ArthroCare Q3 2007 Earnings Call Transcript

Oct.22.07 | About: ArthroCare Corporation (ARTC)

ArthroCare (NASDAQ:ARTC)
Q3 2007 Earnings Call
October 22, 2007 4:30 pm ET

Executives
Mike Baker - President, Chief Executive Officer and Director
Mike Gluk - Chief Financial Officer, Senior Vice President
Cory Irving - Director of Investor Relations

Analysts
Brian Wong - Broadpoint Capital, Inc.
Mark J. Mullikin - Piper Jaffray
David Turkaly - Susquehanna Financial Group LLC
Alexander Arrow, MD - Lazard Freres & Co LLC
James Sidoti – Sidoti Company
Raj Denhoy - Bear Sterns
Joanne Wuensch – BMO Capital Markets
William Plovanic - Canaccord Adams
Steven Lichtman - Banc of America Securities LLC
Ed Shenkan - Needham & Co. <

Presentation

Operator

Ladies and Gentlemen, thank you for standing by. Welcome to the ArthroCare third quarter financial reserves conference call. During the presentation, all participants will be in listen only mode. Afterwards we will conduct a question and answer session. (Operator instructions) As a reminder, this conference is being recorded, Monday, October 22, 2007. I would now like to turn the conference over to Miss Cory Irving, Director of Investor Relations. Please go ahead ma’am.

Cory Irving

Good afternoon, and welcome to ArthroCare’s third quarter 2007 conference call. Joining us on today’s call are Mike Baker, President and CEO of ArthroCare, and Mike Gluk, ArthroCare’s CFO. By now, you all should have seen a copy of today’s press release, which was released earlier this afternoon. But if you haven’t, it is available on our website, www.arthrocare.com. A live and on demand web cast of this call is also available on our website. Following introductory comments by management, we will open up lines for a brief question and answer session. In order to give as many of you an opportunity to ask questions, we will accept one question and one follow up per caller. Afterwards we welcome callers to rejoin the queue.

Before we begin, we would like to advise you. Other than historical information, the matters we will be discussing today consist of forward-looking statements. These statements are subject to the risks and uncertainties detailed in our Securities and Exchange Commission filings, including our 10-K, for the year-end of December 31, 2006 and our 10-Q, for the quarter ending June 30th, 2007. Actual results could differ materially. The statements made in this conference call are based on the information available to ArthroCare today, and the company does not undertake any obligation to update or correct them before it’s regularly scheduled call at the end of next quarter. I will now turn the call over to Mike Baker.

Mike Baker

Thanks, Cory, and thanks to all of you for joining in the call today. Here at ArthroCare we continue to aggressively pursue our core strategy of leveraging our platform technologies to deliver innovations to the marketplace in the form of breakthrough products, and to put the infrastructure, clinical credibility and reimbursement in place, to drive the penetration of these products to the marketplace.

We are pleased to be able to report today, that our focus on execution and innovation is continuing to show up on our quarterly results. This quarter we had 78.5 million in total revenue, giving us quarter over quarter revenue growth of 21%, which was right in line with both the published consensus and our expectations. Earnings were at 11.1 million, or $0.39 a share, up 28% from Q3 of 2006 and $0.03 ahead of the published consensus.

This quarter’s strong results were given by, strong double digit growth in the sports medicine business, our largest division, driven by the successful introduction of several key new products, continued growth in the ENT business, and very rapid growth in our spine business, driven by a significant increase in cavity sales, and the introduction of the new MD SpineWand.

We also recorded strong profitability performance in Q3, with an improvement in both gross and operating margins. Based on this strong performance, and our visibility to our ability to sustain this improvement as we go forward. We are officially raising our fourth quarter earnings guidance to between $0.48 and $0.50 per share, which should give you a mean slightly above the high end of the currently published range of estimates.

Mike will be back in a few minutes to give you the details of the financials, and our updated guidance, but in the meantime, let me take a few minutes to comment on each of our strategic business share nets.

First, to the sports medicine business. As you know, the summer quarter is usually the slowest quarter of the year, but we saw strong, double-digit growth in this business despite a steep year over year decline in LEM product shipment. Revenue growth was driven by new product introductions, namely the Magnum PI and the Perfect Passer. And we expect to sustain this performance over the remainder of the year, with the launch of additional new products, including the Twinlocks, which is just being introduced to the market as we speak.

Now to ENT business; overall, the global ENT business grew 24% in Q3. We were encouraged to see good growth from Q2 in the international segment of this business, as the complex new product is beginning to gain traction overseas. This is a little unusual given that Q3 is usually a very sleepy quarter internationally, and it’s definitely an encouraging sign. And what appears to be an annual rite of summer, we saw yet another attempted launch of yet another generation of tonsil product from an ENT competitor. We estimate that the cycle of free evaluation activity probably would cost us about $500000 of business in Q3, and just like last year, will probably continue into Q4 as well. The good news is that the performance of this competitor’s new product appears to again be substandard. And despite an extremely aggressive program of promotional incentives, it does not appear to be getting any appreciable commercial traction.

Finally, during the quarter, we started the national rollout of our sinus initiative. We found a number of indications in functional endoscopic sinus surgery, like sinus polyphectamine (ph), where Coblation technology appears to bring many of the same benefits to sinus surgery, that it did to arthroscopy a decade ago. And we’re excited to bring this expansion into this key market segment. So a solid Q3 in the ENT business, and we look to a stronger Q4, as the competitive evaluations peer out, our international business picks up speed, and we pursue our strategic expansion into the endoscopic sinus surgery segment.

