered our gross margin as well. So you are right. So Q4, we are guiding above 20% operating margin in Q4. And some of that inflection point, Q4 is typically has been higher operating margin for us, so some of that change is going to be an R&D line. We can choose on how much we spend in research and development. We have always said between 10% and 12%, that’s getting a little bit lower in Q4 and also going into next year, I think we slated above 12% R&D line, so we have been as high as 13%, at some quarter this year at 13.5%, a little over our history. So in 2017, we are seeing a max of 12% in research and development line, some of that inflection and then gross margin getting to more of a stable point of our gross margin of that 65% to 66% on a gross margin basis. Then our continuing leverage where you know it’s been and our model has been in the sales and marketing area and that’s much down a good 1% each year, really for last 5 years and we expect that trend to continue as well.

Howard Root

Yes. On the R&D line, I mean some of the things we have been doing, we haven’t talked much about, but the RePlas, there was the scale up commercialization of the equipment, that’s now substantially purchased done and we will not be touching that facility in terms of the equipment for at least another I think 2 years. Some of the other projects that we had, we have to get through testing and you will see, as we said there is a couple here going out 510(k) and 12 expected products launch next year. There is a lot of regulatory work behind the scenes to get that ready for fourth quarter launch. And so it’s a 2017 fourth quarter submissions for a 2017 launch. So we finance every project, we think has a useful clinical and financial utility and it just turns out that it was a little bit higher in the second and third quarter than we normally want. Well, 12% is a good healthy investment in R&D, 13% when you add in, another 4% clinical regulatory on top of that, gets to be a bit more than I would naturally expect that company our size to be spending.

Jason Mills

Got it, okay. That’s helpful. And then with respect to your 2017 guidance and actually I would like to see if you would talk a little bit further out than that, specifically 2018, because – and tell me sort of where am I thinking is perhaps incorrect, but you have the GuideLiner, which generally folks are modeling growth to come down prudently, I think, but you do have – you had this year difficult comps on the year-over-year basis in Japan,. it sounds like you actually should see some ordering from the distributor there. Turnpike, next year is still in relative infancy relative to where it maybe matures in a couple of years. And your pipeline I think is bigger, bigger than it has been in any of 7 years or 8 years that I have covered the company, when we are thinking about the out year, so your guidance seems prudently conservative for the reasons you have already talked about, Howard, but it seems like ‘17 actually sets up fairly well, whereas ‘18, perhaps you are comping against the difficult ‘17 and you are still a year away from some of these bigger products, so I am sure you thought about it, but are you willing to discuss sort of the dynamics a year later than ‘17 and the 2018 timeframe?

Howard Root

I will talk in general terms without getting into numbers. I mean you are right in this sense, 2017 or 2016 we had a $5 million Japan order from the year before. So in 2015, it was $5 million of GuideLiner sales, just to start the pipeline. And you don’t get that 2 years in a row. So 2016, our growth here is on top of starting $5 million down. So in 2017, the comp is 2016. So now 2016, was almost essentially zero in GuideLiner sales in Japan through the first three quarters, fourth quarter kicks in again. And next year, it will be using it at a healthy run rate. I mean our distributor is doing a great job, getting the product used and we will have kind of the natural purchases in Japan. So 2017 shapes up nicely for that reason as well as Turnpike coming off of $3 million in 2015, $13 million or so in 2016. You can see that coming out of the year, we will be doing closer to the $20 million just on the natural run rate. So that sets up well for 2017. 2018, I mean part of it is, our products that second year of launch. So what you are going to see coming in 2017 is what’s going to hit in 2018, to give us that upside. So these 12 new products in 2017, even if we do really well, won’t be that big of a material driver of revenue in 2017 like Turnpike, first year out $3 million in revenue. Well, that’s not much, but it really sets you up next year to get to that $13 million. So we haven’t even shown you what’s going to launch in 2017 to get to 2018. And as far as our pipeline, it’s amazing. Once the government stops breaking you in a courthouse in San Antonio, how much research and development you can get done and products you can actually finish. So that’s the benefit of starting in March when I don’t have to worry about legal things and we can focus our time, attention and money on developing new medical devices. So I won’t call it very conservative guidance we have done and we have always tried to get conservative guidance, but it’s realistic as well. And this is a business you followed us for a long, long time. It doesn’t have those sharp ends to it. It doesn’t go way up, it doesn’t go way down. It’s kind of an incremental growth and trying to continue to do what you have done in the last year into the next year. So that’s what we want to continue to do until we hit the big products, will change that. Freeze-dried plasma will be the first year of launches. Large bore closure, we get to that point, will be big that year as well. And then it’s also the acquisitions. While we were fighting the government, we weren’t spending our money doing acquisitions. Now we have been evaluating and we are in the negotiations. So using cash to buy products, is purely accretive from day one and that’s what we are looking to do in terms of sales and on the earnings line as well.

