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Orthofix International NV (NASDAQ:OFIX)

Q3 2007 Earnings Call

November 6, 2007 11:00 am ET

Executives

Dan Yarbrough - VP of IR

Alan Milinazzo - CEO

Tom Hein - CFO

Tim Adams - CFO

Analysts

Josh - Jefferies and Company

Steven Lichtman - Bank of America Securities

Michael Matson - Wackovia

Steve Ogilvie - ThinkEquity

Jason Wittes - Leerink Swann

Dave Turkaly - SFG

James Sidoti - Sidoti & Company

Stan Manny - Manny Family Investment

John Putnam - DawsonJames Securities

Operator

Good morning. My name is Amy, and I will be your conferenceoperator today. At this time, I would like to welcome everyone to the OrthofixThird Quarter Financial Results Conference Call. (Operator Instructions) As areminder, ladies and gentlemen, this conference is being recorded today,November 6, 2007.

Thank you. I would now like to introduce Mr. Dan Yarbrough,Vice President of Investor Relations of Orthofix. Mr. Yarbrough, you may beginyour conference.

Dan Yarbrough

Thanks operator. Good morning everyone and thanks forjoining us this morning, to discuss Orthofix International's financial resultsfor the third quarter of 2007. During this call, we will be makingforward-looking statements within the meaning of Section 27-A of the SecuritiesAct of 1933, and Section 21-E of the Securities Exchange Act of 1934 thatinvolve risks and uncertainties.

All statements other than statements of historical fact areforward-looking statements, including any earnings guidance we provide and anystatements about our plans, beliefs, strategies, intentions, expectations,objectives, goals, or prospects. Factors that could cause actual results todiffer materially from forward-looking statements made by us on this call,include the risks disclosed under the heading "Risk Factors" in our2006 Form 10-K and subsequent Form 10-Q filed with the SEC.

Presenting on our call today will be Orthofix's CEO, AlanMilinazzo; and our current CFO, Tom Hein; as well as our new CFO, as ofNovember 19, Tim Adams. With that, I'll turn the call over to Alan.

Alan Milinazzo

Thanks, Dan, and good morning everyone. As you'll have seenfrom our two press releases earlier this morning, in addition to our thirdquarter financial results, we announced some additional important newsregarding the settlement of our intellectual property litigation withMedtronic's, as well as the employment of Tim Adams, as our new Chief FinancialOfficer. I will review each of these important events in detail later in thecall. First, however, let’s outline the highlights of another successfulquarter at Orthofix.

With third quarter revenue growth of 45%, including thepositive impact of the Blackstone acquisition, and earnings of $0.48 per share,we were once again in line with our range of guidance. In what has historicallybeen our weakest quarter of the year, once again, each of our core businessunits showed strong revenue growth year-over-year. Spine sales were up 109% ona reported basis, including the impact of the Blackstone acquisition. If webreak that down into the implant and stimulation segments, revenue growth fromthe Blackstone Products remained on target at 41%, and spine stimulation saleswere up 9%.

However, if we consider that the third quarter of last yearincluded about $650,000 of stimulation revenue from the government’s Tricare program, which represented a lump sum catch-upreimbursement for the prior period cervical stimulator sales, the adjustedgrowth rate is roughly 11% year-over-year. Either way, as we had expected,there was a clear acceleration of spinal-stim revenue growth in the thirdquarter, compared with the 7% growth rate we reported during the first half ofthis year.

Strong year-over-year growth in our spinal implant andbiologic revenue was once again driven by a variety of products. From ourunique ICON minimally-invasive pedicle screw systems and Unity Anterior LumbarPlating Systems, to our Pillar and Construx vertebralbody replacement devices, and revenue from our biologics portfolio continues togrow as well, and made up about 19% of total implant revenue in the thirdquarter of this year versus only about 14% a year ago. These numbers don’t yetreflect any significant increase in the supply of opportunity received from (inaudible) Therapeutics, but we are stilloptimistic that we may begin to see an increase that could create momentumgoing into 2008.

As you may have alsoseen from our press release during the third quarter, we announced at Euro Spinein Brusselsthat we had acquired the technology for the InSWing Interspinous Spacer fordistribution, primarily in our international market. This is an excitingaddition to our portfolio of products, and we currently expect to begin ournormal physician assessments and limited market release stages in selectinternational markets over the next few months.

At the NorthAmerican Spine Society, or NASS Conference, a couple of weeks ago, wehighlighted some new instruments we have added to our portfolio includingProview, our suite of instruments designed to be used at a minimally invasivesurgical environment, as well as, Blackjack which is an innovative design, devicedesigned to simplify both the distraction of the spine, any insertion of Allograft,and vertebral body replacements.

At NASS, we alsohighlighted Advent, our Artificial Cervical Disc, which is currently indevelopment. You may remember, we announced this summer that we have performedthe first human implant of this device in Brazil. At this point, we stillanticipate CE markings later this year in a limited launch of the Advent discin Europe in early 2008.

Pushing to the United States for a minute, we recently receivedconditional approval for IDE of the Advent Cervical Disc, which will allow usto begin clinical studies in the U.S. starting early next year. Our currentplans include a 25 site study that will involve approximately 180 to 200patients. If everything goes according to our plan, we would expect Advent tobe commercially available in the United States around the end of2011.

As we have indicatedin recent public presentations, acquisitions will continue to play a major partof our strategic growth plans over the next couple of years, and our corporatedevelopment group continues to explore a number of opportunities that webelieve could help us achieve our goals.

Summarizing our spine results, our total year-to-daterevenue of $180 million makes us the fifth largest spine company in the world.

Moving onto our orthopedic business unit, revenue rose 12%year-over-year. We experienced another strong quarter of sales growth from ourPhysio-Stim long bone stimulator, which continued to take market share with a28% increase in sales.