Next I’d like to make a few comments on the spine business. Our spine business had another quarter of strong revenue growth, with quarter over quarter revenue growth of nearly 95% over the third quarter of last year. This represents the fourth consecutive quarter in which we’ve seen strong growth in the spine business. The vast majority of revenue in this business seems to come from our PDD products. However, in Q3, the acceleration of growth from Q2 was driven by the introduction of the MD SpineWand, our Coblation microdiscectomy product, and the continued acceleration in the growth of the cavity product, whose sales are currently reported as part of the overall spine segment.

We are very early on in the introduction of the MD SpineWand, but the early feedback is very encouraging. The surgeons who have had a chance to use this product so far have been very excited about its potential, since it appears to both make the procedure both faster and easier for the surgeon, and hold the promise of an improved outcome for the patient. During the quarter, there were multiple peer review podium and poster presentations, documenting the outstanding clinical outcomes of PDD therapy. The first results from the Gertston (ph) study, which is the prospective, multi-center, randomized control study, comparing plasma disdecompression (ph) to conservative care, were presented at the Congress of Neurological Surgeons, and Eurospine, and will be presented at mass again this week. Additionally, papers highlighting the benefits of PDD therapy were presented at the European Association of Neurological Societies, meeting in Glasgow, in early September, and will be presented at the World Federation of Neurological Societies in Japan in November.

As I said in the last call, we have PDD reimbursement established in the major countries of Western Europe, we are well established with government and worker’s comp authorities in the US, and we are now getting reimbursed, albeit on a case-by-case basis, by all the major private payers in the US as well. While we still have a great deal of work to do with private payers in the US before national coverage guidelines are in place, the addition of this kind of high quality scientific data to the peer review literature, will only make that work more straightforward. I’d like to make a few comments on the interventional therapy business, whose sales as I mentioned earlier, were recorded as part of the overall spine segment. The revenue numbers are still too small to break out these separately, however, the enthusiasm for this business continues to grow. We continue to see a strong increase in case activity, and we were actually challenged during the quarter to build enough product to keep up with the case of increasing demand.

Cavity therapy was featured in a poster presentation at the Congress of Neurological Surgeons in San Diego last month as well.

So, with a quarter to go in 2007, things are playing out better than we’d anticipated, and as such, we are raising our guidance for the fourth quarter and for the calendar year. We find ourselves efficient to meet not only our financial objectives for this year, but also our financial and strategic objectives for our planning horizon. I’ll be back in a few moments to answer any questions you might have, but for now I’ll hand the call over to Mike to run through the financials.

Mike Gluk

Okay, thanks Mike. As you said, our revenue and operational plans continue to be on track for the quarter and for the year. For the next few minutes, I’d like to provide investors with some insight in the key income statement and balance sheet terms.

First to revenue, which totaled $78.5 million for the quarter, was in line with consensus, and on track with our expectations for the year. Through the first nine months of the year, revenue growth has been 20%, with significant revenue increases. Our sports medicine revenue growth was 11% for the quarter, and 11% for the year to date. Included in the growth for the quarter is a very difficult comparison for our OEM segment. In last year’s third quarter, our OEM business experienced some relatively large initial orders, which created a difficult comp for the business in the third quarter of this year.

Adjusting to these orders, the sports medicine growth rate would have been several percentage points higher this quarter. New product introduction, particularly in our Opus product line, have continued to drive double-digit revenue growth in our largest business, and we expect the sports medicine growth rate to increase in the fourth quarter.

Once again our spine business continued to grow. Importantly, to demonstrate traction in two additional emerging markets, microdiscectomy, and spinal tumors. I should also point out that the 95% growth in our spine business, and our 74% year to date growth, is higher than our expected growth for the year. So what should we see? We should see a lower percentage growth rate, although not a lower dollar growth rate, in the fourth quarter. As our spine business growth started to accelerate in the fourth quarter of 2006. Similarly, the percentage growth of 24% in ENT business was at the lower end of our expectations, it was largely due to our reemergence of competitive activity.

That said, we are 23% growth year to date, and we are expecting a strong fourth quarter for the ENT business, based on science determinative product offerings, and geographic expansion, which we expect to continue to drive revenues.

Finally on revenue, on a constant currency basis, our international total revenue grew 26% over the third quarter of 2006, and on that same basis, for the whole company, total revenue growth was 20%. This growth was primarily due to increased sports medicine Coblation sales, and increased spine sales.

Moving to product margin. Our third quarter margin of 71.9% represented a four point improvement over the third quarter of last year, and for the first nine months, our product margin stands at 71.5%, which puts us ahead of our calendar year goal of a 100 basis point improvement, over 2006’s 69.7%. Product mix, material cost reductions, and international profitability, continue to be the main drivers to our margin improvement.

Moving down the income statement to operating expenses. Operating expense increased to over $11 million from the third quarter of 2006. $9 million of the increase is in sales and marketing expense, reflecting additions to our direct sales forces, and higher marketing spend on promotional materials, samples and demos, for all the new product launches across the business unit. Spending and R&D increased 16% to $6.5 million, or approximately 8% of revenue, again reflecting our continued focus on new product development across all of our business units. Our operating margin improved to 17.1 from 16.4 in the second quarter, and 12.1 in the first quarter.

This improvement is in line with our internal assumptions, and keeps us on track toward hitting our guidance level, for another basis point improvement over the 16% operating margin we achieved in 2006.

Moving down the income statement, other income and expenses over $1 million, favorable, versus the prior quarter. Primarily result of increased interest income, resulting from us being debt free in the third quarter of 2007, with higher cash balances, as well as in favorable foreign exchange gain. 23%, again, right on track with the rest of the year and where we expect end of 2007. Adding it all up, reported net income was $11.1 million, 28% increase over the third quarter of last year, which translates to $0.39 per diluted share, $0.03 above the consensus.

