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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 - Dawson James Securities

Operator

Good morning. My name is Amy, and I will be your conference operator today. At this time, I would like to welcome everyone to the Orthofix Third Quarter Financial Results Conference Call. (Operator Instructions) As a reminder, 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 begin your conference.

Dan Yarbrough

Thanks operator. Good morning everyone and thanks for joining us this morning, to discuss Orthofix International's financial results for the third quarter of 2007. During this call, we will be making forward-looking statements within the meaning of Section 27-A of the Securities Act of 1933, and Section 21-E of the Securities Exchange Act of 1934 that involve risks and uncertainties.

All statements other than statements of historical fact are forward-looking statements, including any earnings guidance we provide and any statements about our plans, beliefs, strategies, intentions, expectations, objectives, goals, or prospects. Factors that could cause actual results to differ materially from forward-looking statements made by us on this call, include the risks disclosed under the heading "Risk Factors" in our 2006 Form 10-K and subsequent Form 10-Q filed with the SEC.

Presenting on our call today will be Orthofix's CEO, Alan Milinazzo; and our current CFO, Tom Hein; as well as our new CFO, as of November 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 seen from our two press releases earlier this morning, in addition to our third quarter financial results, we announced some additional important news regarding the settlement of our intellectual property litigation with Medtronic's, as well as the employment of Tim Adams, as our new Chief Financial Officer. I will review each of these important events in detail later in the call. First, however, let’s outline the highlights of another successful quarter at Orthofix.

With third quarter revenue growth of 45%, including the positive 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 historically been our weakest quarter of the year, once again, each of our core business units showed strong revenue growth year-over-year. Spine sales were up 109% on a reported basis, including the impact of the Blackstone acquisition. If we break that down into the implant and stimulation segments, revenue growth from the Blackstone Products remained on target at 41%, and spine stimulation sales were up 9%.

However, if we consider that the third quarter of last year included about $650,000 of stimulation revenue from the government’s Tricare program, which represented a lump sum catch-up reimbursement for the prior period cervical stimulator sales, the adjusted growth 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 third quarter, compared with the 7% growth rate we reported during the first half of this year.

Strong year-over-year growth in our spinal implant and biologic revenue was once again driven by a variety of products. From our unique ICON minimally-invasive pedicle screw systems and Unity Anterior Lumbar Plating Systems, to our Pillar and Construx vertebral body replacement devices, and revenue from our biologics portfolio continues to grow as well, and made up about 19% of total implant revenue in the third quarter of this year versus only about 14% a year ago. These numbers don’t yet reflect any significant increase in the supply of opportunity received from (inaudible) Therapeutics, but we are still optimistic that we may begin to see an increase that could create momentum going into 2008.

As you may have also seen from our press release during the third quarter, we announced at Euro Spine in Brussels that we had acquired the technology for the InSWing Interspinous Spacer for distribution, primarily in our international market. This is an exciting addition to our portfolio of products, and we currently expect to begin our normal physician assessments and limited market release stages in select international markets over the next few months.

At the North American Spine Society, or NASS Conference, a couple of weeks ago, we highlighted some new instruments we have added to our portfolio including Proview, our suite of instruments designed to be used at a minimally invasive surgical environment, as well as, Blackjack which is an innovative design, device designed to simplify both the distraction of the spine, any insertion of Allograft, and vertebral body replacements.

At NASS, we also highlighted Advent, our Artificial Cervical Disc, which is currently in development. You may remember, we announced this summer that we have performed the first human implant of this device in Brazil. At this point, we still anticipate CE markings later this year in a limited launch of the Advent disc in Europe in early 2008.

Pushing to the United States for a minute, we recently received conditional approval for IDE of the Advent Cervical Disc, which will allow us to begin clinical studies in the U.S. starting early next year. Our current plans include a 25 site study that will involve approximately 180 to 200 patients. If everything goes according to our plan, we would expect Advent to be commercially available in the United States around the end of 2011.