This also reflected the positive impact of increased revenuefrom our most recently launched internal fixation and deformity correctiondevices, including our VeroNail and Centronail internal fixation nailingsystems, which were introduced at the AALF conference earlier this year.

Finally our innovative eight-Plate for pediatric deformity,continues to gain clinical acceptance, and this increased revenues for us.

Continuing to be a bright spot for us in 2007, our SportsMedicine business grew at twice the rate of the overall market, with a salesincrease of 14% year-over-year. This impressive increase was driven by an 18%increase in our functional knee bracing sales, reflecting the continuedpopularity of FUSION, which is ournewest line of braces that were introduced at the beginning of last year.

We also experienced a 15% increase in sales of our coldtherapy products including our newly introduced Kodiak line of products. Webelieve Kodiak will help us maintain our position as the market leader incontinuous flow cold therapy products.

Turning to international, international revenues for thequarter were light at 7% year-over-year. We can attribute a good portion of thesoftness in our international revenue to our largest vascular distributor, whichis reducing their inventory and their year-end inventory level by 50%.

While we are still seeing consistent demand at the userlevel this did result in lower third quarter revenue for us in this segment. Wedo expect to have some impact in Q4, as well as our distributor continues toadjust their inventory levels to reflect their new operational guidelines.

However, despite this softness in our internationaldivision, if we exclude the revenue contributions from the Blackstone spineimplant biologic products, our legacy Orthofix businesses overall still grew asolid 10% year-over-year.

Moving on to our gross margin, as expected this quarter wesaw a significant improvement in this ratio compared to the first two quartersof this year. We reported a gross margin of 74.6% in Q3 compared with 73.2% inthe previous quarter this year.

As Tom, will discuss in a minute we did get a benefit to ourgross margin during Q3, but even excluding that benefit we would have been ataround 73.9%. This is an improvement from the prior quarter, and about where wethought we would be in Q3 as we continue to expect improvement in this metricthrough the fourth quarter.

Before I turn the call over to Tom, I’d like to spend a fewminutes discussing the few other important announcements we made this morning.We are very please that we have reached an agreement with Medtronic's relatingto a patent infringement suit they filed last year involving BlackstoneMedical.

Though we are not releasing the terms of this agreement, youmay have noted from this morning’s press release that it did negatively impactour third quarter results by $0.02 per share. Tom will walk you through theaccounting of this settlement in another minute or two, but I am very pleasedto have resolved this issue and reached this agreement with Medtronic's.

Having this issued resolved in a fair and expedient mannerwill allow us to focus more on continuing to improve our operations and thereturn to our shareholders. Having said that at this point, I'll turn the callover to Tom, after which, I'll talk about our new CFO, Tim Adams, you'll get achance to hear from Tim, and give you an update on some of the activities thatwill benefit us in 2008, as well as, give you the expectations for the fourthquarter, Tom?

Tom Hein

Thank you, Alan. Good morning. My comments will start withthe income statement, and then move to the balance sheet and cash flow. As I amsure, you are aware, the third quarter represented the completion of our firstfull year of ownership of Blackstone Medical, and as I'm sure you willremember, the third quarter last year, included the effects of the purchaseaccounting associated with this acquisition.

As we reported today, in our earnings release, and as Alancovered in some details, sales for the third quarter were $121.1 million, up45% over the prior year, including the positive impact from the inclusion ofBlackstone, which had a 41% increase in revenues, year-over-year.

The impact of foreign currency on sales in the third quarterwas a positive $1.5 million or 1.2% of total sales. Excluding the contributionfrom Blackstone, Legacy Orthofix revenues grew approximately 10%, compared withthe third quarter of 2006.

Year-to-date sales are also up 45% over the prior year, to$361.5 million, including 5.5 million or 1.5% from currency.

Year-to-date, revenue from Blackstone products are up 41%,compared with 2006. Excluding Blackstone, year-to-date revenue from LegacyOrthofix businesses are up about 11% compared to the prior year. I refer you toAlan's previous comments, and to our earnings release for additionalinformation on our product and market sector sales.

Shifting now to margin, gross margin, our gross margin of74.6% in the third quarter compares to 74.8% in the same period in the prioryear. This year’s third quarter number included the negative impact from theamortization of the step-up in inventory associated with a Blackstone purchase,and also from foreign currency, both of which items we have discussed with you inconnection with their effects in prior quarterly calls.

As a reminder, the third quarter marks the end of theamortization of the step-up in inventory, which will benefit our growth marginby about 70 basis points beginning with the current quarter.

We also experienced the benefits to our third quarter gross margin,primarily due to reversal of a previously recorded accrual for potential costsassociated with the negotiations with the distributor. If we exclude thisbenefit, to the growth margin in the third quarter, then the gross margin ratiowould have been 73.9% excluding the impact of amortization and foreign currencywhich is right about where we had previously estimated, would be in the thirdquarter, and reflect in part the result of having worked through the margincompression we experienced in our spine-stimulation business in the first halfof the year.

The reason I am taking extra time to go through this is sothat in your modeling you don’t just assume that you can add 70 basis pointsbenefit from the ending of the amortization of the Blackstone inventory step-upto the current quarter’s reported growth margin.

Operating expenses, our sales and marketing expense ratiowas 38.8% in the third quarter, compared to 38.4% in the prior quarter, andcompared to 43.5% for the prior year. Sales and marketing expense in the thirdquarter of last year included the impact of approximately $4.7 million ofmonthly fees associated with the termination of the Danek marketing agreement.Excluding these fees the sales and marketing ratio in the third quarter was37.9%.

The year-over-year increase in the sales and marketingratio, excluding the impact of the termination of the Danek agreement isprimarily attributable to the acquisition of Blackstone, which currentlycarries a higher sales and marketing ratio within the legacy Orthofix businessand it also includes the amortization of the Medtronic’s settlement in thethird quarter.