Moving on to the balance sheet. ArthroCare continues to generate significant amounts of cash, with cash, cash equivalents and short term investments increasing to approximately $55 million, from $31 million at the end of last year, and $41 million a the end of the third quarter. Accounts receivable, were $71.7 million at September 30th, compared to $61.9 million at September 31st, and is essentially within our sales growth for the nine months to date.

Total inventories were $52.4 million, an increase of only 2% from year-end 2006, and a $3.2 million increase over the second quarter, that primarily reflects a seasonal buildup for our strong fourth quarter sales efforts.

Now the three quarters of 2007 already behind us, we remain on target to hear our 2007 guidance revenue growth of at least 20%, operating margin improvement of 100 basis points over 2006, and GAAP EPS in the range of $1.40 to $1.50. But specifically for the fourth quarter, we are comfortable that revenue will be within the range of published forecasts. We do note that the current consensus is somewhat above 20%. We expect spine revenue growth to be in the range of 50%.

We expect an acceleration of the revenue growth rate over the third quarter growth rates for both our sports medicine and our ENT businesses. And finally in terms of earnings, after a successful third quarter, we are setting earnings guiding for Q4 at $0.48 to $0.50 per share, versus the consensus of $0.47 per share and the street high estimate of $0.49 per share.

As we indicated on the last call, we will be providing some preliminary 2008 guidance during our analyst meeting this Wednesday. For those of you who will not be attending in person, a live Webcast will be available on the corporate website. With that, I think I’d like to open the call for questions. Operator, could you please take questions from our listeners.

Operator

Of course. Our first question comes from the line of Mr. Brian Wong with Broadpoint Capital.

Brian Wong - Broadpoint Capital

Thanks for taking my question. Good afternoon guys. Nice quarter. I just wanted to follow up on the ENT market. You’d originally said, I believe at the beginning of the year that you’re looking at 30%, or you hope to get 30% plus growth in that segment for the year. Obviously, I think you’re behind that. I was wondering if you could talk a little about what is causing that to be a little below what you expected.

Michael Baker

What did we say about ENT in the last call?

Mike Gluk

Last quarter we said 25-30.

Michael Baker

I think that’s pretty much what we expected. We didn’t forecast this relaunch of the competitive product that we saw this quarter. So they’re out there giving product away again, and I think our estimate is that something in excess of half a million dollars of free product was given out in Q3 and we’ll probably see some more of that bleed into Q4. That was the pattern we saw last year. The positive is, or the good news is, is that no one seems to really want to buy the product. It doesn’t work as well as our product and despite some very rich promotional incentives that are being offered to doctors for trying it, they’re not getting any commercial traction. So that’s the most important thing for us long term.

Beyond that, I think we’re beginning to see some signs of life in terms of tonsil penetration outside of the U.S., which is something we’ve been looking to see for some time now. As we said in the first quarter call of this year, the U.K. government has sort of signed on to help out with training surgeons to do Coblation tonsillectomy, and that decision was really driven by the tremendous outcomes differential they see when patients are treated with Coblation tonsillectomy versus traditional tonsillectomy. It’s taken a couple of months for that effort to really move the needle, but I think we’re beginning to see some signs of life there, so between that and sinus, we’re looking for a stronger Q4 in ENT.

Brian Wong - Broadpoint Capital

Okay, and are you still holding to that 25-30% then?

Michael Baker
We’d have to have a pretty good Q4 to get to 30%, but 25% is probably not out of reach.

Michael Gluk

You know as we said Brian we did 24% this quarter, and we’re hoping to have a better Q4 than we had in Q3.

Brian Wong - Broadpoint Capital

Okay, thanks. I’ll jump back into queue.

Michael Baker

Okay, thanks Brian.

Operator

Our next question comes from the line of Mr. Mark Mullikin with Piper Jaffray. Please go ahead.

Mark Mullikin - Piper Jaffray

Good afternoon.

Michael Baker

Hello Mark, how are you?

Mark Mullikin - Piper Jaffray

Good, how are you? I was wondering if you could just give us a little more color on what’s driving the gross margin improvement. Maybe just sort of a rough breakout of how much of it was mix versus the international versus the lower material costs.

Michael Baker

All three of us those were significant, and we’re actually seeing a favorable mix shift in all three of our businesses. Our fastest selling products, in all four of our businesses, pardon me, our fastest selling products across the company in all four businesses are higher margin products. And part of that is due to the fact that they’re the newer products that have been designed to be higher margin, but part of it is they’re also, they add more value and most them have higher ESP’s.

Internationally, obviously we had some help from the currency and the improved profitability business. I think, Mike you detailed some of that.

Michael Gluk

Yeah, you just put them in rank order without giving them numbers, I’d say that product mix is our biggest favorable factor, material cost savings probably rolls in at number two, and then the improved profitability in our international business, some of which is affect and some of it is just a better set of products being sold in our business overseas, and particularly in our sports medicine business, that’s helping us.

Michael Baker

Actually, we discontinued distribution of some products last year that were non-core, and so now our international sales force, and especially in our direct markets, are able to focus more attention on selling the sports medicine products that we think are core to us, the Coblation products and Opus products, and those products have higher margins. So international profitability is, particularly in our direct markets, is definitely improving.

Mark Mullikin - Piper Jaffray

Okay then, just one follow-up. I guess I’m curious, you know, how are you getting lower materials costs. I’m just surprised that you’re getting that in this economic environment. What materials are you seeing some improvements in the cost structure?

Michael Baker

Well, you know, we started off three or four years ago with a program of trying, as we got to be a bigger company and a more sophisticated manufacturing company. We actually brought in for the first time a team of people who are more strategic sourcing experts than just buyers. And if you were to go back five or six years we sourced all of our raw materials, kind of the way most Silicon Valley startup companies did, from wherever the closest vendor was, and we weren’t really that focused on getting the materials at lower costs. Now we’re building these things in much higher volumes, and we’ve professionals who are sort of looking globally for the best suppliers and lowest cost suppliers.