As we have indicated in recent public presentations, acquisitions will continue to play a major part of our strategic growth plans over the next couple of years, and our corporate development group continues to explore a number of opportunities that we believe could help us achieve our goals.

Summarizing our spine results, our total year-to-date revenue 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 our Physio-Stim long bone stimulator, which continued to take market share with a 28% increase in sales.

This also reflected the positive impact of increased revenue from our most recently launched internal fixation and deformity correction devices, including our VeroNail and Centronail internal fixation nailing systems, 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 Sports Medicine business grew at twice the rate of the overall market, with a sales increase of 14% year-over-year. This impressive increase was driven by an 18% increase in our functional knee bracing sales, reflecting the continued popularity of FUSION, which is our newest line of braces that were introduced at the beginning of last year.

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

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

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

However, despite this softness in our international division, if we exclude the revenue contributions from the Blackstone spine implant biologic products, our legacy Orthofix businesses overall still grew a solid 10% year-over-year.

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

As Tom, will discuss in a minute we did get a benefit to our gross margin during Q3, but even excluding that benefit we would have been at around 73.9%. This is an improvement from the prior quarter, and about where we thought we would be in Q3 as we continue to expect improvement in this metric through the fourth quarter.

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

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

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

Tom Hein

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

As we reported today, in our earnings release, and as Alan covered in some details, sales for the third quarter were $121.1 million, up 45% over the prior year, including the positive impact from the inclusion of Blackstone, which had a 41% increase in revenues, year-over-year.

The impact of foreign currency on sales in the third quarter was a positive $1.5 million or 1.2% of total sales. Excluding the contribution from Blackstone, Legacy Orthofix revenues grew approximately 10%, compared with the 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 Legacy Orthofix businesses are up about 11% compared to the prior year. I refer you to Alan's previous comments, and to our earnings release for additional information on our product and market sector sales.

Shifting now to margin, gross margin, our gross margin of 74.6% in the third quarter compares to 74.8% in the same period in the prior year. This year’s third quarter number included the negative impact from the amortization 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 in connection with their effects in prior quarterly calls.

As a reminder, the third quarter marks the end of the amortization of the step-up in inventory, which will benefit our growth margin by 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 costs associated with the negotiations with the distributor. If we exclude this benefit, to the growth margin in the third quarter, then the gross margin ratio would have been 73.9% excluding the impact of amortization and foreign currency which is right about where we had previously estimated, would be in the third quarter, and reflect in part the result of having worked through the margin compression we experienced in our spine-stimulation business in the first half of the year.

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

Operating expenses, our sales and marketing expense ratio was 38.8% in the third quarter, compared to 38.4% in the prior quarter, and compared to 43.5% for the prior year. Sales and marketing expense in the third quarter of last year included the impact of approximately $4.7 million of monthly fees associated with the termination of the Danek marketing agreement. Excluding these fees the sales and marketing ratio in the third quarter was 37.9%.

The year-over-year increase in the sales and marketing ratio, excluding the impact of the termination of the Danek agreement is primarily attributable to the acquisition of Blackstone, which currently carries a higher sales and marketing ratio within the legacy Orthofix business and it also includes the amortization of the Medtronic’s settlement in the third quarter.

General and Administrative expense as a percent of sales decreased by 10 basis points to 14% for the third quarter compared to the prior year, reflecting leverage obtained from spreading G&A costs over a larger revenue base after the Blackstone acquisition. G&A costs in the quarter did include the payroll tax expense items noted in our specified items table.

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

Other income of $529,000, in the third quarter compares to other expense of $508,000 in the prior year. The other income in this year's third quarter was due to foreign exchange gains resulting from the weakening during the quarter of the U.S. dollar as contrasted to the opposite effect in the 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 third quarter tax rate reflects the positive impact of an R&D tax credit of approximately $230,000 for the 2003 and 2006 tax years. We filed the amended returns to recover those R&D tax credits.