General and Administrative expense as a percent of salesdecreased by 10 basis points to 14% for the third quarter compared to the prioryear, reflecting leverage obtained from spreading G&A costs over a largerrevenue base after the Blackstone acquisition. G&A costs in the quarter didinclude the payroll tax expense items noted in our specified items table.

Research and development costs were 4.9% of sales in thethird quarter. This compares to 3.4% for the prior year, excluding the impactof $40 million in purchase accounting adjustments made for in process R&Din the prior year associated with the Blackstone acquisition. The increase isdue to the fact that Blackstone's R&D expenditures represent a higher portionof their total revenues than legacy Orthofix’s R&D ratio.

Other income of $529,000, in the third quarter compares toother expense of $508,000 in the prior year. The other income in this year'sthird quarter was due to foreign exchange gains resulting from the weakeningduring the quarter of the U.S. dollar as contrasted to the opposite effect inthe third quarter of last year.

The tax rate in the third quarter was approximately 25%.Some what lower than the company's full year guidance of 28% to 30%. The thirdquarter tax rate reflects the positive impact of an R&D tax credit ofapproximately $230,000 for the 2003 and 2006 tax years. We filed the amendedreturns to recover those R&D tax credits.

Turning to the balance sheet and cash flow; total cashbalances at September 30, were $35.1 million, including $23.6 million in fullyavailable cash balances, and $11.6 million in restricted cash additionallyavailable to our U.S.entity.

Our key measures of asset management are day sales andreceivables, or DSO and inventory turns. Day sales and receivables were 90 daysat September 30, compared to 87 days at June 30, 2007. The higher DSO versusthe prior quarter reflects principally a higher proportion of U.S. Medicarereceivables that were outstanding at the end of the third quarter, as well asthe normal extension of Italian receivables between factoring periods.

Inventory turns were 1.4 at September 30, 2007 compared to1.5 at June 30, 2007. The higher inventory reflects additional investments madeto support higher anticipated sales in certain products including investment inBlackstone inventory and in internal fixation product inventory.

As Alan mentioned, we entered into a settlement agreementwith Medtronic, and as the Regulation G reconciliation in our press releaseindicates, the third quarter impact to this agreement was about $0.02 pershare. This represents the amortization of our prepaid assets that was recordedin connection with the settlement, and the third quarter expense covered theperiod from the date of our acquisition of Blackstone, last September 22, tothe end of the third quarter for about a one-year period.

We will continue to report this amortization for a number ofyears going forward and beginning in 2008, the annual amortization expense willbe roughly equal to the amount recorded in the third quarter.

With that, I would like to turn the call back over to Alan.

Alan Milinazzo

Thanks very much, Tom. A few more points on Q3, I promisedon our last earnings call that I would give you an update on our efforts toexpand the distribution of our spinal implant biologic products. I am happy toreport that we’ve added two key new distributors for our spinal products duringthe month of October. One of those distributors is in Europe, and the other isin the South Eastern part of the United States. We did not expect tosee significant revenue impact in Q4 as we are currently building the requiredinventory in completing the necessary training processes at this time.

We continue to have discussions with other potential newdistributors, and we are exploring the option of hiring direct sales reps incertain geographic markets, where we believe, this will be a more effectivealternative. Also, from the business development standpoint, during the thirdquarter, we finalized an agreement with Nano-Therapeutics; it gives usexclusive worldwide orthopedic distribution rights for their unique origin[DDM] with bioactive class.

This product delivers the capabilities of bone morphogenicproteins in a DDM combined with the bone bonding properties of bioactive class,which has the ability to guide tissue growth and bond chemically to the bone.Adding origin to our portfolio of orthopedic products, gives us anotherinnovative option to offer our surging customers, which further differentiatesus from our competitors.

Finally, I'd like to move on to the second press release weissued this morning, announcing that our Board of Directors has appointed TimAdams as our new Chief Financial Officer, effective November 19. Tim was mostrecently the Chief Financial Officer for Cytyc Corporation, a global medicaldevice and Diagnosis Company in (Technical Difficulty). It was acquired lastmonth by Hologic Inc. Amy, are you still there?

Operator

Yes sir, I am.

Alan Milinazzo

Okay, thank you. During Tim's three years at Cytyc, he wasthe lead Financial Executive during several acquisitions, the company made,which were valued at more than $750 million in total. Among otheraccomplishments, Tim negotiated a $345 million bank credit facility, as wellas, a new long-term contract with Cytyc's largest commercial customer.

Over his career, Tim also has experienced with debt routefinancing and a secondary stock offering of over $1 billion. With his extensivebackground, we believe, Tim's financial leadership will strengthen our abilityto execute our corporate strategies as we move forward.

Additionally, he has established relationship with theinvestment community, will be a valuable asset as we continue to communicate ourstrategies and goals with individuals like those of you are on today's call.

Having said that, I would like to say a few words about TomHein; Tom joined the company in 1999, and has been a key part of the team thatgrew the company from just over a $100 million in revenues to approximately$500 million that we expect this year. During that same period, our market caphas grown from $200 million to its current level of about $850 million. Armedwith an instrumental part of negotiation, closing, and financing of both theBreg and Blackstone acquisitions, and continues to be a key leader providingvaluable contributions to our financial and accounting functions.

We are very pleased that Tom will be staying with Orthofix as our executive vice-president of finance,assisting us with Tim's transition, and also continuing to play a key role inexecuting our strategic objective.

With that I will invite Tim just to make a few commentsbefore we go to Q4 guidance. Tim?

Tim Adams

Thank you Alan good morning everyone. First of all it isvery exciting for me to join another great company as Alan mentioned. I just lefta great company in Cytyc, that was a wonderful experience for me for the pastthree years, and I am looking to the same or better here with Orthofix. So Alan, thank you and thank the board and thankthe management team for having the confidence in me to join such a greatcompany.