So we’ve actually been driving down our material costs by significant amounts every year. For the last three or four years. And that more than anything is what’s continuing to drive that part of gross margin improvement, just being smarter about how we buy things, buying from better suppliers, buying globally, and buying in larger quantities.

And isn’t all high-tech stuff, I mean some of it’s high-tech stuff, but some of it’s as simple as just sourcing your cardboard boxes. When you do, as we do, several million devices a year, you save a cent on every cardboard box you buy, you save a lot of money.

Mark Mullikin - Piper Jaffray

Great, thank you very much.

Operator

Our next question comes from the line of Mr. Dave Turkaly with SIG. Please go ahead.

Michael Baker

Hey Dave.

Dave Turkaly - Susquehanna International Group

Thanks a lot. Looking under ENT again, if we look at kind of your core business, tonsils and adenoids, and I know we talked a little bit about some of the other opportunities, are you currently selling product today for either the pediatric turbinates, the smile procedure replacement, I think there was a product, maybe some of the sinus surgery, and how big, or is that a significant part of your business today?

Michael Baker

It’s not a significant part of the business today. The best way to think about that, we have (inaudible) There’s always a cell phone call right in the middle of the conference call when you forget to turn off your cell phone. I’ll spare you guys the Giuliani and not answer this. We actually have doctors in every region of the U.S., in every one of our sales regions, who were doing all of those procedures. We had doctors who were doing, pediatric turbinate doctors who were doing the sleep surgery, and doctors who are doing the sinus surgery, but it’s not enough of it at this point to really move the needle.

Although I think that you’re going to see more from that going forward, and as I mentioned in my part of the script, this quarter we actually officially launched our sinus initiative in the United States. And I think that is, of those three, that one in my opinion has the chance to go the fastest, because there are some procedures in sinus surgery like adenoidectomy where the use of Coblation technology significantly speeds up and makes easier and cleaner and less traumatic a procedure that today is being done with mechanical instruments and electro (inaudible). And those kind of opportunities usually can develop more quickly than things that require, sort of more chronicle buy-in, like pediatric turbinates or sleep surgery. I don’t know if that answered your question.

Dave Turkaly - Susquehanna International Group

That’s helpful. I know you mentioned some of the businesses, how they grew internationally. Do you guys by any chance have a breakout of what your total OUS or international sales were for the quarter? Across the businesses.

Michael Baker

International sales were up 35%, but you know what, we don’t have that number in the press release. Do you have that with you, Mike?

Michael Gluk

Sure. So our, Dave, our total international sales were $15.7 million.

Dave Turkaly - Susquehanna International Group

Great, and one last one, interest in other income, can you talk about what was in there this quarter and what we should expect from that line item moving forward?

Michael Gluk

Third quarter last year we had about a $20 million outstanding debt from our credit facility related to some of the purchase buy-outs on Opus. This quarter we have about $55 million of cash and effects, you know some of the effects have just been run through that account. So that’s really the core difference. $20 million of debt and $55 million of cash quarter over quarter is by far the biggest generator of that positive area.

Dave Turkaly - Susquehanna International Group

Great thanks a lot.

Operator

Our next question comes from the line of Mr. Alex Arrow with Lazard Capital. Please go ahead.

Alex Arrow - Lazard Capital

The actual launch of the microdiscectomy SpineWand, has it already occurred. I though it was going to happen right at NAS but you mentioned in your prepared remarks you’ve already had some initial feedback from the field, from surgeons trying it.

Michael Baker

When we introduce a new products, we usually do what’s called a tier one introduction, where we’ll have limited quantities of the product available to a subset of surgeons to get their feedback and to make sure there’s nothing that we’ve missed in terms of the training for the product and making sure the product performs correctly. And also, to give our manufacturing organization the opportunity to sort of shake down the manufacture of it. We did tier one of the MD SpineWand in Q3, got very favorable results, and actually began some commercial shipments of that product in September to a limited number of customers. You’re correct, the first trade show that we’ll actually be showing that product at, is going to be this NAS show that starts tomorrow.

Alex Arrow - Lazard Capital

Okay, so there are some of this new SpineWand that are in the numbers you just reported?

Michael Baker

Absolutely. Q3 of this year is the first time that we’ve had any significant amount of MD SpineWand revenue in it. And it’s because we got finished the tier one in Q3, had good initial feedback, and went ahead and began selling to accounts that were ready to buy.

Alex Arrow - Lazard Capital

Are you at liberty to comment on the price point?

Michael Baker

Um, no, I don’t have that in front of me, to tell you the truth.

Alex Arrow - Lazard Capital

Okay, and how about just, how this MD SpineWand differs from the previous Wand, or versus the other product….

Michael Baker

The earlier versions of this worked well but the feedback we got from the surgeons who were using them was that they were, that they needed to made more robust and they needed to be made easier to use. So that they didn’t require as much training, and that sort of anyone could pick up the wand, with a relatively straightforward amount of training, and be able to rely on and use it in every case and get good results. And I think this new design, which is the design that we’re launching, looks as though it hits the mark in terms of it being much more robust and more easier to use.

Alex Arrow - Lazard Capital

Okay, great, and then last question. I know all of your various wands are, or at least most of them I think, are interchangeable with the same consoles. In this case, you know, spine surgeons are a group that may not have consoles already in place because they’re not your standard orthopedic wands customers in the past, so is part of this launch that you’re doing tomorrow involve a blitz of getting out new consoles and can you comment on the speed you think at which that will happen, so we can judge how this launch might go?

