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Exactech, Inc. (NASDAQ:EXAC)

Q1 2012 Earnings Call

May 2, 2012 10:00 a.m. ET

Executives

William Petty - Chairman and Chief Executive Officer

Joel Phillips - Chief Financial Officer

David Petty - President

Analysts

William Plovanic - Canaccord Genuity

James Sidoti - Sidoti & Company

Mark Landy - Summer Street Research

Jason Bednar - Robert W. Baird

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the Exactech, Inc. First Quarter 2012 Results Conference Call. During today's presentation, all participants will be in a listen-only mode. Following the presentation the conference will be opened for questions. (Operator Instructions) Today's conference is being recorded, May 2, 2012.

I would now like to turn the conference over to Dr. Bill Petty. Please go ahead.

William Petty

Thank you, and welcome to our conference call. I will begin by reading the disclaimer and then we will move to some general comments from both myself and Jody Phillips, our CFO, and then we will go to the question and answer session.

The release contains various forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the SEC Act of 1934. They represent the company's expectations or beliefs concerning future events of the company's financial performance. The forward-looking statements are further qualified by important factors that could cause actual results to differ materially from those in the forward-looking statements. These factors include the effect of competitive pricing, the company's dependence on the ability of third-party manufacturers to produce components on a basis which is cost-effective to the company, market acceptance of the company's products, the effects of government regulation and other unforeseen effects. Results actually achieved may differ substantially or materially from the expected results included in our statements.

Exactech revenues for the first quarter of 2012 were $58.6 million, which is a 10% increase over $53.4 million in the first quarter of 2011. Net income was $3.3 million or $0.25 per diluted share compared to $3 million or $0.22 per diluted share in the same quarter a year ago. Now looking briefly at our different product lines. Our knee implant revenue was up 1% to $21.5 million. Extremity implant revenue increased 37% to $13 million. Hip plant revenue also increased 37% and that was to $11 million. Our biologic and spine revenue decreased 13% to $6.2 million and other revenue which includes primarily instruments and bone cement, decrease 6% to $7.1 million.

Our growth of 1% in our knee prosthesis line is about on pace with what we believe the industry growth was. Our biologic and spine revenue as I mentioned decreased as did our other product sales. However, our growth in both hips and extremities far exceeded industry growth. Most of the extremity growth was domestic though we are certainly making inroads outside the U.S. as well. Our hip growth is attributable to success with our new hip products generally, and also growing sales in Asian and Latin American markets.

Looking at the breakdown between in the U.S. and outside the U.S. sales, our outside the U.S. sales increased 19% to $21.9 million from $18.4 million in the same quarter last year. Our domestic sales or U.S. sales increased 5% to $36.8 million compared to $35 million in the same quarter last year. Our international revenues now comprise about 37% of our total revenue.

I am now going to ask Jody Phillips to give a little more of the financial detail. Jody?

Joel Phillips

Thank you, Dr. Petty. Good morning, everyone and thank you for joining us for this morning’s first quarter conference call. As I mentioned in the release, the first quarter sales and earnings results were slightly ahead of our expectation and we feel we have a solid start to 2012. In order to review our first quarter operating performance, I will review the major elements of the income statement and then make a few comments on balance sheet items.

Our gross margin percentage expansion during the quarter from 68.7% to 69.1% was consistent with our expectation, and as we look to the balance of 2012 we expect flat to a modest 50 basis point increase in gross margin percentages on quarter-over-quarter basis, as we expect internal manufacturing cost reductions to continue to offset modest pricing pressure.

From a S&M expense perspective, the 9% increase was consistent with our sales growth and we expect sales and marketing expense growth to be in line with sales growth for the balance of the year as the large infrastructure buildup in direct operations outside the U.S. that occurred during 2010 and early 2011, has now annualized.

First quarter 2012 G&A expenses were roughly flat as compared to the same quarter last year, as compliance spending was roughly half of what we experienced in the first quarter of 2011. At this time we have elected to discontinue our non-GAAP reporting as we feel that the compliance spending that we are expecting is our new reality, and this type of spending will continue for the foreseeable future.

R&D expenditures it the first quarter returned to an increase of 18% as we continue to full fund our product line and also due to cartilage study expenses related to our Taiwanese clinical trial. For the balance of the year we expect similar to slightly higher growth dollars on R&D expenses and therefore we continue to expect a full year increase of approximately 20%. Although that increase will be significantly higher in the second quarter and then lower in the third quarter and fourth quarter due to different comparables from 2011.

Depreciation and amortization expenses increased 11% for the quarter and that is the type of increase that we expect for the remainder of 2012. First quarter total operating expenses therefore increased 8% and as a percentage of sales, total operating expenses decreased to 60% of sales from 61% in the first quarter last year. And we expect similar increases and related percentage of sales reductions for the balance of 2012.