As Alan knows, we spent a fair amount of time together overthe past few weeks in our respective diligence processes, and my take away isthat this is a great company with a very strong management team and a greatmarket opportunity. Alan and I have talked through the strategy of where thecompany has been, but more importantly where they are going and I really likethis opportunity in this spine market. I think its a growing market, you folkscertainly know it better that I do, but there are a lot of new technologies outthere, but then I think it is very exciting and I think there is a lot that wecan do together to really grow this franchise.

Just a comment on Cytyc, for the past three years I wasthere. I joined the company when it was a little bit under $400 million inrevenue, and we had told Wall Street, for calendar ’07 that we were on track tobe about $750 million Company and a very profitable company. So we had the opportunityto grow that company over the past three years, both organically and throughacquisitions. We completed a handful of acquisitions during my tenure and theyhave all served us very well.

Most importantly the company was just recently sold toHologic, and that the deal closed a couple of weeks ago, and I think thatresulted in a very positive outcome for our shareholders. I think Pat Sullivan,he gave me a great opportunity there to help grow the business, and putfinancing in place to secure some of the acquisitions. And now bring all thatexperience here to Orthofix and I look forward to working with Alan and histeam and the Board of Directors and all you to grow the company.

I think they are already off to a great start with theBlackstone acquisition, and that looks like a really a good one for thecompany. I know there are some other interesting opportunities out there and Ilook forward to helping this team grow the business and increasing ourshareholder values. So Alan, thank you and to the team for the opportunity.

Alan Milinazzo

You are welcome Tim and welcome to the team, looking forwardto your contributions. Folks I am going shift now to our fourth quarterexpectations before we open up the line to some questions.

As we indicated in this morning’s press release, in thefourth quarter we expect to generate revenue of about $127 million to $133million, and earn $0.60 to $0.65 per share on a GAAP basis, which willtranslate into about $0.90 to $0.95 per share and adjusted net income excludingspecified non-cash items. This means we have tightened up the range of our fullyear estimates and expect full year sales to be between $488 million to $494million.

We have also tightened up our full year GAAP EPS estimatesto a range of $1.87 to $1.92. This would translate into adjusted earnings pershare excluding additional specified non-cash items of about $3.6 to $3.11.

So with that operator I believe we are ready to take somequestions.

Question-and-AnswerSession

Operator

Thank you. (Operator Instructions) Your first question comesfrom the line of Mark Ritcher from Jefferies and Company.

Josh - Jefferies andCompany

Hi. This is Josh signing in for Mark. Thanks for taking thequestions. I know it's hard to forecast on Trinity, due to supply constraints,but can you give us an update on supply in the quarter and how supply islooking in the fourth quarter so far?

Alan Milinazzo

Sure, Josh. We had a good quarter with Trinity. We did get alittle bit more revenue out of Trinity based on the fact that the supplyimproved. We generated close to $1 million more in revenue in the quarter thanwe had in prior quarters. Good news is we were also able to open up a few newaccounts. So, we’ve actually increased the number of positions that areaccessing the technology, so we feel good about that. Our expectations are thatwe will continue the improvement in supply. So we hope that we could -- and wecertainly could surpass our Q3 numbers with the supply we expect, but it's alsoa function, Josh, of the type of sizes that we get from Osiris, and so we arestill trying to make sure that we get the appropriate sizes based upon where weare targeting this product. So we did improve close to $1million in the quarterand we would expect to see continued growth in Trinity in Q4.

Josh - Jefferies andCompany

Great. And can you give us little bit more detail on yourplans for the international launch of the Advent Cervical Disc, in terms of howyou are going to roll that out?

Alan Milinazzo

Yeah, we at this point, we’ve got a CE mark applicationpending, and we have responded to some questions from the investigators at thispoint. We would expect to roll it out probably in Germany first. We have probably themajority of our infrastructure for our spine business in Germany, feel very good about oursales capabilities there. Additionally, you know, the customers that we’veidentified in Germanyappear to be very qualified to look at this technology with us. So, from Germany it’s really going to depend upon whatOliver Burckhardt wants to do around Europe, but I would say we would stay inEurope and then possibly look to Brazil based upon some of the earlyEuropean experience that we would get in our limited market release. So, all ofthose, well Josh, end of the year or early part of ’08 will have the approval,Q1 we would be dealing our limited market release in key European marketsprimarily Germany and then on to Brazil.

Josh - Jefferies andCompany

Okay. Thanks. And then lastly I am not sure if you are ableto give it, but any update on the OIG investigation and any progress there?

Alan Milinazzo

At this point I would just say, Josh, that we continue to respondto requests from the OIG for documents, and so that continues on a regularbasis; we are fully involved in that, and at this point I would say that it’ssteady as you go.

Josh - Jefferies andCompany

Alright. Thanks a lot.

Alan Milinazzo

You are welcome.

Operator

You next question comes from the line of Steven Lichtmanfrom Bank of America Securities.

Steven Lichtman -Bank of AmericaSecurities

Thank you, and good morning, guys.

Alan Milinazzo

Hi, Steve.

Steven Lichtman -Bank of AmericaSecurities

First in spine, Alan, can you just give us an update on whatyou are seeing out their with regard to synergies between Blackstone and thespines in business?

Alan Milinazzo

Yeah we -- again as we commented before, Steve, we see moreupside on the stimulation side preliminary, and given our portfolio in stand thefact that we’ve got the only cervical product approved. So, we continue to seeimprovement on the stim side based on those relationships that were developing.We’ve not, you know, we’ve not formalized, and I think that’s to the frustrationof some of you on the call, we have not formalized the cross-selling strategy.We are trying to rolling that out in 2008. It’s a tougher thing to sell acrossthe implant lines as we talked about in the past. So, monthly we continue tosee sales increases in our stim business; monthly, we continue to see modestincreases on the Blackstone side because of these phases if you will, repsgetting to know reps doctor introduction.

The formal process for really trying to capture this benefitwill be in '08, but we're making progress and then again, primarily the benefitis being seen on the stim side.