Michael Baker

The MD SpineWand will run off of any of our existing controllers due to the System 2000 of the Atlas and so I think, I don’t think we’re going to have to shipping large numbers of controllers for this. In fact, most of our existing spine customers today use System 2000.

Alex Arrow - Lazard Capital

Okay, but I mean, most of your existing spine customers have been the interventionists as opposed to the spine surgeons, I think, right, so wouldn’t the spine surgeons be a call point, that a lot of them wouldn’t have a console yet?

Michael Baker

Right, but we have a lot of System 2000s and Atlases that, and in fact right now we haven’t built System 2000s in a long time. When we open a new spine account and they need a System 2000, we can basically refurbish an old control and ship it to them.

Alex Arrow - Lazard Capital

Okay, so that’s not going to be a limiting factor in the speed of the launch.

Michael Baker

Don’t think so. You know, there’s a number of different variables there, but I think the basic statement that controllers are probably not going to be a limiting factor within the SpineWand launch is correct.

Alex Arrow - Lazard Capital

Okay great. We’ll see you in a couple of days.

Operator

Our next question comes along with Mr. William J. Plovanic with Canaccord Adams please go ahead.


William Plovanic - Canaccord Adams

Great, thank you good evening. Just a couple of questions, the operating efficiencies in the quarter were pretty astounding you guys seemed to bring in a lot to the bottom line. Just would like to get a feel for what you attribute that to.

Mike Gluk

Well I mean we’ve got a strong improvement of the gross margin line that we talked about earlier in question and then I think while we are seeing a big investment in sales and marketing as we’re adding sales resources and marketing resources, we are getting some leverage out of the other lines in the operating statements. Mike I don’t know if you want to…

Mike Baker

I think that’s exactly right, if you look at, I think if you look at where we’re spending our money we actually spent a pretty healthy additional amount of ARTC money, but we cleared them the sales and marketing line and we put in our RND, so where are we getting that leverage? We’re getting it our GNA and tangibles aren’t moving at all, it’s a combination of that, the really large increase in gross margin and begin able to generate some leverage out of GNA is what’s really helping us on the operating income line. And then quarter-to-quarter we obviously have that favorable change from in interest income from not actually, not being in debt and having some cash to generate some interest income.


William Plovanic - Canaccord Adams

Right I think you said you’d expect that interest to run at a particularly high rate, correct?

Mike Gluk

Well as long as we have that cash in the bank we should be able to generate a reasonable amount of interest income, that’s correct.

William Plovanic - Canaccord Adams

Okay, and then on the other lines we would expect the continuation of leverage on the GNA line on the intangibles, kind of to run at the somewhere nominal rates they’re running at today?

Mike Gluk

That’s right. I’ve actually made an acquisition to do something to intangibles because intangibles are going to be what they are and our GNA line is fairly stable period after period, so yeah.

William Plovanic - Canaccord Adams

Okay and then on your OEM you mentioned you did benefits from EG or comp year over year, is there any way to quantify that in our model?

Mike Baker

I’d actually go with the opposite. Comp was actually much more difficult because the OEM business declined fairly steeply over the year and I don’t know, we’re not at liberty to be much more specific than that Mike, you want to try and

Mike Gluk

Just to repeat what I said you can extrapolate from there, which is our sports medicine growth rate would’ve been a couple of points better had we had just a break even OEM quarter.

William Plovanic - Canaccord Adams

Okay and then just a last question, spine has been doing tremendously well and I’m wondering if the sale of receivable in that business have helped out at all?

Mike Baker

No I don’t believe

Mike Gluk

No we don’t sell receivables.

William Plovanic - Canaccord Adams

OH, okay for some reason I thought you did. Alright, thank you very much.

Operator

Our next question comes from the line of Mr. Steven Lichtman with Bank of America securities please go ahead.

Steven Lichtman - Banc of America Securities LLC

Hi, guys. Just one question in the sports medicine line, you guys are, could you just talk about where you are in terms of the role out of the perfect passer in the Magnum PI, are they now in full production and you also mentioned the twin lock, if you could just touch on what that product is that would be great.

Mike Baker

Okay, the perfect passer is available and its in full production although I can’t tell you that we have as many of them as we’d like to have and the Magnum PI’s are in full production, I don’t think we have any limitations on the number of those we can build. The twin locks a brand new product and actually the first trade show that anyone’s going to see that at is going to be at (inaudible) in two weeks, although those you who were at the analyst meeting here on Wednesday will get a chance to see the twin lock.

That’s just coming out of pier one and the position feedback from the pier one evaluations of it were, was very very strong, it looks like a very good product so we’re very excited about the number of new high performance products that we have in the sports medicine business and I think actually it’s kind of fun to watch because the sales people have got just a lot of new things that they can go and talk to doctors about, all speaking to the same theme of allowing doctors to fix their (inaudible) array of pathology endoscopically which allows us to drive surgeries from being open surgery to endoscopic surgery which as you know for us represents a pure sort of share gain opportunity. So it’s nice to see that strategy play out and to see it begin to show up as a field.

Steven Lichtman - Banc of America Securities LLC

Okay, great and then just one follow up on the international tonsillectomy opportunity, can you flesh it out a little bit more for us in terms of focus just on the UK at this point and what do you need to do from an infrastructure standpoint to take advantage of that opportunity as it grows?

Mike Gluk

Well we have direct sales organizations in both the UK and Germany and in Australia and those markets would probably be the first international markets where we expect the see the tonsillectomy gain traction because you do need to train surgeons or surgeons need to be trained either by us or by other surgeons to perform the procedure correctly and there is some support required especially in the first few surgeries the doctor does with coblation tonsillectomy.

So, those markets will probably go first and I expect the process to look a lot like the process looks like here in the US here as you get sort of critical mass of doctors trained to do the procedure you can start to see the revenue accelerate.

