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Greatbatch, Inc. (NYSE:GB)

Q3 2007 Earnings Call

November 6, 2007 8:30 am ET

Executives

Tony Borowicz - Treasurer and Director of IR

Thomas Hook - President and CEO

Tom Mazza - SVP and CFO

Analysts

Bob Hopkins - Lehman Brothers

Alex Arrow - Lazard Capital Markets

Jason Mills - Canaccord Adams

Tim Nelson - Piper Jaffray

Jeff Englander - Standard & Poor's

Operator

Welcome, everyone, to the third quarter of Greatbatch, Incorporated Earnings Call. Before we begin, I would like to read the Safe Harbor Statement. This presentation and our press release contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, and involve a number of risk and uncertainties.

These risks and uncertainties are described in the company's annual report and form 10-K. The statements are based upon Greatbatch Incorporated's current expectations and actual results could differ materially from those stated or implied. The company assumes no obligations to update forward-looking information included in this conference call to reflect changed assumptions, the occurrence of unanticipated events or changes in future operating results, financial conditions or prospects.

I would now like to turn the call over to today's host, Treasurer and Director of Investor Relations, Mr. Tony Borowicz.

Tony Borowicz

Thank you, Lauren. And welcome to the third quarter Greatbatch earnings conference call. On the call today are Thomas Hook, President and Chief Executive Officer and Tom Mazza, Senior Vice President and Chief Financial Officer.

In terms of today's agenda, Tom Hook will start with a review of the strategic rationale for each of the acquisitions made today and provide our preliminary thoughts regarding our 2008 sales outlook. He will then turn the call over to Tom Mazza to review our Q3 results and comment on our 2007 guidance. We also thought it would be useful to provide a review of our capital structure to help you in modeling net interest expense for 2008.

Tom, will conclude with some commentary on the new FASB legislation, which could change the method of accounting for interest expense for the convertible notes that can be settled in cash. As we have done in the past, we are including slide visuals to go along with this presentation and which you can access on our website. With that let me turn the call over to Tom Hook.

Thomas Hook

Thank you, Tony. As everyone is aware we have spent the last three years optimizing the operations of the company. We relocated 85% of our operations, in which we consolidated eight facilities with two of them in progress, built two new world class manufacturing facilities and commenced construction on a new commercial power building. We have accomplished this while simultaneously growing sales and our medical and commercial businesses at rates faster than our underlying markets.

Over this three year period our sales have increased by 15% compounded annually. Our strategic initiatives have been focused on creating a leverageable platform that can support further growth. We remain steadfast in our mission of being a leader in the comprehensive design and manufacture of custom component technologies for the commercial power and implantable medical markets.

Our intent is to grow through innovation, targeted investments and strategic acquisitions to broaden our technology and market base. Earlier this year, we put in place over $400 million of financial capacity to facilitate this growth. We commenced execution on our growth strategy with the schedule completion of five acquisitions in the current year. These acquisitions are very synergistic with our model of being a leading supplier of innovative specialty niche products, supported with strong intellectual property. Each of these acquisitions has served to compliment our existing business model and add to our current capabilities.

Let me provide a brief review of how these acquisitions stead our strategic direction. In April of this year we purchased BIOMEC, in Cleveland, Ohio. BIOMEC provides us with enhanced design service capability and extends our customer reach from device concept to commercial manufacturing.

In addition, BIOMEC provides the establishment of important clinical relationships and increase our neurostimulation market presence with a minority ownership in Intellect Medical.

In June 2007, we acquired Enpath Medical in Minneapolis, Minnesota. This acquisition provides a number of strategic benefits. First, it broadens our reach into the vascular market. Second, it expands our current product offerings to the existing Greatbatch customer base. Third, it complements our current CRM business and provides a platform to build on in the vascular neurostimulation markets. And fourth, it leverages the proprietary product portfolio, which covers neurostimulation, catheter and Venous Introducers technologies.

We've negotiated a series of three additional acquisitions over the past week. First, we acquired IntelliSensing based in Buffalo, New York, which designs and manufacturers battery-powered wireless sensing solution.

These sensors are used in applications such as oil drilling and provide essential temperature and pressure measurements. This acquisition complements our current oil and gas product offering and enables us to better serve our customers through a more comprehensive solution. We believe, in the future, we will be able to leverage our newly acquired wireless sensor capabilities in the medical market as well.

Next, we acquired Quan Emerteq based in Minneapolis, Minnesota. Quan Emerteq adds to our critical mass in the vascular market. In addition approximately 50% of their sales come from CRM and neurostimulation products, which further strengthen our position and the current customers in these markets.