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

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

Inventory turns were 1.4 at September 30, 2007 compared to 1.5 at June 30, 2007. The higher inventory reflects additional investments made to support higher anticipated sales in certain products including investment in Blackstone inventory and in internal fixation product inventory.

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

We will continue to report this amortization for a number of years going forward and beginning in 2008, the annual amortization expense will be 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 promised on our last earnings call that I would give you an update on our efforts to expand the distribution of our spinal implant biologic products. I am happy to report that we’ve added two key new distributors for our spinal products during the month of October. One of those distributors is in Europe, and the other is in the South Eastern part of the United States. We did not expect to see significant revenue impact in Q4 as we are currently building the required inventory in completing the necessary training processes at this time.

We continue to have discussions with other potential new distributors, and we are exploring the option of hiring direct sales reps in certain geographic markets, where we believe, this will be a more effective alternative. Also, from the business development standpoint, during the third quarter, we finalized an agreement with Nano-Therapeutics; it gives us exclusive worldwide orthopedic distribution rights for their unique origin [DDM] with bioactive class.

This product delivers the capabilities of bone morphogenic proteins 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 another innovative option to offer our surging customers, which further differentiates us from our competitors.

Finally, I'd like to move on to the second press release we issued this morning, announcing that our Board of Directors has appointed Tim Adams as our new Chief Financial Officer, effective November 19. Tim was most recently the Chief Financial Officer for Cytyc Corporation, a global medical device and Diagnosis Company in (Technical Difficulty). It was acquired last month 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 was the lead Financial Executive during several acquisitions, the company made, which were valued at more than $750 million in total. Among other accomplishments, Tim negotiated a $345 million bank credit facility, as well as, a new long-term contract with Cytyc's largest commercial customer.

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

Additionally, he has established relationship with the investment community, will be a valuable asset as we continue to communicate our strategies 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 Tom Hein; Tom joined the company in 1999, and has been a key part of the team that grew 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 cap has grown from $200 million to its current level of about $850 million. Armed with an instrumental part of negotiation, closing, and financing of both the Breg and Blackstone acquisitions, and continues to be a key leader providing valuable 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 in executing our strategic objective.

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

Tim Adams

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

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

Just a comment on Cytyc, for the past three years I was there. I joined the company when it was a little bit under $400 million in revenue, and we had told Wall Street, for calendar ’07 that we were on track to be about $750 million Company and a very profitable company. So we had the opportunity to grow that company over the past three years, both organically and through acquisitions. We completed a handful of acquisitions during my tenure and they have all served us very well.

Most importantly the company was just recently sold to Hologic, and that the deal closed a couple of weeks ago, and I think that resulted 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 put financing in place to secure some of the acquisitions. And now bring all that experience here to Orthofix and I look forward to working with Alan and his team and the Board of Directors and all you to grow the company.

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

Alan Milinazzo

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

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

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

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

Question-and-Answer Session

Operator

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

Josh - Jefferies and Company

Hi. This is Josh signing in for Mark. Thanks for taking the questions. 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 is looking in the fourth quarter so far?

Alan Milinazzo

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

Josh - Jefferies and Company

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

Alan Milinazzo

Yeah, we at this point, we’ve got a CE mark application pending, and we have responded to some questions from the investigators at this point. We would expect to roll it out probably in Germany first. We have probably the majority of our infrastructure for our spine business in Germany, feel very good about our sales capabilities there. Additionally, you know, the customers that we’ve identified in Germany appear to be very qualified to look at this technology with us. So, from Germany it’s really going to depend upon what Oliver Burckhardt wants to do around Europe, but I would say we would stay in Europe and then possibly look to Brazil based upon some of the early European experience that we would get in our limited market release. So, all of those, 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 markets primarily Germany and then on to Brazil.

Josh - Jefferies and Company

Okay. Thanks. And then lastly I am not sure if you are able to 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 respond to requests from the OIG for documents, and so that continues on a regular basis; we are fully involved in that, and at this point I would say that it’s steady as you go.