Up until now we’ve done very little business outside the US in coblation tonsillectomy but Q-3 was actually the first quarter where we saw the empty sales outside of the US begin to speed up a little and that’s very encouraging especially given the fact that normally Q-3 outside the US is a normally slow quarter for all the businesses.

Steven Lichtman - Banc of America Securities LLC

So, that’s one of the incrementals you’re expecting here in 4Q?

Mike Gluk

Correct. I think that on the negative side we’ll continue to see some competitive evaluations and product waves, on the positive side Q-4’s always a stronger quarter for tonsils than Q-3 is. We are going to see I think more international penetration and I think we’ll start to see some contribution from some of the new initiates particularly the sinus one.

Steven Lichtman - Banc of America Securities LLC

Okay, great I’ll go back again thanks guys.

Operator

Our next question comes from the line of Mr. Ed Shenkan with Needham please go ahead.

Ed Shenkan - Needham & Co.

Thanks, I have a question on the nuclear plastic products or the PDT as we’re calling it now percutaneous decompression. The revenues have been ramping pretty well could you talk about future expectations you know long and short term for the product and maybe what role reimbursement as well as data publications have had.

Mike Baker

Well the data has been what’s driving the acceptance of the product really that’s what makes the product credible with surgeons and surgeons are of course the ones that control the vast majority of patients, they’re the ones who see the patients that have hernia discs. And as the procedures become credible and surgeons have wanted to do the procedure that has driven improvement in payments globally and as I said in my comments basically now we have reimbursement of the products.

It’s very straightforward in most of the major countries in Europe, it’s straightforward with government payers here in the US, it’s straightforward with the workman’s comp payers and we are now getting paid even though we have to go through sort of cake by cake approval process whether its preauthorization or appeal or whatever, we are getting paid by all the major payment authorities here in the US.

Still have more work to do there, but the publication and presentation of the kind of data that is now being published and presented as spine and neurosurgeon and meeting by spine and neurosurgeon to other spine and neurosurgeons is going to make the remaining work that we have to do very straight forward and we’re excited about what this means for the future because obviously there are a very large number of people out there who have pain that’s caused by contained hernia disc and now we have an effective credible treatment for those folks and it is a major opportunity for us economically.

Ed Shenkan - Needham & Co.

Then Mike can you walk us through the focus that you have on the physicians, is it the INR and the spine doc and others what it is now and how you expect it to change in the future in the spine business.

Mike Baker

Well, our focus right now for this product and for the microsectomy product is absolutely on the spine surgeon to a lesser extent than a neurosurgeon. Those are the folks who are going to perform those procedures, most of them going forward and that’s all. If you look at the new customers that we’re adding they’re overwhelming spine and neurosurgeons.

Ed Shenkan - Needham & Co.

Looking forward to seeing you guys on Wednesday. Can you talk at all about spine product expectations or any preview you could give us for Wednesday?

Mike Baker

Yeah, I’ll say a couple of things and I’ll also take the opportunity to correct a (inaudible) I had earlier. We’ll have the NB at the product display and it will be part of what we’ll be talking about on Wednesday, obviously it will be at the booth also and we’ll also be showing some of the other new spine products that are going to be available starting in fourth quarter. I also want to correct something I said earlier. We do have a specific controller per spine that can be used and I think a lot of our new customers are going to be getting the new spine controller, a lot of our… a special model controller for spine customers and that’s probably what we’re going to be using the majority of the cases going forward.

Ed Shenkan - Needham & Co.

Is there any other pipeline to talk about for spine that you could tell us now or should we wait till Wednesday?

Mike Baker

You gotta wait till Wednesday; Mike doesn’t want me to spoil the surprise.

Ed Shenkan - Needham & Co.

Good looking forward to seeing you guys

Operator

Our next question comes from the line of Mr. Brian Weinstein with William Blair please go ahead.

Brian Weinstein - William Blair & Company

Hi good afternoon. On the sports medicine business if you guys could just talk a little bit about the competitive environment there and is it playing out as you expected it and how do you sort of see it developing forward.

Mike Baker

Well it’s a very competitive business it’s by far our most competitive business. We obviously compete with a large number of companies, most of them are much bigger than we are, they have a lot more resources and a lot broader distribution than we have and I think the reason we’re successful in that business, the reason we have been successful and we expect to be able to continue to being successful going forward is really all encompassed in the product line.

I mean if you look at our product line, product by product, we are selling a broader array of Coblation products and Opus products, they’re higher performance products and they’re able to come in sort of premium share in the market place and in many cases premium pricing, but that is a very competitive business and we face significant competition for everything we sell in that business.

Brian Weinstein - William Blair & Company

Are you seeing anything that’s surprising in terms of Opus franchise sort of being to threaten either you coming out with new products faster than you expected or anything that’s innovative that you guys maybe not expected initially?

Mike Baker

Now we haven’t accepted anything we haven’t expected, I think it’s just taken a little longer than perhaps we expected for the competitive offerings to appear and most of our competitors there have at least some first generation technology that tries to mimic what Opus does in terms of automatics suturing not with hankering. But, at this point we’ve already moved on to second and third generation technology and we’re continuing to bring out even more advanced products like the perfect passer and the twin lock that enables us to address an even broader array of pathologies and even shoulder surgery and I think the only explanation in my mind for why we’re continuing to leak innovation into this field is it represents something really different for us than for the large companies.

If you’re a large company that sells a lot of existing anchors you’re new endoscopic anchor per system is nice because it may be command for small price premium over your old anchors, but it’s going to cannibalize over the old anchor when you use it. So these things like Opus represent for us pure play growth opportunities because don’t have a legacy franchise in open surgery and I think they represent a slightly different thing for the big companies who have a big legacy businesses in open surgery.