In addition to the synergy with our base CRM neurostimulation and vascular markets, Quan Emerteq also provides for entry into the high growth peripheral, coronary and neurovascular market space. The addition of Quan Emerteq's vascular products complements Enpath portfolio to create value for our customers and provides for diversification to Greatbatch's business base.

The combination of Quan Emerteq and Enpath portfolios will create the bases for our therapy delivery product line. Yesterday we announced our fifth acquisition the asset purchase of EAC, based in Teterboro, New Jersey. EAC designs and manufactures rechargeable battery pack solutions for customers in the External Medical, Communication, Automatic Data Collection and Environmental and Safety markets. This acquisition is synergestic with our strategy of increased product offerings to our existing commercial customers. The addition of EAC enhances our primary cell product portfolio to include rechargeable batteries and design solutions. EAC complements the markets we currently serve, such as the military market and allows for expansion into the growing External Medical market.

On a pro-forma basis, the addition of these acquisitions will bring our 2007 annual revenue to approximately $360 million. For 2008, our preliminary sales outlook is as follows. We expect our CRM and neuro sales to increase by approximately 5%. We expect our therapeutic delivery sales, which consist of Enpath and Quan Emerteq, to increase by 12% plus. We expect our commercial sales, including EAC and IntelliSensing to grow at approximately 7%.

In summary, we are anticipating our 2008 sales to be approaching $400 million. It is an exciting time for Greatbatch and we look forward to communicating our progress on the integration of these companies and the value these acquisitions will create. With that, I will now turn the call over to Tom Mazza, who will review our results for the quarter.

Tom Mazza

Thanks, Tom. I will provide a brief overview of this quarter's results. I will then talk briefly about our capital structure and finally provide a comment relative to our 2007 guidance. In terms of our third quarter results, we reported sales of $79 million, an increase of 14% over last year. Sales totaling approximately $10 million from Enpath were included in this quarter's results. Excluding these sales, second quarter's results were consistent with last year. As anticipated, sales for the quarter, in particular feed-through sales, were impacted by inventory adjustments from CRM customers.

Our gross margin was consistent with last year's margin at 37%. However, our cost of sales for the quarter includes $1.1 million of inventory step-up amortization relative to the Enpath acquisition.

Excluding this amortization, our gross margin percentage improved to 38%. As at the end of the quarter, there was no inventory step-up amortization remaining relative to the Enpath acquisition.

Operating income adjusted for the ongoing move-related expenses, and also for the purchase accounting cost which was $9.4 million, a decrease of 9% over the same period last year.

Higher RD&E cost and higher SG&A cost offset the improved gross profit generated. These costs increased primarily as a result of including Enpath operations in the 2007 results.

As Tom Hook mentioned, I would like to remind everyone that early in 2007, we started putting into place the financing package to enable the acquisitions we have been executing over the past several months. Our financing activities included refinancing of $118 million of convertible debt and issuing new convertible debt of $80 million.

As a result of completed convertible offering in March 2007, we are left with a total of $250 million in convertible notes, $52 million in the old convertible notes with an effective maturity date of June, 2010, and a $198 million in new convertible notes with an effective maturity of June, 2013.

Nearly, all of our annual interest expense of $8.4 million relates to the $250 million in convertible notes. As of the end of September, subsequent to spending $110 million for the Enpath and BIOMEC acquisitions, cash and short-term investments totaled over $115 million.

In the near-term, we anticipate spending approximately $75 million for the following, $55 million Quan Emerteq acquisition, $12 million on EAC, and $4 million IntelliSensing, plus related expenses for each of these projects, which should leave us a cash balance of approximately $40 million.

The second piece to our financing package was establishment of a new credit facility, which increased our revolving line of credit to $235 million with an [according] feature that could take it to $335 million. At present, none of this credit line is currently drawn.

We expect our cash flow from operations continue to be strong, our operating cash flows combined with our financing package should allow for successful implementation of our aggressive growth strategy.

As many of you are aware, many of you have been reading that the FASB board has issued a Position Paper for comment, which could change the method of accounting for interest expense for convertible notes that can be cash settled. If adopted as proposed, the amount of interest expense recognized for book purposes relative to $198 million in new notes could be substantially increased. This could require interest expense we recognized on a market rate instead of the current 2.25% actually payable on the notes. It should be noted that the two economics in cash flows would not be altered as a result of this change in accounting.

Since we are in the process of attaining purchase price accounting valuations for the acquisitions announcement subsequent to quarter end, our guidance has not been updated to reflect the impact on our 2007 results. Excluding the impacts of acquisitions we are reiterating our revenue guidance of $305 million to $315 million and our adjusted earnings per share guidance of $1.37 to $1.41.

At this point, I would like to turn the call over to moderator to facilitate questions and answers.