Jason Mills

That makes sense. I will ask one more and I will get back in queue, more or just a general question Howard is I think longest 10-year CEO of any medical device company, you have a perspective – an interesting perspective on the dynamics of the fundamentals of med-tech specifically cardiovascular med-tech over a long period of time, could you just give us a sense, I mean a lot of investors I think vary of the elections, so without getting into politics of it, just generally speaking how the fundamentals of cardiovascular med-tech from your standpoint are relative to maybe the last decade? Thank you.

Howard Root

Well, I will just do a real brief one because I go on for a long time about that. I think from when I started the company in 1997, 20 years ago, it’s a different world out there. I mean the one thing that we have that’s so valuable for us to continue to do what we do is our distribution system. You just can’t go out there and create a new sales force in the U.S. to bring clinically relevant niche devices to the market. That just doesn’t happen. So the few companies like us out there, the [indiscernible] of the world and other companies like that Spectranetics that have that sales force along with the portfolio, are able to continue to grow and are able to continue to succeed, whereas really the ability of the companies to do what we have done 20 years ago is almost zero. That allows competition to go down, it allows us to have a stickier position with our products. It allows us to frankly have stickier position with our pricing of our products as well and playing in the niche area where the drug-eluting stents and the defibrillators are getting beaten up everyday by hospitals on pricing. Our products are in the very small segment of the hospital’s budget. So don’t get that kind of spotlight, as well as we generally have very little or sometimes no alternative products. So that puts us in a very stable position going forward. The politics, I don’t see any changes. The Obamacare was a big change to the U.S. healthcare system and had essentially no impact on our business. Medical device tax, obviously is well. It’s got a 2-year holiday, we will see if it comes back, obviously, that hits the bottom line and takes money away. We could be spending on R&D and other things, but it’s not going to throw us into a money losing situation. It affects the new companies like most of these things do rather than the established companies. I mean once we are in, we have crossed that Rubicon. We are now into the game, we are selling, we are profitable and that’s the great place to be. Unfortunately, I don’t think there is a next Vascular Solutions out there, because the challenge is to get to this point are almost insurmountable for anyone. So good news, bad news, certainly good news for our company, I think bad news for the industry. But I will stop there, because then I could start getting into a lot of other things as well.

Jason Mills

I appreciate that Howard. Thanks.

Howard Root

Thanks Jason.

Operator

We will take our next question from Ben Haynor of Feltl and Company. Please go ahead sir.

Ben Haynor

Good afternoon gentlemen. Thanks for taking the questions.

Howard Root

Hi Ben. Thanks.

Ben Haynor

Just one point of clarification and then a quick one is all that left from me. On GuideLiner as in Japan as we get into 2017, am I understanding it correctly that the reorder patterns will be bit more steady and you would see recurring orders every quarter or how should I think about that?

Howard Root

Right, yes. Starting in the fourth quarter, they will start buying on kind of replacement usage pattern. I mean, the Japanese market is fairly unique fairly I would call it, inefficient, where there is a distributor. The distributor has sub-distributors and then there is consignment. So, if you have a 1,000 Cath Labs, they have to stock the product and every Cath Lab shelf to sub-distributor shelf and the distributor shelf. And then in 2015, we had the V2 and then the V3 launching in Japan the same year, but there was double inventory launch requirements, and then in 2016, they are burning that down to where the V2 was now gone. The V3 is getting to a place where it’s just a normal par level. And then in 2017, what they will be buying, a normal regular quarterly patterns like any other distributor is the number of GuideLiners to replace those that are used in the quarter. So, once you get past this one event, which is the launch quantity of a pretty major product launch in Japan, it becomes a lot more like everyday normal country. So, I think this is the last time we will talk about the comparable, because it was $1 million in the first quarter of 2015, $3 million in the second quarter, $1 million in the third quarter, that was the $5 million of launch quantities they bought last year. And then starting in the fourth quarter of 2016, it’s a pretty much exhausted and they will start buying replacement units. And then through 2017, we think it will be a normal ordering pattern.