Josh - Jefferies and Company

Alright. Thanks a lot.

Alan Milinazzo

You are welcome.

Operator

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

Steven Lichtman - Bank of America Securities

Thank you, and good morning, guys.

Alan Milinazzo

Hi, Steve.

Steven Lichtman - Bank of America Securities

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

Alan Milinazzo

Yeah we -- again as we commented before, Steve, we see more upside on the stimulation side preliminary, and given our portfolio in stand the fact that we’ve got the only cervical product approved. So, we continue to see improvement 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 frustration of 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 across the implant lines as we talked about in the past. So, monthly we continue to see sales increases in our stim business; monthly, we continue to see modest increases on the Blackstone side because of these phases if you will, reps getting to know reps doctor introduction.

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

Steven Lichtman - Bank of America Securities

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

Alan Milinazzo

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

Additionally, I've mentioned in the past that with distributors, there is a high big desire for those distributors if they convert over to have non-compete protection, to have inventory purchase and to get some sort of a lump sum payment, and we've really been reluctant to do that in any of these situations. So, Oliver Burckhardt was named the President of our division, as you know, a couple of months ago. Oliver's background is in distribution in the spine space, having ten years of experience building a US and OUS operation. So, I would forward to take -- continue to take steps each quarter to 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 America Securities

Okay. Fair enough. And then on sports medicine, obviously you have been able to grow well above market led by Fusion, what keeps that growth 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 sport medicine business is that they have been focused. The past 12 months or so, the management team, which again has just performed very well has been focused on a couple of key areas that they think they can win in, and so I think some of the distractions of migrating into other product areas through a strategic planning process were identified and they focused on these two key segments. In addition, just to an overall commitment to executing in the marketplace, maybe one other point I would say, is that the sales management team that has refined their distribution strategy so that they are actually tightening up distribution, increasing their footprint around the U.S. and that’s allowed us to penetrate markets where we previously maybe have lower share positions. So, I would summarize 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 us this growth.

Steven Lichtman - Bank of America Securities

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

Tom Hein

The amortization of the Medtronic settlement is in sales and marketing.

Steven Lichtman - Bank of America Securities

Okay.

Steven Lichtman - Bank of America Securities

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

Steven Lichtman - Bank of America Securities

And then, why should we be thinking about fourth quarter relatively 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 with Blackstone organization. Their acquisition gave us a chance to go back and file for some R&D credits in prior years, file amended returns. We still have 2004 and 2005 to calculate with our auditors, but for the moment we are going to sit with our current guidance between 28 to 30%.

Steven Lichtman - Bank of America Securities

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

Alan Milinazzo

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

Steven Lichtman - Bank of America Securities

Okay.

Alan Milinazzo

We will update that for next year..

Steven Lichtman - Bank of America Securities

Okay. Great. Thanks guys.

Alan Milinazzo

Thanks, Steve.

Operator

The next question comes from the line of Michael Matson of Wackovia

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% of sales and I will talk mine last quarter, is that kind of level that you expect that to stay out from or is that possible that that could tick back up with the advent study?

Alan Milinazzo

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

Steven Lichtman - Bank of America Securities

Okay. And then, can you tell us what percent of Blackstone sales were generated outside the US? I am not sure if you gave that on 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 we talked about this in Q2, because we actually had a higher percentage in Q2. It was roughly 12% in Q2. But Q1, it was 6%. And so about 8% of revenues were international from Blackstone in Q3.

So we talk a little bit about that volatility in the international markets from it, because we have a lot of distributors that their order patterns that are a little off. But from our standpoint, we are in line with the 10% that we had guided to earlier in the year. So 6% in Q1, 12% in Q2 and then 8% this quarter.

Michael Matson - Wachovia

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

Tom Hein

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

Michael Matson - Wachovia

Okay. And then finally, with the larger hip and knee firms settling their DHA investigation and having to make public some of their consulting arrangements, I guess, first of all, is that driving you guys to go back and look at your practices? I mean obviously you guess have gotten the subpoena from the OIG.