Brian Weinstein - William Blair & Company

Sure, okay. Mike Gluk, if you could just clarify the effects in (inaudible) key three, I just want to make sure I got that correct and what you expect given the guidance that you’ve given what you would start for affex in key four?

Mike Gluk

I wish I knew what the effects were in key four I’d probably quit this job and go with the (inaudible) exchange there with you in Chicago, but I think what I said is that our revenue growth, here let me just go back and verify that for you. I think we said 20, 26 percent was the growth without – compared to that was 35% with the affex in there.

Mike Baker

With about 9% growth internationally related to affex and that translates to about 1 point for the total company

Mike Gluk

A little over 21% in total and a constant dollar basis that was over 20%. It would’ve been a little over 20%.

Brian Weinstein

Okay, yeah. And there’s no change of hunting strategy, there’s still largely unhedged to the bottom line, is that correct?

Mike Gluk

That’s correct and as we talked about before we’re not as exposed as some of the other companies since there’s a larger part of our overseas sales actually does occur in US dollars.

Brian Weinstein

Right. Right, Okay, great, thank you.

Operator

Our next question comes from the line of Mr. Brian Wong with Broadpoint Capital please go ahead.

Brian Wong

Thanks again for taking my question. Just a follow up on gross margins obviously you guys are doing pretty well there with 72%. Do you think that you could continue to improve that and squeeze more?

Mike Baker

Yes, absolutely because again our fastest growing products right now are our highest margin products, which means that this mix shift that we’ve been seeing is probably going to continue and we continue to have very active an I would have to say very successful strategies under cost reductions flow through the counting In a way that we actually make a cost reduction and we don’t see the benefit of the cost reduction until several quarters after, so you know, as we sit here today we know that the cost of some of our key materials is actually in decline as we go forward and at the same time we should continue to see positive mix shift and as our manufacturing infrastructure improves we actually see improvement in manufacturing efficiency and in yield as well.

Michael Gluk

You know Brian, I think obviously our biggest exposure so far is in material cost and if oil continues to shoot up and it hits over $100 a barrel and precious metals continue to increase while facing increasing pressure we’ve been able to offset that by good sourcing and volume. And then the other two elements mix and productivity in the plant are more under our control then both of those trends are pointing in the right direction for us.

Michael Baker

If you look at our exposure over all and the direction that our overall costs are moving in, we appear to be pretty well positioned.

Brian Wong – Broadpoint Capital, Inc.
Are you hedging at all in terms of dealing with material costs? Is that part of your strategy?

Michael Baker

We really don’t use enough of anything that it makes sense to hedge it. If you look at any of our products they really aren’t, there is certainly a significant amount of material cost in some of them but not like you would if you were talking about building an automobile or, you know, something that required a lot of material.

Brian Wong – Broadpoint Capital, Inc.

Gotcha, okay. And then you’ve just continued a little bit further on that line of questioning then. Are we on the realm of several points again, improvements? It’s 72, could that move to 75, 80, I mean where could that ultimately go long term?

Michael Gluk

Well Brian, we’re going to give folks a way of guidance on Wednesday at the analyst meeting so I think that’s something we’d just like to defer for a couple of days.

Brian Wong – Broadpoint Capital, Inc.

All right I had to try. And lastly, in terms of your MD SpineWands, you know obviously it’s a better product that seems to be your future in that area. Do you expect that to cannibalize your current SpineWand sales?

Michael Baker

No it’s actually for a different indication. Patients that are treated with PDD are patients with contained herniated disks and prior to PDD there really was not a successful credible procedure to treat those patients. The MD SpineWand is used in a procedure called microdiscectomy which currently being done with mechanical tools and microdiscectomy is really done for a different group of patients. Patients that have either much larger herniations or herniations that have ruptured and you’ve got extruded material. So the MD SpineWand is going to cannibalize the use of the mechanical devices that are currently used for microdiscectomy and should not impact details of plasmic disc and compression.

Brian Wong – Broadpoint Capital, Inc.

Okay great thank you.

Operator

Our next question comes from Mr. James Sidoti with Sidoti Company, please go ahead.

Michael Baker and Michael Gluk

Hey Jim.

James Sidoti – Sidoti Company

Good afternoon, can you hear me?

Michael Baker

We can Jim.

James Sidoti– Sidoti Company

Okay, two quick ones. One can you just give us some kind of quantitative guide here on the growth in spine, was it almost all due to the PDD or did the microdiscectomy 1 play a significant part in this quarter?

Michael Baker

Well, to go back to what I said in the script the increase in growth from Q2 to Q3 is almost entirely attributable to both increased sales of Cavity and the initial sales of the MD SpineWand.

James – Sidoti Company

Okay. Can you give us, was the Cavity more or less, significantly more or about the same compared to the microdiscectomy wand?

Michael Baker

I’m just trying to think about a way to characterize it more specifically. Cavity is growing from a real small base but it’s growing very rapidly. MD SpineWand essentially grew Q2 to Q3 from a base of zero to a decent size number in Q3 with the initial shipments of the product. They both contributed, I don’t know if I can characterize with you on that.

James Sidoti– Sidoti Company

I’m just trying to get a feel for the next quarter when you have that fully launched what we should expect?

Michael Baker

I mean, Mike gave a pretty good guidance with the overall spine segment. I mean obviously next quarter will be the first quarter where we’re comparing to a prior year quarter where there were significant PDD sales. So that percentage is not likely to be as gaudy as it was this quarter. 95% growth was kind of hard to contain, but I do think we’re going to continue to see strong growth out of both the MD SpineWand and the Cavity. I think we potentially could have sold even more Cavity Wands in Q3 if we had had more Cavity Wands t sell. We actually were a little bit surprised by the demand for that product and had to make some adjustments in manufacturing to make sure that we could keep up. So they both look like hot products at this point and I’m not sure I can precisely handicap which one is going to go faster.