Ben Haynor

Okay, perfect. That’s helpful. And then the last one from me is was there any impact on revenue and gross margin due to foreign exchange during the quarter?

James Hennen

There was zero impact to our foreign exchange in revenue for this quarter.

Ben Haynor

Okay.

James Hennen

Yes, all of our international distribution agreements are done in U.S. dollars with the exception in Germany. So, we don’t have much exposure to be in with.

Ben Haynor

Okay, great. That’s all I had gentlemen. Thank you very much.

Howard Root

Thanks, Ben.

Operator

And we will take our next question from Jim Sidoti from Sidoti & Company. Please go ahead, sir.

Jim Sidoti

Good afternoon. Can you hear me?

Howard Root

Yes, Jim. I could hear you fine.

Jim Sidoti

Great. Just two follow-up questions. One, if you compare this quarter to the June quarter, you had slightly higher revenue, but your sales and marketing expense came down by $300,000, while your R&D expense went up about a $0.5 million. Can you just talk about what those changes were?

James Hennen

Yes. On the R&D line, it’s really a timing of our projects are flowing through a system. So, during the third quarter, just due to timing of those projects coming through was a lot heavier during the third quarter compared to the second quarter. And on the sales and marketing line, generally commissions are pretty steady at a certain percentage. What changes in there is different marketing meetings we are going to go to that can fluctuate as the quarters progressed throughout the year.

Howard Root

Yes, summer months marketing meetings are down in the Q3, historically.

Jim Sidoti

Okay, that makes sense. And then when you provided the guidance for 2017, what are you assuming for a tax rate?

James Hennen

33.5% for tax rate for 2017. And then it will be reduced by any of the stock compensation GAAP that changed the excess stock benefits be reduced by that. So, those depend on when options get exercised and restricted share in the stock price. So, we guide 33.5% and then reduced by any of those option exercises.

Jim Sidoti

Alright, thank you.

James Hennen

Thanks, Jim.

Operator

[Operator Instructions] And we will take our next question from Larry Haimovitch of HMTC. Please go ahead, sir.

Larry Haimovitch

Good afternoon. My question is on RePlas, will you generate any revenue when you are in the clinical trial phase?

Howard Root

Hi, Larry, yes, I will take that. No, we are not going to. The clinical study will be around 100 patients or maybe it’s slightly less than 100 patients. So, we are not really looking at any revenue. It’s a small clinical study that’s actually paid for by the U.S. Army Combat Casualty Care and we supply the product, but we will not get any revenue from that clinical study.

Larry Haimovitch

Okay. And then Howard, also for you, I think you said during the call, you projected what Turnpike’s revenue would be for this year, did I capture that right?

Howard Root

Yes, for this year, we are looking at around $13 million, a little bit more than that. And you can back out the first three quarters and get to what the fourth quarter is, but it’s a pretty linear ramp, maybe not linear, but it’s a nice jump in the fourth quarter as these procedures get done more in the winter months than they do in the summer months and that’s up from a little better than $3 million in 2015. So, it’s a $10 million growth in Turnpike sales in 2016. So yes, Q4, the projection, it’s around I think about $4.2 million to $4.3 million in Turnpike if you just do the back out from the first three quarters of actual to the annual projection. Annual projection around $13.5 million is what we are looking at for the year.

Larry Haimovitch

Okay, good. I would just say like you are maybe getting back in the projection business again, so I was just checking that out...

Howard Root

Well, you are going to fail on something, Larry I will fail on that one.

Larry Haimovitch

Do you know how much fun I would love teasing you about that, but it’s alright, you have been wrong and wrong in the right way, so we all love you for it. Keep up the good work. Thanks a lot.

Howard Root

Thanks, Larry.

Operator

At this time, I am showing no further questions. Mr. Root, please continue with your closing remarks.

Howard Root

Well, I just want to thank our employees, customers, shareholders for their support. It is another great quarter for the third quarter for Vascular Solutions and I look forward to more as we end 2016. Thank you very much.

Operator

Ladies and gentlemen, that concludes our conference for today. Thank you for participating in Vascular Solutions third quarter conference call. You may disconnect.

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