As a result of these sales margin and operating expense results, our operating margin increased 29% to 8.8% of sales during the first quarter. In the other income and expense area, we experienced and increase in the interest expense of $200,000 as compared to the first quarter of 2011. And this was due to a combination of the increased borrowing as well as some expensing of deferred finance costs related to our debt facilities restructuring that we completed in the first quarter.

The quarterly effective tax rate was 33.7% versus roughly 31% in the first quarter of last year, and that was primarily due to the expiration of the research and development credit. We expect the tax rate to roughly remain in this area through the balance of 2012 based on what we know today. As a result of these activities our net income of $3.3 million was an increase of 11% and as I noted before, it was slightly ahead of our expectations as was the diluted earnings per share at $0.25.

From a balance sheet perspective, we experienced a modest increase in inventory of $1.7 million although our inventory turns during the quarter actually increased due to the velocity of our sales and our cog. The increase in accounts receivable of $8 million during the quarter was due to a number of factors including expansion of accounts receivable in Europe and relatively strong sales performance in the month of March. The days sales outstanding expanded from 70 to 78 days during the quarter, so it really was not a total surprise to us as we projected DSO to expand to 81 days during the year in our filings earlier this year as well as on the conference call. We obviously are paying close attention to this and currently significant progress in total AR during the third quarter of this year, specifically due to activities in Europe.

From a guidance perspective, we have increased our 2012 guidance for the outperformance in the first quarter to a revenue target of $217 million to $224 million. This represents a 5% to 10% top line growth and associated with this a range of diluted EPS of $0.90 to $0.97 which equates to 37% to 47% increase in net income. Our second quarter revenue guidance of $54 million to $57 million represents a 5% to 10% increase and slightly lower revenues then the first quarter which has been our experience for the last few years. And a GAAP EPS guidance for the second quarter of $0.22 to $0.24, which represents a -- or roughly translates to a 7% to 19% increase in after-tax net income.

Again, we think we are off to a great start for 2012 and we appreciate you guys joining us this morning.

William Petty

Thank you, Jody. Elisha, we are ready for questions.

Question-and-Answer Session

Operator

(Operator Instructions) And our first question comes from the line of Bill Plovanic with Canaccord Genuity. Please go ahead.

William Plovanic - Canaccord Genuity

Congratulations on a good quarter. Just a couple of questions. International was very strong and as we look at that, kind of what is the mix direct versus distributor and what was that in year ago quarter?

David Petty

This is David, Bill, good morning. It’s currently about 65% of the direct business within our global offices. And. Boy I have struggled to know exactly what that number was first quarter of last year.

Joel Phillips

It was probably in the neighborhood of 50% a year ago, Bill. The growth in the direct operations has outpaced the growth in our independent distributors.

William Plovanic - Canaccord Genuity

And then my second quarter on that is, you know the accounts receivable, you quoted Europe and just a strong March as the driver for that. It’s a pretty big job. Are those receivables out of your direct channel, out of your stocking channel, out of Europe? Just any kind of color on that might be helpful.

Joel Phillips

The bulk of it is in our direct channels. Again that’s where we have a lot more of the growth though, by nature, and I think that will drive a lot -- a large part of the mix and also a significant amount of it is in Southern Europe. And we are paying close attention to that and have quite a bit of information on the ground and are expecting significant movement on that in the third quarter of this year.

William Plovanic - Canaccord Genuity

Okay. And then just as we look at the growth, I mean obviously extremity and hip was extremely strong and I congratulate you on continuing that. On the knee, is there any major new product you think could really kind of reaccelerate or get growth going there. Or is there just any easy comps that we are starting to hit, any thoughts there? And that’s it, thanks.

David Petty

Sure. Well the knee outside the U.S. was really strong and of course that’s in the face of the difficult economy challenges that we face in Europe. I think everybody is facing in Europe. And happily we have offset that very nicely with good growth in our other Americas regions, South America mostly. And also our operations in the Asia Pacific region, and that’s not just limited to Japan and China, which is doing very well, but some of our other markets there as well.

Domestically, I think everyone knows there has been a procedure slow down. It’s I think early days to say if that’s bounced back in a significant way, though it appears that perhaps it is. And so we have had that working against us as well as more pricing pressure then we have experienced in the past. So having said all of that, we have been very focused on this over the last 9 months or so and we believe we are starting to see some traction around the new products.

And when I say new products under the Logic trade name, of course that’s been out for quite some time in the PS version. But we are really just starting to hit our stride with the launch of the Logic Cruciate Retaining system as well as the Logic FIT tibial tray. And then throughout the course of this year some line extensions in the tibial insert line. And that’s all we are ready to talk about right now, though we have some other things in the works for later in the year that we may be ready to talk about later in the year.