James Sidoti– Sidoti Company

Okay. And the issue with the declines in the OEM, you said you had a tough comp in the third quarter last year how does the fourth quarter last year look?

Michael Gluk

The fourth quarter looks a little better. That’s why we’re relatively clear about our ability to improve over our third quarter growing trend given that we have a better comp in the OEM business in the fourth quarter.

James Sidoti– Sidoti Company

Ok. Alright thank you.

Operator

Our next question comes from the line of Mr. Raj Denhoy - Bear Sterns with Bear Sterns.

Raj Denhoy - Bear Sterns

Thank you. Good afternoon. Doing pretty well. How are you? I just wanted to follow up a little bit on the operating margin expansion. You know, in the past I think you guys have talked about 100 basis points a year. It doesn’t seem like you’re tracking quite on that this year. You didn’t mention it in the release or I think even in your prepared remarks, is that something that we’re still looking at for 2007?

Michael Baker

You know what we said Raj, if you go back to the beginning yes we put a large amount of money in place that would be kind of a permanent addition to our signal line starting in the first quarter to really fund the growth of both the spine business and this opportunity in this growing oncology initiative among other things, and that would be a larger slug of cost and would continue to be able to offset that with increased revenues over time so that our operating margin in the first quarter was 12%, which was well below our average at 16% for last year, and we followed it up with a better performance in the second quarter and now we’re at 17%, we expect to be significantly better than that in the fourth quarter so yes we’re still on track we believe. We’re doing about a point better than our 16% margin last year, for the full year.

Raj Denhoy - Bear Sterns

Okay. I guess even when, just even looking at numbers that’s going to require pretty big.

Michael Baker

Yeah that’s going to be basically a carryover Q3 in terms of SGNA and a pretty good relative ramp, which I think is based into most people’s forecast for us.

Raj Denhoy - Bear Sterns

Okay so it does sound like you think those businesses, spine in particular, is at the point where you can start leveraging some of that SGNA spending even now, and start getting, I guess, leverage out of that business.

Michael Baker

While you know ArthroCare and aggregates going to generate quite a bit of leverage in the fourth quarter. I’m not sure that I’d say that there’s a lot of leverage coming out of the spine business at this point.

Raj Denhoy - Bear Sterns

But then I guess taking it one step further I suppose even next year if you’re already starting to pare back that spending relative to the revenue growth we could really see some margin expansion come here in 2008.

Michael Baker

I think the business has the potential for sort of continued systematic margin expansion as we go forward and if that’s clearly a part of our strategy and what we expect to accomplish.

Raj Denhoy - Bear Sterns

Fair enough. I’ll see you guys later this week.

Michael Baker

Thanks Raj.

Operator

We have a follow up question from the line of Mr. Mark Mullikin with Piper Jaffary, please go ahead.

Mark Millikin – Piper Jaffary

Actually all of my questions have been answered. Thanks

Operator

We have one last follow up question from the line of Mr. Dave Turkaly with SIG. Please go ahead.

Dave Turkaley – SIG

Thanks just one last housekeeping one; The discontinuation of the product line in sports med, was that Q6 ‘06 and if so, I think it was, and my recollection was that sports med might then reaccelerate in the back half of this year because of that. Is that true and then was the OEM impact what kind of brought the sports med number slightly down sequentially?

Michael Baker

I think that’s about right. The product line was discontinued at the end of Q2 of last year, so Q3 would have been the first comparable quarter. Although we did see, what’s actually a very steep drop in LEM sales in Q3, and that really was probably could have been expected because Q3 of last year was when we did the initial shipments of products to our early in partners. Those two impacts to some extent offset each other but I think Mike’s point is the correct one and if it had not been for that would have been a couple of points higher in sports med growth.

Dave Turkaley – SIG

Great. Thank you.

Operator

And we have a last question from the line of Ms. Joanne Wuensch with BMO Capital Markets. Please go ahead ma’am.

Joanne Wuensch – BMO Capital Markets

Hi. Thank You. Most of my questions have been answered, but I’m curious. Part of the thesis around ENT was that in addition to tonsillectomies you had opportunities in adenoidectomies and other sinus surgeries. Can you give us an update on where those other applications are?

Michael Baker

Yeah, I think we talked a lot about sinus earlier. We are now far enough along in sinus and we’ve sort of begun the national role out of that and I actually think that of the new indications that may be the one that goes the fastest. But we are pursuing adenoidectomy stuff, and in fact, we do quite a few adenoids right now usually in conjunction with the tonsillectomy. We are pursuing the pediatric turbinate initiative and we are pursuing this initiative with this new form of surgery for sleep disorders. All of them by themselves are large discreet opportunities and we’re over time expecting to get to all of them. My own personal opinion is that the sinus one will probably be the one that makes a significant contribution first, but we’ll see how it plays out. I’ve been surprised before.

Joanne Wuensch – BMO Capital Markets

Okay thank you.

Operator

And we have no further questions at this time.

Michael Baker

We appreciate you guys dialing in. I know this is a very busy time of year and we have this major trade show going on too and we’re happy to be able to afford a very solid Q3. We’re basically well positioned to do everything we need to do this year and we ‘re very much looking forward to the opportunity to those of you who can make it to our analyst meeting which will be here in Austin on Wednesday. We have a lot of interesting things to show you and Mike has got a sort of financial guidance prepared for ‘08. You guys have a great day and we look forward to seeing you on Wednesday.

Operator

Ladies and gentleman, that does conclude the conference call for today. We thank you for your participation and ask that you please disconnect your lines.


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