Steven Lichtman -Bank of AmericaSecurities

Actually earlier in the call, you alluded to building out a distributionnetwork, you've spoken before about going into some key cities in the U.S? Canyou frame for us, the timing why it’s approximately, how long you think thatwill be, I mean is, a few months, or should we give it a year, I mean, in termsof that process, how long do you envision that taking us to broaden the salesforce?

Alan Milinazzo

Yeah, we’re happy to report we had a couple of successesjust recently, in October and looking kind of, market by market, really forwhat is the right way to approach that market, and so we are considering directrepresentation, as well as, augmenting our distributors. I would look at it asa several quarter process, Steve. In some of these cases, we have to taketerritories that are currently covered by an existing distributor, manage asolution for that distributor to lose that geography without losing theopportunities, so it takes a little bit more time.

Additionally, I've mentioned in the past that withdistributors, there is a high big desire for those distributors if they convertover to have non-compete protection, to have inventory purchase and to get somesort of a lump sum payment, and we've really been reluctant to do that in anyof these situations. So, Oliver Burckhardt was named the President of ourdivision, as you know, a couple of months ago. Oliver's background is indistribution in the spine space, having ten years of experience building a US and OUSoperation. So, I would forward to take -- continue to take steps each quarterto build that out and, it will take us several quarters, I suspect to complete,what we would consider to be the necessary distribution steps for the business.

Steven Lichtman -Bank of AmericaSecurities

Okay. Fair enough. And then on sports medicine, obviouslyyou have been able to grow well above market led by Fusion, what keeps thatgrowth above market as we look at over the next 12 to 24 months in your view?

Alan Milinazzo

You know, I think a consistent theme for BREG our sportmedicine business is that they have been focused. The past 12 months or so, themanagement team, which again has just performed very well has been focused on acouple of key areas that they think they can win in, and so I think some of thedistractions of migrating into other product areas through a strategic planningprocess were identified and they focused on these two key segments. In addition,just to an overall commitment to executing in the marketplace, maybe one otherpoint I would say, is that the sales management team that has refined theirdistribution strategy so that they are actually tightening up distribution,increasing their footprint around the U.S. and that’s allowed us to penetratemarkets where we previously maybe have lower share positions. So, I wouldsummarize by saying that the combination of focus in areas we think we can win,and the distribution systems to match that focus is really what‘s giving usthis growth.

Steven Lichtman -Bank of AmericaSecurities

And then just lastly just couple of P&L clarifications,with regard to a couple of the charges in the quarter, the Medtronicsettlement was that in recorded in G&A and then, I think Tom, you mentionedon that option of tax expenses, was that in GNA as well as the $504,000.

Tom Hein

The amortization of the Medtronicsettlement is in sales and marketing.

Steven Lichtman -Bank of AmericaSecurities

Okay.

Steven Lichtman -Bank of AmericaSecurities

And the payroll tax expense related to the U.K stock optionwas recorded in G&A.

Steven Lichtman -Bank of AmericaSecurities

And then, why should we be thinking about fourth quarterrelatively to tax rate?

Alan Milinazzo

We are not coming off of our overall guidance of 28% to 30%,but we will, hopefully we will be able to file some amended returns withBlackstone organization. Their acquisition gave us a chance to go back and filefor some R&D credits in prior years, file amended returns. We still have2004 and 2005 to calculate with our auditors, but for the moment we are goingto sit with our current guidance between 28 to 30%.

Steven Lichtman -Bank of AmericaSecurities

Okay. So we should hear that for 4Q, but may be some downwardguidance we look forward? Year-to-date has been 27%?

Alan Milinazzo

Yeah, I think that weare to wait till we do our fourth quarter call.

Steven Lichtman -Bank of AmericaSecurities

Okay.

Alan Milinazzo

We will update that for next year..

Steven Lichtman -Bank of AmericaSecurities

Okay. Great. Thanks guys.

Alan Milinazzo

Thanks, Steve.

Operator

The next question comes from the line of Michael Matson ofWackovia

Alan Milinazzo

Hi, Michael.

Operator

One moment?

Alan Milinazzo

Okay.

Operator

Okay, Mr. Matson your line is open?

Michael Matson -Wackovia

Okay, can you hear me?

Alan Milinazzo

We got you Mike.

Michael Matson - Wackovia

Okay. Question on your R&D levels, was about 4.9% ofsales and I will talk mine last quarter, is that kind of level that you expectthat to stay out from or is that possible that that could tick back up with theadvent study?

Alan Milinazzo

Yeah, good question Mike. I think you would expect that webegin to enroll, but we will start to see a spike there. I think we have talkedin the past of maybe getting up to 5.5%, or a little north of that dependingupon enrollment. So, you could you could see that go up in 08 just as theenrollment rolls out. That’s really the only contributing factor. Now, havingsaid that, we do look for other areas to invest in, and so we will giveguidance next year on any other areas of major investment, but at this point Iwould say Advent would be the one thing that would drive that up maybe to 5.5to 6 at various points in time.

Steven Lichtman -Bank of AmericaSecurities

Okay. And then, can you tell us what percent of Blackstonesales were generated outside the US? I am not sure if you gave thaton the call. I pardon you if you did already say that.

Alan Milinazzo

Yeah, we did, Mike. It's a good question. And I think wetalked about this in Q2, because we actually had a higher percentage in Q2. Itwas roughly 12% in Q2. But Q1, it was 6%. And so about 8% of revenues wereinternational from Blackstone in Q3.

So we talk a little bit about that volatility in theinternational markets from it, because we have a lot of distributors that theirorder patterns that are a little off. But from our standpoint, we are in linewith the 10% that we had guided to earlier in the year. So 6% in Q1, 12% in Q2and then 8% this quarter.

Michael Matson -Wachovia

Okay. And then I know that you can't reveal the exact termsof the Medtronic settlement on the patent suit. But if I am hearing Tomcorrectly, there is going to be an ongoing drag there from amortization of thatexpense. Is that correct?