That's the first part of the question. And then I guess the second part would be, I guess, is there any sense as to whether or not these changes are going to affect these companies' spine businesses as well? And if so, is that something that you think might make it easier for you all to go out and 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 to clarify 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 compliance programs. I think we have really in the past year or so been upgrading our compliance programs. We joined AdvaMed. We are working for AdvaMed compliance. And for us, it’s kind of a constant. We have compliance officers in our businesses and Blackstone specifically as well.

So, overall when we diligent the company, we feel good about it. We continue to feel good, but are always improving in that area. Relative to the market opportunity, I mean as you look at the results and better than anybody, Michael, I think some of the larger companies are seeing a deceleration of their spinal revenues, single-digit growth. Obviously, Stryker has been doing very well.

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

So, we think that there are opportunities in the marketplace for some of the larger companies. I am not sure it’s related to this, couldn’t attribute it to that, in fact. But we do see opportunities coming from all over and in particular for some of the larger companies, if you just don’t have the focus 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 from ThinkEquity.

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 going up against fusion or at that point do you think it makes more sense to randomize 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 randomizing against another disc, although we could consider modifying or protocol based upon approvals down the road. But right now, about a 180 to 200 is against traditional therapy. In fact, they are using one of our plating systems as part of that.

Steve Ogilvie - ThinkEquity

Okay. And then my other question was, you look at the orthopedics 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 for commoditizing.

As you look at those businesses, is there something you guys feel like you can do to get it back after the growth rate of the other business units 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. And so we've talked openly about the fact that spine probably gets a disproportionate amount of our resources. Having said that, some of the products that we have introduced recently have helped us, what I would say, on the orthopedic side is that we are still evaluating our ability to be successful in the hard trauma segment, highly completive. You all know that.

But you start to see a little bit of more pressure, also with external fixation becoming less and less popular from the treatment standpoint. Making up for any of that external fixation state with the internal fixation products was somewhat successful. But you see a little bit this quarter a deceleration of revenues. So, I would say the jury is still out for us 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 with that Physio-Stim focus. 28% growth in Physio-Stim is just phenomenal. The team has done a great job 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 market moves 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 sequentially down the next two or three quarters. What do you feel like the organization can adapt and continue to move with the market?

Alan Milinazzo

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

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

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

Steve Ogilvie - ThinkEquity

Alright. Thanks

Operator

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

Jason Wittes - Leerink Swann

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

Alan Milinazzo

We recorded all of our royalty, expense in sales and marketing

Jason Wittes - Leerink Swann

Okay.

Alan Milinazzo

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

Jason Wittes - Leerink Swann

Okay so we can assume from a cash standpoint that as it accrues 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 is for this quarter taking all the charges etcetera?

Alan Milinazzo

We just said, we are staying with our guidance of 28% to 30%.

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's at 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 this quarter. Alan and I am just curious. I think if I heard correctly it was in the south eastern region, which my understanding was that that is one of your strongest regions. I guess why was there a decision to add was it an opportunistic add or was a replacement there, could you just give us a little more color there?

Alan Milinazzo

Yeah, now we added two Jason this quarter. One was in Europe and other was in the south eastern U.S. So even though we have good distribution if look at it, some of these markets, some of your best distributors trying to keep up with some of the demand, it creates opportunity to carve out territories. So that’s really what you saw us doing. We haven’t yet realized the full impact of that. So in situations where we have business growing and our distribution in that area may be isn’t getting up with some of the demand. We will add distributors in that market and then in some of the big markets 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 or indirect. I think we will be able to much like Steve's questions, I think over the successive quarters we'll talking to you more about how we are rounding out those markets that we are not currently represented in.