Question-and-Answer Session

Operator

(Operator Instructions). And your first question comes from the line of Bob Hopkins with Lehman Brothers.

Bob Hopkins - Lehman Brothers

Thanks and good morning.

Thomas Hook

Good morning.

Bob Hopkins - Lehman Brothers

A couple of things Tom, first, how is it that all these deals are happening in such a close proximity to one another? It [states] me that typically M&A doesn't happen that way. Were these all keyed up and you guys just came to a decision that you wanted to do them all at once and therefore were able to execute them in close proximity? Could you just give us a little bit more of a history there?

Thomas Hook

Well, if roll the hands of time back to the beginning of the year, we very consciously, and in conjunction with the management team and the Board of Directors, rolled the strategic plan to grow the company following our consolidation initiatives we've been running for the past three years. And with that we embarked on a targeted investment and acquisition strategy, both medically and commercially, to identify candidates for targeted acquisition. And we proceeded down the path to complete those in a timely manner.

We have made sure, from a scheduling standpoint, that we are aggressive to the schedule. We did not purposely try to target specific dates, but we had a mindset of wanting to be targeted and aggressive in closing, and have been very open with the aggressiveness of the process with the Board of Directors, who garnered their support. And some of the timing of the deals here over the past couple of weeks is -- they are not linked or consciously linked in any way, but the timing worked out to be that they were coincidental over the same week to week and a half.

Bob Hopkins - Lehman Brothers

Okay. And then as you guys were talking about 2008 guidance, it strikes me that you were talking about things in a little bit of a different way than you have in the past. Are you guys going to be providing guidance a little differently than you have previously, because you are talking about CRM & Neuro and therapy delivery and commercial. Are you still going to be willing to breakdown the components of CRM as you have in the past?

Thomas Hook

I think what we're going to do is now that we've brought some more product lines on both commercially and medically, and I'll reiterate that we continue to have an active interest in targeted investments and acquisitions in these segments. We're going to continue to be adding product lines in there.

And so we are going to shift to report in our principal lines of business around CRM and neurostimulation, what we're calling therapy delivery now and also historically what we called commercial power. Or onto the commercial banner which is somewhat broader than we have originally described in terms of electrochemical cells, which will include primary and rechargeable batteries in a lot broader range of end-market applications. But that's how we're going to, as we move forward provide color on the segments.

Bob Hopkins - Lehman Brothers

So you won't be disclosing pacer batteries, ICD batteries, capacitor sales, things like that?

Thomas Hook

That's correct.

Bob Hopkins - Lehman Brothers

And then Tom, one thing you said earlier this year is that you expected Greatbatch to be exiting 2007 at a 20% operating margin. With these deals and the necessary investments required to build out R&D of these deals, how far has that pushed back or pushed out into the future now that 20%, is it a year, is it two years, can you give us some sense there?

Thomas Hook

Clearly in the base business that we have, the consolidation initiatives will continue to pay, following the shutdown of the Columbia plant and the final relocation down to the Greatbatch Mexico facility. But you are correct, it's with the acquisition of the product lines and the expense that we are taking on and also some strategic moves that we planned on implementing that we have not highlighted yet in the press releases that we have made. We will have to provide more of a walk from a go-forward standpoint.

You are correct that our long-term goals have not changed, we are reiterating these. We want to grow revenue faster than the market. We are targeting 20% operating income and 15% ROIC though, but there will be obviously a difference between the base business, profitability and the product line acquisitions that we bring on. And we are not prepared to provide that breakout yet, but we will provide it, going forward, to give the timing of how we see the strategy unfolding.

Bob Hopkins - Lehman Brothers

And then last question for me is, as we think about next year, because there are so many moving parts and I do appreciate the top line thoughts. But if we're thinking about '08 from an operating margin perspective, if we were thinking about something in the mid-teens, is that in the ballpark of what you guys are thinking about, or something below that?

Thomas Hook

It's probably premature to comment. I felt comfortable enough providing as we did last year, some general top-line view. We are still in the process of -- we have not closed these transactions yet, we still have work to be done, and we are in the end of year process from the base business. So, it won't be until really the beginning of the year when we'll comment on our earnings guidance for 2008 and give more color to that. But we understand that with all the moving parts that there is a desire to have that information, but we're not ready for it yet.

Bob Hopkins - Lehman Brothers

Okay. Thanks, guys.

Operator

And your next question comes from the line of Alex Arrow with Lazard Capital Markets.

Alex Arrow - Lazard Capital Markets

Thank you. On the Columbia plant closure, do you have any more visibility on exact date that you're going to shut the doors there, I mean the first quarter '08 is, I think, the last thing you said?