Tom Hein

Yeah, the settlement was set up in as a prepaid royalty inour deferred taxes and other long-term assets line, and it's being amortized atthe rate of about $450,000 a year.

Michael Matson -Wachovia

Okay. And then finally, with the larger hip and knee firmssettling their DHA investigation and having to make public some of theirconsulting arrangements, I guess, first of all, is that driving you guys to goback and look at your practices? I mean obviously you guess havegotten the subpoena from the OIG.

That's the first part of the question. And then I guess thesecond part would be, I guess, is there any sense as to whether or not thesechanges are going to affect these companies' spine businesses as well? And ifso, is that something that you think might make it easier for you all to go outand pick up some share or pick up some of their larger customers maybe?

Alan Milinazzo

Yeah, Michael, a couple of points on that. One is just toclarify again, Blackstone received the subpoena from the OIG and not Orthofix,just to remind everyone.

Michael Matson -Wachovia

Okay.

Alan Milinazzo

I would say we are constantly reviewing our complianceprograms. I think we have really in the past year or so been upgrading ourcompliance programs. We joined AdvaMed. We are working for AdvaMed compliance. And for us, it’s kind of aconstant. We have compliance officers in our businesses and Blackstonespecifically as well.

So, overall when we diligent the company, we feel good aboutit. We continue to feel good, but are always improving in that area. Relativeto the market opportunity, I mean as you look at the results and better thananybody, Michael, I think some of the larger companies are seeing adeceleration of their spinal revenues, single-digit growth. Obviously, Strykerhas been doing very well.

So, we do think that there is an opportunity for us as someof the bigger companies, maybe aren't as focused on it. As we have talked aboutin the past, this is 50% of our revenue and it's going to continue to grow forus.

So, we think that there are opportunities in the marketplacefor some of the larger companies. I am not sure it’s related to this, couldn’tattribute it to that, in fact. But we do see opportunities coming from all overand in particular for some of the larger companies, if you just don’t have thefocus that we do in this space.

Michael Matson -Wachovia

All right. That’s all I have got. Thanks a lot.

Alan Milinazzo

Thanks, Michael.

Operator

Your next question comes from the line of Steve Ogilvie fromThinkEquity.

Steve Ogilvie -ThinkEquity

Hey, guys.

Alan Milinazzo

Hi, Steve.

Steve Ogilvie -ThinkEquity

I don’t know if you have said this or you are willing to,but in designing the Advent trial in the US, do you think you will be goingup against fusion or at that point do you think it makes more sense torandomize against another approved disc?

Alan Milinazzo

I'm not sure that we have chatted about that. But right now,we are not considering randomizing against -- Steve, can you hear me?

Steve Ogilvie -ThinkEquity

Yeah.

Alan Milinazzo

Okay, sorry. At this point, we are not considering randomizingagainst another disc, although we could consider modifying or protocol basedupon approvals down the road. But right now, about a 180 to 200 is againsttraditional therapy. In fact, they are using one of our plating systems as partof that.

Steve Ogilvie -ThinkEquity

Okay. And then my other question was, you look at theorthopedics business, and it was a bit lower than what we thought it could do.A lot of people going after a [heart] trauma, big companies ask forcommoditizing.

As you look at those businesses, is there something you guysfeel like you can do to get it back after the growth rate of the other businessunits or just the mix of these, it's better to spend your bullets on spine?

Alan Milinazzo

Good question. I mean we don't have unlimited resources. Andso we've talked openly about the fact that spine probably gets adisproportionate amount of our resources. Having said that, some of theproducts that we have introduced recently have helped us, what I would say, onthe orthopedic side is that we are still evaluating our ability to besuccessful in the hard trauma segment, highly completive. You all know that.

But you start to see a little bit of more pressure, alsowith external fixation becoming less and less popular from the treatmentstandpoint. Making up for any of that external fixation state with the internalfixation products was somewhat successful. But you see a little bit thisquarter a deceleration of revenues. So, I would say the jury is still out forus in terms of how we feel about the hard trauma segment.

We still feel good about growth rate. And in particular,within our orthopedic business, we want to focus on how successful we are withthat Physio-Stim focus. 28% growth in Physio-Stim is just phenomenal. The team has done a greatjob there, because those folks sell both for us.

Steve Ogilvie -ThinkEquity

Okay. And then just a quick follow-up on that. I mean,obviously the external fixation, the history of the company and as the marketmoves away from that, do you feel organization either culturally or just the personnel,are they ready to move with the market or the product is not there?

Is it a bigger problem, or is it going it be sequentiallydown the next two or three quarters. What do you feel like the organization canadapt and continue to move with the market?

Alan Milinazzo

I think probably the answer really is twofold. One is, wecontinue to look for ways to enhance our external fixation offering, somethings that we are doing from an R&D and business development standpointthat should improve that. I hope to be able to talk to you about that nextquarter. So, we are not given up on that space by any stretch, because we dohave a good brand there.

But again, I think the organization migrating over to hardtrauma, we are asking a lot of our orthopedic business. So to move into hardtrauma to do deformity correction, to maintain that external fixation businessand self stimulation.

So historically, we have done that okay, but we are addingmore products to the mix. And so that is going to be our challenge. Can we doall that well? And I look forward to just updating you, Steve, but it’s a greatquestion.

Steve Ogilvie -ThinkEquity

Alright. Thanks

Operator

Your next question comes from the line of Jason Wittes fromLeerink Swann.

Jason Wittes -Leerink Swann

Thank you. Hi, guys. I guess first question is just fromhousekeeping on the Medtronic settlement. Do yourefer to that as a prepaid royalty? And if it being the case, why wouldn’t itappear in gross margin and also has all the cash been paid or is that going tobe again paid over several years?