Operator

Thank you. Our next question comes from the line of Jim Sidoti with Sidoti & Company. Please go ahead.

James Sidoti - Sidoti & Company

Good morning. Well, I will just start off with the hips. $11 million, I think that’s the -- I am just looking through my numbers, that’s the best in hips by a couple of million, ever. What drove that growth and is it sustainable?

David Petty

We sure hope it’s sustainable. But let's talk about what drove it. And I think the most important thing is we continue to see real positive traction outside the U.S., particularly in both Japan and Spain. So that’s been helpful but it’s not limited to that. There’s some other distributor markets in the other Americas that are helping. And remember that we never sold hips really in any meaningful way in Spain until we set up our own direct operation. So that’s helping a lot.

Japan, we got this clearances, I think 1 year to a year and half ago. And so our team is out working hard there. In addition to that we have had, I think a really good response to our direct anterior approach, surgical approach limitation, and have made progress with our Novation element. Hip stem, we have also made good progress with our Novation Crown Cup and some line expansions there. So there is some new products driving it and my comment about sustaining it, we do have an important line expansion coming with that Novation element hip stem that will give us competitive advantages over the market leader for that style of hip stem. So we hope that will help us continue to attract more surgeons domestically.

And then finally our porous metal InteGrip acetabular system. We are just starting to get out of the box with that. So it is a combination of new products and new markets outside the U.S. and positive response to launches over the last 18 months in hip. And so we do feel good about our hip business right now.

James Sidoti - Sidoti & Company

All right. Because if you look through last year, the first three quarters you were stuck in around $8 million and then you started to see it accelerate in the fourth quarter last year and it continues to accelerate. Do you think, this is a good base level or do you think you could grow from this point.

David Petty

We are certainly planning on growing. I don’t know that we are going to sign up for 37% growth on a continual basis. But certainly one-way to think about it is we expect to be substantially above market growth rates for the foreseeable future.

James Sidoti - Sidoti & Company

Okay. Great. And then as far as the U.S. knee market goes, I know you are a little hesitant to say things are picking up, but could you at least give us some sense, do you think things have at least leveled off there as far as procedure growth rates go.

David Petty

In our business, yes. Basically another way to say it is we were relatively flat in units and had couple of points of downward pressure on pricing. And we expect that we will continue at the type of pricing side and we are intending to have, to get the unit growth up in the final three quarters of the year.

James Sidoti - Sidoti & Company

Okay. And then last question on the spine. You have two new products I think this year that you are coming out with. When do you think that business starts to grow again?

David Petty

So if you look at the way we report the spine and biologics together, we have from Q4 to Q1, consecutive quarter of growth in that combination. And if you want to dig a little deeper, the biologics business has been problematic for reasons we have discussed, I think in the large part due to the focus on cost and healthcare, and these are often add-on products and we have gotten push back over the last year and half. But that business, we think we have stabilized that business and we are working hard to go back at the economic customer within the hospital systems to recover some of that business. And we I think have been able to stabilize the biologics business also with a focus on our bone marrow concentrate product.

And in the spine business, you are right, the release of the new products, particularly the Proliant pedicle screw system and the Gibralt posterior cervical system, are providing growth to our spine business unit. We do have some additional products to roll out this year. So we are relying on new products to get to total positive growth in spine throughout the year.

Operator

Thank you. Our next question comes from the line of Mark Landy with Summer Street Research. Please go ahead.

Mark Landy - Summer Street Research

Good morning, folks, and again congratulations on a really good quarter. Jody, just looking at the gross margin, it did creep you nicely this quarter. Is that a function of just the higher sales or are there some initiatives to kind of reduce some of the fixed cost related to manufacturing.

Joel Phillips

There’s continual initiatives on the manufacturing front to reduce costs. That’s certainly a contributor to that increase. And as I mentioned, it was able to offset some of the pricing pressure that David referenced and so we will continue to do that. We also have a very quarter from a production volume standpoint, just due to the demand that we have, that’s continuing. So that was a help. And we are pretty confident with being able to remain at flat to the 50 basis point improvement on the quarter-over-quarter basis as we look forward that I referenced earlier.

Mark Landy - Summer Street Research

Okay. So then just looking at the optimistic scenario. If we see some of the sustained demand or the increased demand in the quarters to come, how should we think about gross margin expansion based on just the improvements in the volume?

David Petty

I think the wild card there is going to be pricing. If we assume that pricing is relatively stable, we will probably be closer to that 50 basis point improvement in gross margin. If pricing kind of continues to be pretty tough, it could put us more towards that lower end or basically same type comparable gross margins.