Thomas Hook

Yes. I think on previous calls I've said that one of the challenges of shutting down the plants 100% is that with regards to customers, we have to make sure each customer product is transferred completely.

And what results is that Columbia really is already partially shutdown, so rather than a drop stop date, it tends to be phased out over time and the vast majority of manufacturing has already been moved to Greatbatch, Mexico.

But there are what I would call, a few product lines that are straggling in the timeline that do extend into first quarter of 2008, and it's really solely governed by when our customers can gain their regulatory approvals for us to stop manufacturing in Columbia.

And right now, where we stand as we see three products that had moved into that window really kind of end of the last few weeks of the year, first few weeks of next year, but largely it depends on the regulatory review windows for the actual and there is testing results that are reviewed for us to actually, so to speak, turn the lights off.

So we're optimistic really in the first quarter, but we'll support our customers until all the risks have been retired and they are fully satisfied with their approvals to do the shut down.

Alex Arrow - Lazard Capital Markets

Okay, so for our purposes for modeling the benefit of the operating margins. Have we already begun to see some of that in your third quarter or is that really starting now in the fourth quarter with the partial shut down benefiting now or?

Tom Mazza

It's probably safe to say, you have seen an effect of about half of the benefit, that we described back when we started the projects and the remainder of the benefit is still yet to come.

Alex Arrow - Lazard Capital Markets

And when you start to see that the other half of the benefit already was in play during this third quarter you just had?

Thomas Hook

That's right, Alex.

Alex Arrow - Lazard Capital Markets

Okay.

Thomas Hook

We think it's about half through similar to what we mentioned last quarter. That's our expectations for '07 and '08 we would hopefully once we exit the building in the first quarter. We would achieve the balance of the benefit.

Alex Arrow - Lazard Capital Markets

And then the final or maybe the crowning piece of your plant changing program over the last two years, I think of what you are doing with the Electrochem division in mid '08. Can you give us the same kind of guidance on that that you just did on this Columbia plant and what are you doing with that facility and also now that you have got [telesensors] and anyone else is adding to the ECP what effect did that have on that commitment?

Thomas Hook

The facilities we are building in the suburb of Boston and Raynham is in progress. We actually, have already broken ground and they are putting in the foundation and really the footers for the building. On the net it has gone very well, the team has done a magnificent job getting that project started and the weather has cooperated. So, we are ahead of schedule. Our plan is to have the Raynham facility up and operational on this time next year or slightly earlier. Some of it is weather dependent, but we will continue to run the Canton, Massachusetts facility, our current facility, until the Raynham facility is up and operational. At that time, we'll move whatever final pieces of equipment are required to the new facility and we will exit and sell the existing Canton facility and then not operate in that building any longer.

Alex Arrow - Lazard Capital Markets

Okay, so the real benefit of operating margins from that happens today. You close the Canton facility which then sounds like it won't be until early '09, if you have got some overlap there as you typically do, right?

Thomas Hook

That is correct and the other half of your question Alex that related to the acquisitions, our first priority is to see the closure of the acquisition that we are still have in the commercial side, pending which is EAC, which we would plan sometime more by the end of month. And in the process of doing that, they have operations in Teterboro, New Jersey as well as in China. We will have the ability for us to drive more volume in those facilities, right now with Canton, we tend to be fairly constrained. And it's a challenge, obviously, until we get into the new facility to be able to take advantage of opportunities in the market to sell. And with the addition of EAC and rechargeable battery technology and the design work that they do, it opens up a new market opportunity for us to press volume through those facilities and capitalize on a very large market opportunity in commercial power.

So we are excited about the opportunity to work with the EAC management team and although IntelliSensing is a smaller company, we are equally as excited with the IntelliSensing team to get into the wireless sensing area and to grow our product line that's really at the beginning of a very large opportunity and it brings us closer to the end customers in the marketplace. For not only the batteries but also for the device that's used in the market.

Alex Arrow - Lazard Capital Markets

If we're modeling about the same benefit to operating margins from closing Canton as we are from closing Columbia is that about right or is it more robust?

Thomas Hook

I would say its bit more fair say to we've been calling out the one-time expenses with regards to the move, so that there's visibility on what that cost is. But largely there is not a cost savings for the move to the new facility in commercial power.

It's more a capacity expansion to allow us to grow the business, which obviously in turn we hope drives the operating income from the top line rather than from a cost savings standpoint. There is automation and productivity efforts going on in the plant, which we also think will benefit but they weren't the primary move for the new facility.

Alex Arrow - Lazard Capital Markets

But they will result in lower cost of goods sold wouldn't they, if you're automating them?

Thomas Hook

It will drive the ability for us to enhance profits and drive volume as well. You are correct.