Alan Milinazzo

We recorded all of our royalty, expense in sales andmarketing

Jason Wittes -Leerink Swann

Okay.

Alan Milinazzo

And the cash has not been paid yet it has been accrued inthe balance sheet.

Jason Wittes -Leerink Swann

Okay so we can assume from a cash standpoint that as itaccrues you are actually paying it Medtronic or …

Alan Milinazzo

It will be lump sum payment.

Jason Wittes -Leerink Swann

It will be a lump sum and when is that lump sum due?

Alan Milinazzo

Again those are under the terms of the agreement.

Jason Wittes -Leerink Swann

Okay. Also what should we assume the normalized tax rate isfor this quarter taking all the charges etcetera?

Alan Milinazzo

We just said, we are staying with our guidance of 28% to30%.

Jason Wittes -Leerink Swann

But for this quarter specifically.

Alan Milinazzo

For fourth quarter or for Q3?

Jason Wittes -Leerink Swann

For Q3, is there a specific tax rate we should be assuming it'sat a moderate this time given all the one time charges.

Alan Milinazzo

You would be just over 27%.

Jason Wittes -Leerink Swann

Okay. Great, and also I guess you added a distributor thisquarter. Alan and I am just curious. I think if I heard correctly it was in thesouth eastern region, which my understanding was that that is one of yourstrongest regions. I guess why was there a decision to add was it anopportunistic add or was a replacement there, could you just give us a littlemore color there?

Alan Milinazzo

Yeah, now we added two Jason this quarter. One was in Europeand other was in the south eastern U.S. So even though we have gooddistribution if look at it, some of these markets, some of your bestdistributors trying to keep up with some of the demand, it creates opportunityto carve out territories. So that’s really what you saw us doing. We haven’tyet realized the full impact of that. So in situations where we have businessgrowing and our distribution in that area may be isn’t getting up with some ofthe demand. We will add distributors in that market and then in some of the bigmarkets we've talked about in the past where we just don’t have representation.We are still looking for exactly the right decision, whether it’s direct orindirect. I think we will be able to much like Steve's questions, I think overthe successive quarters we'll talking to you more about how we are rounding outthose markets that we are not currently represented in.

Jason Wittes -Leerink Swann

Fair enough. Have there been any other changes todistribution this quarter. Specifically in Blackstone have any of the distributorsdropped out et cetera that we should know about?

Alan Milinazzo

No, none. Obviously this quarter we made the shift. Webrought Oliver Burckhardt over from our international business to runBlackstone and Oliver's background in distribution we think makes him a perfectcandidate. So, short of that, which was obviously a major change since, MattLyons has run the business. That's been our only major change. Otherwise at thedistribution level we've had no significant changes.

Jason Wittes -Leerink Swann

Okay great, thank you very much.

Alan Milinazzo

Thank you, Jason.

Operator

You next question comes from the line of Dave Turkaly fromSFG

Dave Turkaly - SFG

Thanks a lot. Given the comments on the Legacy business, I'djust like to say two quarters in a row of strong performance there. Is thereanything looking ahead that we should be considering? Should that trendcontinue in your Legacy Orthofix businesses? Thanks.

Alan Milinazzo

Yeah, thanks Dave. Again I think we talked about 10% growthbeing kind of our target 10%, 12% growth in our Legacy business. So, thereisn’t anything that I would tell you would change that Dave on a short termbasis and then obviously we will get into 2008 in February when wegive you the full year guidance.

Dave Turkaly - SFG

Then maybe a quick one for Tim. In terms of his pastexperience any comment on your role in business development. How active wereyou in kind of identifying opportunities for your firm or company to acquireand maybe a second follow up would be from an IR standpoint getting up to seethe street. Was that something you were familiar with or experienced in priorto joining Orthofix? Thanks.

Tim Adams

Sure, so as related to biz desk I had a colleague that was adirect report to the CEO, one of my peers that ran the [BizDesk] group, but Iwas the CFO of the company, certainly involved in all of the acquisitions. Wewould let the BizDesk group go out and really knock on the doors, attend allthe conferences, really understand some of the emerging technologies that wereout there. But I think the way Pat Sullivan tried to run it is that his seniorexecutive team would really be at the table when these opportunities werepresented.

So, I was very involved in early on, is this a good idea forthe company? Do we want to pursue it? And if so then certainly my team was veryinvolved as I was myself with all of the diligence, ultimately the structuringof the deal and the final negotiation of the deal. So, I think involved quite abit as it relates to working with Wall Street. That was a piece of the job thatI enjoyed very much.

Pat Sullivan, Dan Levangie and myself were really the frontfolks, if you will for the company. And towards the end of it was reallyprobably more of Pat and myself attending about 10 conferences a year, non-dealroad show. We were on the road with Jack and Glen from Hologic when our dealwas announced with them back in May and back in June. We attended the bankmeeting, so we had a lot of experience working with the street and I certainlyenjoyed that very much.

Dave Turkaly - SFG

Great thanks a lot.

AlanMilinazzo

Yeah, Dave, I’ve just one other point on that, is we arestructured from business development standpoint virtually the same as Tim’sexperience was with Cytyc and as we’ve got a business development group that weput on board here in the past 18 months. They work very closely with the seniormanagement team identifying the opportunities and then my team obviously willsit down to review those based upon number of inputs. So the structured thatTim is going to be entering here is virtually identical to what he had atCytyc. Operator?

Operator

Okay, your next question comes from the line of James Sidotifrom Sidoti & Company.

James Sidoti - Sidoti& Company

Good morning Alan, can y'all hear me?

AlanMilinazzo

Hi Jim, we've got you.

James Sidoti - Sidoti& Company

Quick question, when you talk about increase indistribution, is that going to be mainly through independent distributors andhow should we think about that and the affects on the sales market?