Jason Wittes - Leerink Swann

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

Alan Milinazzo

No, none. Obviously this quarter we made the shift. We brought Oliver Burckhardt over from our international business to run Blackstone and Oliver's background in distribution we think makes him a perfect candidate. So, short of that, which was obviously a major change since, Matt Lyons has run the business. That's been our only major change. Otherwise at the distribution 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 from SFG

Dave Turkaly - SFG

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

Alan Milinazzo

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

Dave Turkaly - SFG

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

Tim Adams

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

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

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

Dave Turkaly - SFG

Great thanks a lot.

Alan Milinazzo

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

Operator

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

James Sidoti - Sidoti & Company

Good morning Alan, can y'all hear me?

Alan Milinazzo

Hi Jim, we've got you.

James Sidoti - Sidoti & Company

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

Alan Milinazzo

Yeah, I would say, it's a combination, if you look at any industry, in particular, on the spine side. You see a company as they evolve as they get bigger, your need to tailor distribution becomes bigger. We certainly have the benefit of a stimulation team already in place that's direct. On pure commission base, which is a good model for us, we'd like to see any direct reps we bring on continue in that model, whether they be implant or biologic reps on a specific basis. So, I think, we'll end up with a mix and that'll be based upon the markets that we are in and who we think makes the best long term decision force in a given market. So, and as a key point Jim, I want to just make is that we want to build for the long term here and not for short term gain, 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 the sales marketing line over the next couple of quarters as you add to that?

Alan Milinazzo

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

James Sidoti - Sidoti & Company

Okay, all right, thank you.

Alan Milinazzo

You are welcome, Jim.

Operator

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

Stan Manny - Manny Family Investment

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

Alan Milinazzo

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

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

Stan Manny - Manny Family Investment

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

Alan Milinazzo

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

We would expect to see that continue into Q4 although there is also a mix component to it. We request certain sizes from the company and making sure we get those sizes we'll also dictate how our revenues look. Given our full guidance for the quarter and within that that would show some improvements with Trinity, but we don’t expect it will have a two axe improvement in the in the quarter.

Stan Manny - Manny Family Investment

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

Tom Hein

We do Stan; I think we want to balance that with other strategic activities that we have in mind. We did something earlier in the year with this in swing product that we alluded to couple of times in the call, not a huge amount of money, but very important in terms of our portfolio, as well as 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 we would continue to make debt repayments. But again we have to balance that with our own strategic plans for in organic activities.

Stan Manny - Manny Family Investment

Okay, good job, thank you gentlemen.

Alan Milinazzo

Hey, Stan, thanks for the call.

Operator

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

John Putnam - Dawson James Securities

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

Alan Milinazzo

We look at the market John and just looking at third party data that’s out there, it’s probably somewhere between 5% and 7%, call it 7% on the upside. At least for the products that we compete in, we are obviously not in the OR component of that. So, from our standpoint we view the markets call at 7% and our functional bracing products are growing at about 18%. So we are really focused on functional bracing. We think that the FUSION product we launched 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 high level, there's big demand for that product. So that would be kind of the first point, and then secondly, as you know from our cold therapy standpoint, slower growth markets, but we grew about 15%, and again we have leadership in that segment and the management team and the R&D group continues to find ways to innovate, make the products work better and then make them smaller and quieter, et cetera. So, an important component in order to shift execution by the management team and I wouldn’t loose sight of the fact that the highly focused management team is very committed to taking market share. It's just as simple as that.

John Putnam - Dawson James Security

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

Alan Milinazzo

I think we have indicated -- indicated in my script if you take our third quarter, 73.9% net of all adjustments, and add back to that the removal of the amortization on the inventory step up which is about 70 basis points, 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 closing remarks?

Alan Milinazzo

Yes, operator. I want to thank everyone for joining us today. Q3 was a quarter in which we accomplished our financial goals, as well as, some very important strategic objectives. 2007 has been a year of transition for Orthofix and despite the organizational changes and the integration challenges. We continue to achieve our stated financial and strategic 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 now disconnect.

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Source: Orthofix International Q3 2007 Earnings Call Transcript
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