Tom Mazza

It's more of a -- this is Tom, Alex. It's more of a longer run play though. Clearly when we move the certain operations to Tier 1. There was a labor arbitrage that we benefited from immediately that was the primary driver of the cost savings. On Canton it's really going to be getting to fully utilize the automation into that facility. We basically were constrained in our own facility on how much we could actually capacity -- we could actually get through the facility.

Alex Arrow - Lazard Capital Markets

Okay. Thanks. That helped a lot. If I could ask another question, your Quan acquisition, you said 50% of it is in neurostim. Can you comment on your ability to get the neurostim battery business that St. Jude has, and if you have already either gotten that or can you comment on whether you are planning to?

Thomas Hook

Let me clarify, 50% of Quan Emerteq's revenues are vascular, the other 50% are in CRM and neurostimulation combined, is terms of obviously specific customers, we won't comment on. But in general, we have rechargeable battery programs that we have been highly successful in the medical power business with neurostimulation customers. Quan Emerteq will only enhance our ability to provide those products to customers in that market segment. And EAC's acquisition brings us the rechargeable battery product for both external medical, as well as the other commercial power market.

So, the two acquisitions have done a nice job of enhancing our position in those markets, and certainly by having Quan Emerteq's expertise in neurostimulation, it is a nice leverage point for continued success in the rechargeable battery side of the equation for our medical power segment, which we have done a very nice job on the last year and half of winning some key accounts, even though that they'll go nameless at this point.

Alex Arrow - Lazard Capital Markets

At this point, you mean you will name them at some point?

Thomas Hook

It's highly unlikely, unless as you know that there is a requirement that we would have to issue a disclosure for a major contract. But, as a matter of course, we are going to maintain our confidentiality with current customers, as that has been of primary importance with every single one of our customers, and I expect that to continue in to the future as well.

Alex Arrow - Lazard Capital Markets

Okay. All right. Thank you.

Operator

And your next question comes from the line of Jason Mills with Canaccord Adams.

Jason Mills - Canaccord Adams

Hi guys, good morning.

Thomas Hook

Good morning.

Jason Mills - Canaccord Adams

I just wanted to ask a few questions, stemming off of some of Bob's questions. Most of the acquisitions you have announced this year, you talked about at least lately the acquisitions being earnings neutral in 2007 and 2008, so couple of questions. First, on the top-line, could you break it down a little bit in more detail for us and help us understand what your organic number, organic growth rate would be or organic guidance would be, excluding all the acquisitions, maybe including Enpath if you want, because I think most of us have that stimulated into our model.

And the second question would be from Bob's question about going to 20% operating margins, at least in my model I didn't have been doing that at least until 2009, 2010, so I don't know how we get to that level. But we do have this sort of in the upper teens in 2008. And given that you've talked about these acquisitions being earnings neutral, could you comment perhaps as to a sort of a range of operating margins we could expect, just on the base business, assuming again that what you said is true about the acquisitions been earnings neutral in 2008.

Thomas Hook

Sure. Jason if you look in the presentation on page 11, that's about the extent of the information on outlook that we feel comfortable providing at this point. CRM and neurostimulation are effectively the base business that we've been in for Implantable Medical Components for some time and we're calling that outlook for sales next year around 5%.

Therapy delivery is effectively the Enpath and Quan Emerteq combination. We've provided kind of the 12% plus target from an initial standpoint of how we're looking at 2008.

Commercial, which is the base commercial business, plus the two acquisitions we highlighted on the call here, IntelliSensing, which is the small sub $1 million revenue company that we announced week or so ago. Then EAC, which we said in the press release, is kind of $20 million to $23 million in size. And we're guiding that that segment is going to be about 7%.

We are just not really in a position with the moving parts here at this stage and bringing on these product lines to provide a detailed guidance for 2008. We are going to wait till the first quarter conference call to do that. And we will give a little bit more color and visibility to our [walked] operating income strategically and then also where we'll be from a profitability standpoint as we bake, but largely described correctly as a breakeven deal on these from an economic standpoint going forward.

But, clearly, the combination of all these deals is going to provide us some opportunities for continued expansion in the revenues, and potentially some opportunities for consolidation, although that's not the primary purpose. But it is also allows to us to cross-leverage between the businesses more effectively. We, at this point, aren't going to describe what those are, but we will provide more color for them starting at the beginning of the year. And we'll also provide really a formal guidance for 2008 as we normally would in the end of year conference call we do in the February timeframe.

Jason Mills - Canaccord Adams

Yeah, I could certainly appreciate. You guys have many moving parts, and as Bob mentioned they've all come together. And you mentioned coincidentally here in a short period of time, so I can certainly appreciate. I would certainly know how they experienced personally stimulating acquisitions let alone this many at one time. And I am sure you can appreciate at the same time that your equity is being valued on 2008 numbers and we have to come up with some sort of rational view into 2008 and most of us have that I think for 2008 sort of before the [third] acquisition pay started, maybe included Enpath, and you have given some good guidance following Enpath.