AlanMilinazzo

Yeah, I would say, it's a combination, if you look at anyindustry, in particular, on the spine side. You see a company as they evolve asthey get bigger, your need to tailor distribution becomes bigger. We certainlyhave the benefit of a stimulation team already in place that's direct. On purecommission base, which is a good model for us, we'd like to see any direct repswe bring on continue in that model, whether they be implant or biologic reps ona specific basis. So, I think, we'll end up with a mix and that'll be basedupon the markets that we are in and who we think makes the best long termdecision force in a given market. So, and as a key point Jim, I want to justmake is that we want to build for the long term here and not for short termgain, because we think a better mix for us is to build with long term in mind.

James Sidoti - Sidoti& Company

So it's feasible, you might see a little bit of spike in thesales marketing line over the next couple of quarters as you add to that?

AlanMilinazzo

You could, we're certainly forecasted in '08, I think, thatwill also in '08, we'll be able to talk about our cross selling strategies, butat this point I would say I'd be fair to characterize. We could have someincrease there till the revenue continues to accelerate.

James Sidoti - Sidoti& Company

Okay, all right, thank you.

AlanMilinazzo

You are welcome, Jim.

Operator

The next question comes from the lines of Stan Manny fromManny Family Investment.

Stan Manny - MannyFamily Investment

Good job gentlemen, I just have a couple of simplequestions. One; can you talk to the affects, you had two major competitorsacquired DJO and Biomet and tell us if there has been any affect that you havenoticed or seen positive/negative on any comments?

AlanMilinazzo

Hey, Stan, good morning, good question. With Biomet, I wouldsay we probably had a little bit more success on the stimulation side, it’s asmall market few competitors, Biomet had a lot of share there and so with ourEDI business we may have benefited to an extent there, although I would alsoargue that our distribution system is tailored to succeed and we have the onlycervical product. So it certainly can't hurt us, but at this point I would say Biometmay have given us a little bit of an opportunity recently.

Now about the DJO, not so much, I think DJO has been aroundand has gone through different [iterations] has done it very well. And so Ithink what we are seeing more at our sports medicine business is what I alludedto earlier just increased focus by the team and then enhancing theirdistribution strategy as I alluded to.

Stan Manny - MannyFamily Investment

Okay I have two more question one on Osiris you mentionedsome numbers the amount that you are selling from and expect the increase thatyou expect. Could reaffirm that for us on the call?

AlanMilinazzo

We don’t give guidance Stan specifically what I was alludingto was I think Steve Lichtman asked a question about the Trinity sale and whatI was saying is that in Q3 we did see some improvement to our supply. Again thesupply in this product areas is driven by Osiris and downstream if you wererelative to the whole stem cell collection process et cetera its verycomplicated, but we saw an increase in supply thus we had nearly $1 millionincrease in revenue for the quarter.

We would expect to see that continue into Q4 although thereis also a mix component to it. We request certain sizes from the company andmaking sure we get those sizes we'll also dictate how our revenues look. Givenour full guidance for the quarter and within that that would show someimprovements with Trinity, but we don’t expect it will have a two axeimprovement in the in the quarter.

Stan Manny - MannyFamily Investment

Okay and the last question you haven’t paid down any debt doyou have any plans on debt pay-downs at all, near term?

TomHein

We do Stan; I think we want to balance that with otherstrategic activities that we have in mind. We did something earlier in the yearwith this in swing product that we alluded to couple of times in the call, nota huge amount of money, but very important in terms of our portfolio, as wellas our ability to attract quality distributors in markets outside the U.S. So,it is a conversation I have with the Board regularly and I would expect that wewould continue to make debt repayments. But again we have to balance that withour own strategic plans for in organic activities.

Stan Manny - MannyFamily Investment

Okay, good job, thank you gentlemen.

AlanMilinazzo

Hey, Stan, thanks for the call.

Operator

And your final question comes from the line John Putnam fromDawson James Securities

John Putnam - Dawson James Securities

Yeah thanks. Gentlemen, I wonder if you could give us someidea of what the sports medicine market is growing or what your products aregrowing as you took out the knee brace and also the cold FUSION products.

AlanMilinazzo

We look at the market John and just looking at third partydata that’s out there, it’s probably somewhere between 5% and 7%, call it 7% onthe upside. At least for the products that we compete in, we are obviously notin the OR component of that. So, from our standpoint we view the markets callat 7% and our functional bracing products are growing at about 18%. So we arereally focused on functional bracing. We think that the FUSION product welaunched last year and continue to roll out this year and it’s just a winner.It's a well designed product, the sales force is executing at a very highlevel, there's big demand for that product. So that would be kind of the firstpoint, and then secondly, as you know from our cold therapy standpoint, slowergrowth markets, but we grew about 15%, and again we have leadership in thatsegment and the management team and the R&D group continues to find ways toinnovate, make the products work better and then make them smaller and quieter,et cetera. So, an important component in order to shift execution by themanagement team and I wouldn’t loose sight of the fact that the highly focusedmanagement team is very committed to taking market share. It's just as simpleas that.

John Putnam - Dawson James Security

Okay. Great. And also can you give us some idea where youthink the gross margin will be in the fourth quarter?

Alan Milinazzo

I think we have indicated -- indicated in my script if youtake our third quarter, 73.9% net of all adjustments, and add back to that theremoval of the amortization on the inventory step up which is about 70 basispoints, it would put us somewhere in the mid 74ish range.

John Putnam - Dawson James Security

Okay. Thanks.

Alan Milinazzo

Thanks, John.

Operator

And that was the final question. Do you have any closingremarks?

Alan Milinazzo

Yes, operator. I want to thank everyone for joining ustoday. Q3 was a quarter in which we accomplished our financial goals, as wellas, some very important strategic objectives. 2007 has been a year oftransition for Orthofix and despite the organizational changes and theintegration challenges. We continue to achieve our stated financial andstrategic objectives. We look forward to continuing to update you next quarter.Thanks again for joining us.

Operator

And this concludes today's conference call. You may nowdisconnect.

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