So, I guess I am pushing you a little Tom, in understanding the sort of the difficulty that you have. You can appreciate where we are and perhaps we could talk about it, sort of all things been equal. In another words, Tom mentioned the potential step-up in interest expense so there is a lot of moving parts there, which really are out of your control at this point.

But sort of all things been equal excluding that and perhaps assuming the earnings neutrality of the other acquisitions, it looks like consensus is somewhere in the let's call $1.60 to $1.75 range or sort of operating margins in the 16% to 18% range on what before expecting for a revenue base sort of before these acquisitions. I suppose you may wanted to refer again, but I just started giving another shot, because there is a need for us to get our clients a better viewpoint or a better sort of rational thinking about 2008?

Thomas Hook

Sure, I think when you look at the base business that we've had and have been providing guidance since the beginning of the year [glide path], although slightly affected by the delay in the shutdown of Columbia, is largely on plan. We've done a nice job of moving and doing the revenue growth at the same time and producing results as predicted.

When you look at the acquisitions that we've done, the five pieces that has been brought in thus far this year, we've driven with those acquisitions some incremental research development and engineering expense, because we want to capitalize on opportunities more aggressively. And we've also largely put those acquisitions into the company grouped Enpath and Quan Emerteq, obviously Quan Emerteq is not closed yet so that is still pending, and largely we have to put together that business unit which is going to take some investment, and we have to obviously have EAC, IntelliSensing dovetail into what our existing commercial power business.

So there is some incremental expense there but not a great deal. And what will result is after some of that investment if there is going to be any major products announced, we would certainly highlight those. But largely, we would be importing those product lines and running them as is and trying to drive top line growth.

So beyond getting down into the deal synergies and initiatives, it's not having closed these deals yet, it's we are at a little bit of an awkward point and we have to move and get these closed and it's premature to provide really anything below the revenue line in terms of color until we kind of get to the juncture in which we can have the closing date passed.

With our more detailed plans together with the existing management teams that come over and then provide inputs that are backed with strategy and plan between the two management teams on how to move forward. So I understand the frustration and the challenge in situation that you're in.

But I think if you look at just the base business being on the path that we've been executing on and these product lines that we very strategically targeted and put into the business, although we are driving a little bit of extra expense and we are not doing a dude deals in any of these and it won't be a drag kind of earnings and it will largely give you ballpark, the answer that you are looking for.

Jason Mills - Canaccord Adams

Okay. So just sort of thank you for that. So just sort of tail that together, we had a little bit of incremental expense here in the third quarter from the Enpath being fully integrated, perhaps the operating margins this quarter somewhat suppressed versus sort of normal levels from that than we have the facility closure now in the first quarter that should help, and then perhaps a bit of more organic growth, if you will, next year than we saw this year. So, we should see, net-net operating margins expand and you will provide more clarity into what type of expansion we should see, including all the acquisitions on the fourth quarter call. Is that a fair assessment?

Thomas Hook

I think that's a very fair way to assess it, and I think you are looking at it correctly and I think that you are spot on with the macro, the micro obviously is where we can have a lot of, I can't have a lot of discussion.

Tom Mazza

Jason, one thing we can say, I think, which people are underestimating to a certain extent, maybe the level of the RD&E spend, I mean we've mentioned this a couple of times that we are increasing our RD&E spend, and clearly that was not fully, we have not hired all the people we needed to hire in 2007 to make that come through. So that, we expect the run rate for RD&E expense to go up in the fourth quarter and after that.

Jason Mills - Canaccord Adams

That's helpful. By the same token, you have also talked about bringing the SG&A down, is that also on track?

Thomas Hook

Yes.

Tom Mazza

Yes. That's correct.

Jason Mills - Canaccord Adams

Okay. Thanks, guys.

Thomas Hook

You are welcome.

Operator

And your next question comes from the line of Tim Nelson with Piper Jaffray.

Tim Nelson - Piper Jaffray

Hi. Maybe can you elaborate a little bit, when you did the Enpath deal, you talked about significant RD&E increase and marketing increase to leverage those opportunities. How does the Quan Emerteq deal play into that? Were you considering the Quan Emerteq deal, when you talked about those increased expenses, or is Quan Emerteq on top of that?

Thomas Hook

Well, I think where we were at the Quan Emerteq is -- in running the business we never really, what I would say, plan or bank on a deal occurring. We've identified gaps in areas that we need capability and we look at ways to fill those gaps through investments, acquisitions, as well as internal innovation.

And following the Enpath transaction, we have squarely looked at internally funding research and development to innovate and get the technologies that we need to be more competitive in the Enpath product lines, and that in turn, obviously is what we're doing to win deals with customers and to drive revenues.

The addition of Quan Emerteq will help fill some of those gaps quicker, but also because of their technology base opens us up to do more work for our current customer and Quan Emerteq's customers faster.

So we still plan although the details have not been ironed out, we still plan to do research and development expansion at both Enpath and Quan Emerteq to fuel that growth from the revenue side.

And obviously because of the nature of projects, we are acquiring development, testing and regulatory approval. Sometimes there can be a year to two-year separation from design or concept through revenue generation.

But we think being aggressive on that side is the correct way to look at the market and for us that leads with innovative technologies that we can bring in property when we work with our customers for product development. So they can be successful and us at the same time.

So we see that with Enpath and QuanEmerteq together, and working together, we'll be able to leverage those opportunities more effectively. First and foremost, we have to complete the Quan Emerteq transaction, so that we can start to enjoy the benefits of what those combined opportunities are.

Tim Nelson - Piper Jaffray

Okay, Enpath itself when are you going to be able to highlight some of the growth barriers there more fully for instance the arterial vascular assays and some of the other projects. When are they going to coming forth in to the company?

Thomas Hook

As the various projects reach fruition, clearly Enpath, very strong in the venous introducer market. As, we have been fortunate enough to acquire Enpath, there is a very keen interest in the arterial vascular introducer market and all segments, for that there has been a lot of great work that's been done by the Enpath teams to make progress in those markets.

Although, we have not highlighted on any areas that we are prepared to talk about from a strategic standpoint that is an absolute central point of the Enpath strategy and now a central point of the therapy delivery business strategy, that we will plan prominently in terms of communication as we win those opportunities going forward and we highlight the growth opportunities.

So, I don't have an exact date that I would say that we are willing to commit to that we describe it, but definitely they are within the strategy. We have been working the challenges and are very confident in our ability to perform and gain entry into those markets. And that's some of what's driving some of the internal research and development spending is in order to more effectively go after that opportunity at Enpath.

Tim Nelson - Piper Jaffray

And then a final question on the closing schedule of all these deals. Do you think there will be charges out in the Q1 '08, or do you think you'll be able to take care of them all in Q4?

Tom Mazza

We are working on the valuations now, we think we can get the lion share done in Q4, but obviously I doubt they'll be all closed out by the end of the year. I think we'll still have some through ups into the first quarter.

Tim Nelson - Piper Jaffray

Okay, great. I will get back in queue thanks.

Operator

And your next question is a follow-up from the line of Alex Arrow with Lazard Capital Market.

Alex Arrow - Lazard Capital Market

Thanks, the accounting change that you described that could impact your guidance. You described it is cash settlement accounting. I didn't quite understand how much of a magnitude that would make. I mean, if it's difference in cash settlement, and when you are booking revenues, should we take the amount of your receivables and estimate that that's going to be the magnitude of the change when we are looking at. How that's actually going to play out?

Tom Mazza

No, I’m sorry Alex. Now this has nothing to do with revenue recognition, it is only interest expense related and this has not been fully adopted yet, it's still out for comments by the FASB board. What we're doing is highlighting it. We have our convertible $198 million of our $250 million convertible notes, and have net cash settlement provisions, which make it more debt like than equity like. Those types of securities, they refer to as type C securities, are being looked at by the FASB board to cause people to go rather than the 200 quarter percentages, which we're currently paying on them to consider what the market rate of interest would be. So potentially it basically makes no changes in cash flows, no changes of things, but could potentially double the amount of interest expense on those particular items.

Alex Arrow - Lazard Capital Market

On $198 million of principle items.

Tom Mazza

On a $198 million, correct. But, like I said, it absolutely makes no difference in the cash flows, it's a non-cash item and really the two economics are unchanged and this is not been adopted yet. So, it's definitely going to be '08 before we see anything on this.

Alex Arrow - Lazard Capital Market

And you are saying the 2.25% assumed interest rate and that $198 million could go up to or perhaps double that, perhaps 4.5?

Tom Mazza

Yeah, potentially double that. It's 2.25% plus the discounts. So, it could potentially go to 6% to 8% potentially rather then the 3%, 3.5% we currently have been experiencing.

Alex Arrow - Lazard Capital Market

Okay, all right. Thank you.

Tom Mazza

Once again it's a non-cash item.

Alex Arrow - Lazard Capital Market

All right. So, the total magnitude then, would only be about 3% on $200 million or about $6 million of impact?

Tom Mazza

Potentially more, yeah, it's probably more. The definition of how it gets calculated, I'm really hasn't to do it. It could be 3% to 5% more interest expense.

Alex Arrow - Lazard Capital Market

And this sort of affects every company that has…?

Tom Mazza

Every company that's got these, it's all the same. There is 100s of them out there.

Alex Arrow - Lazard Capital Market

Okay. Thank you.

Operator

(Operator Instructions). And your next question comes from the line of Jeff Englander with Standard & Poor's.

Jeff Englander - Standard & Poor's

Good morning. Just a quick question, without talking about specific customers, can you give any color on any fallout in the market in general from the Sprint recall?

Thomas Hook

I couldn’t quite understand the question, Jeff, you are cutting in and out when you asked it?

Jeff Englander - Standard & Poor's

Let me try again. Without talking about specific customers, can you give any color on any fallout in the market in general from the Sprint Fidelis recall?

Thomas Hook

I think I would say that obviously any news such as this provides an overall chilling effect to the macro market. Certainly, from a standpoint of individual companies and individual product line there can be some short-term shifting. We don't have the visibility really to the degree, in terms of the individual product lines to highlight any changes. But, I would say just the macro effect is, any bad news tends to be a drag on our ability to get some lift from the market growth rate.

And I think that's a trend that has kind of hit us moving into 2007. It's obviously been a drag all year with some of the recall moves that's been out there before the year started and during the year. And largely, what we are doing is a very strong job at maintaining linkage with our customers' production system, so that we are in tight coordination, up or down, to be as efficient as possible in working to support them with whatever happens. That's our job and that's pretty much how we will continue to grow the company, despite kind of the tough market news which we all feel.

Jeff Englander - Standard & Poor's

Have you seen any increased pace, or increased activity on the regulatory front, in terms of activities and either tracking components or leads or product development all the way through? There has been some talk about additional regulatory measures to take earlier action on recalls of this kind?

Thomas Hook

I think it's safe to say that a lot of our product lines, we do not do regulatory filings on. We coordinate with our key customers to provide information for them to do that. We do a very thorough job and historically have done an extremely thorough job at testing and providing information in very standardized time proven protocols, and with the acquisitions of Enpath in particular. And in BIOMEC, we have new regulation to the company, because those product lines are regulated. I see for us that while we definitely are increasing our standards because of the nature of the work we are doing, we still have a very strong commitment to quality and reliability, and we do an extensive amount of testing.

I would say regulatory hurdles have been very large for us over the past two to three years because with the number of facility moves that we've been doing, we've been keying those moves to final customer regulatory approvals.

So it does feel like we're subjected to more regulation, but the plant moves are really driving that. I couldn't really comment to say that from our experience, in our product lines, we see that that regulatory is being driven more harshly because of the market recalls per se. I just don't have visibility to that, ours are move-related in the acquisitions of product lines we historically have not had.

Jeff Englander - Standard & Poor's

Great. Thanks very much.

Operator

And your next question comes from the line of Tim Nelson with Piper Jaffray.

Tim Nelson - Piper Jaffray

Yeah. This is a follow-up to that question. Relative to all of the uncertainty in the CRM marketplace, relative to market shares and what not, and your own reconfiguration of your manufacturing facilities, do you have the capacity to respond to short-term needs from any one customer that might have a quick increase in demand?

Thomas Hook

That's an excellent question and was a principal reason behind relocating our manufacturing facilities at the higher stability facilities, just to get exactly at what you're talking about, Tim. We have spent a lot of time making sure we have the bandwidth, so to speak, to efficiently expand production based on what the customers' needs are, and have done a great job in all of our operations to use lean manufacturing technologies as well as Six Sigma quality system to drive the same quality and reliability we've always had. But also worth the responsiveness of lean manufacturing, and largely because of the success of the business units to do these moves, get into new facilities, we have already been able to leverage some nice short-term revenue opportunities that historically would have been a lot more challenging, if maybe not possible at all. So, I think that's an essential point, of having the consolidation done as we can enjoy those now going forward.

Tim Nelson - Piper Jaffray

Great. That's all I had.

Thomas Hook

Thank you, Tim.

Operator

And that does conclude today's question-and-answer session. I would like to turn the call back over to Tony Borowicz for any closing remarks.

Tony Borowicz

Great. Thank you. Again I would like to remind everybody that both the audio portion of this call and the slide visuals will be archived on our website at www.Greatbatch.com for 90 days. As always I am here to help, so I appreciate the phone calls and help with the clarity of these acquisitions. Thanks everyone.

Thomas Hook

Thank you.

Operator

And thank you for your participation. That does conclude today's conference.

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Source: Greatbatch Q3 2007 Earnings Call Transcript
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