Mark Landy - Summer Street Research

And in terms of raw materials, are you seeing any creep in pricing or is it relatively stable?

David Petty

What we have experienced recently is that it has been relatively stable.

Mark Landy - Summer Street Research

Okay. Great. Thanks. And then just turning a little bit to SG&A, you know there has in the past been multiple moving parts to that. And I think now that you passed the monitoring period, is there any chance to think about some SG&A leverage, perhaps as we move through the year, as you get your arms around some of the monitoring costs that are not permanent versus the one time. And some movements in the European distribution, or is that leverage something for the out of the U.S.?

David Petty

Well, there was a little bit of leverage in G&A in the first quarter in the fact that we had no growth in G&A expenses relative to 10% sales growth. So I think we will have some modest increase in the G&A spending through the balance of the year but it certainly should be lower than the top line sales growth. So there will continue to be a little bit of leverage there. Most of the O U.S., or almost all of the O U.S. infrastructure costs are reported through sales and marketing expenses. And that was the area that I referenced that was up 9% and we currently project that to be inline with sales growth. So a little bit of leverage of the G&A, and sales and marketing expenses shouldn’t be working against us like it has been for the last 18 months. So we think there is a little bit of leverage in them all.

Mark Landy - Summer Street Research

Okay. Great. And then lastly, just I suppose turning to the spine and the biologics. When does one get to the point where you feel perhaps the bleeding has really stopped? One of your competitors reported I think a surprising increase in biologics this quarter. But for the most parts you know it has been at best flat to down. Is it just relating to price sensitivity or do you think physicians are slowly evaluating biologics based on the Infuse debacle.

David Petty

Maybe I won't comment on the Infuse situation.

Mark Landy - Summer Street Research

Fair enough.

David Petty

I’d rather go back to your broader question, and really we view 2012 as sort of a hallmark important year, especially for our spine business where we have made investments over a number of years in new product development. And we are really just starting to put those products on the market. Now that we have a more substantial range of products that puts us in a position to attract a higher quality sales team. So we are very focused on the combination of the opportunity that comes with the products themselves and the recruitment of a higher quality sales organization.

So we really are expecting and asking our spine business to pick up the pace and deliver some important contributions, both on the top line and prospectively on the bottom line that will get them a little bit more -- little bit of room on that. And as far as the biologics goes, we got caught in a window over a period of two years where we would not get clearance on an important product that we intended to launch. And we found ourselves with a little bit of a hold in product launches. Interestingly, we are back in conversations with the FDA about that product and we are certainly not going to put it into our sales projections until we know for sure. So that’s just a question mark but perhaps some positive, at least, hope out there.

And so I have said earlier, we did stabilize that business and we are confident that we can get back into growth mode. Though we are not yet feeling confident enough to say we are back to that 20% growth rate we had a couple -- two or three years ago for a couple of consecutive years.

Joel Phillips

The other thing there, Mark, if you just look at the quarterly numbers, really things bottomed out in the Q3 of 2011 but our last, really large comparative was the first quarter of 2011. So we think this quarter that we just reported was kind of our last quarter of the very difficult comp. And in fact the comparative from Q2 ’11 to Q1 ’11 is almost like 15% lower. So going forward we should hopefully stop seeing the drastic quarter over quarterly decreases and hopefully soon be into increases.

Mark Landy - Summer Street Research

No, I saw that. You are up against, I think the 4% decrease versus another teens decrease in the quarters through the remainder of ’11. Well, guys, thanks again for answering my questions and congratulations once again.

Operator

Thank you. (Operator Instructions) And our next question comes from the line of Jason Bednar with Robert W. Baird. Please go ahead.

Jason Bednar - Robert W. Baird

Thanks, good morning, guys. I just wanted to (part) at the operating margin line, and maybe I am going to merge questions a different way here. So if we are trying to look at things on an apples to apples, considering compliance costs you incurred in both periods. It looks like your core operating margins were essentially flat in the quarter. So I am just wondering, you put a very good top line growth, we didn’t see any core leverage this quarter. Revenue growth guidance is 5% to 10% next quarter versus the 10% you put up this quarter. So what level of revenue growth do you think we need to get to in order to generate leverage and how much reliance or how much reliance do you think there is on seeing a rebound in your knee business.

David Petty

I think there is a little bit leverage in there even when you break out the compliance, it’s not a full percent on the operating margin level but there certainly is some. And I think there is opportunities for that to be as much as you know 1% increase to 1.5% as we go throughout the year. Frankly, if we say the 10% type growth level, 9% to 10% type growth level, we can deliver that type of leverage. And if we get above that, it can even be greater.

Jason Bednar - Robert W. Baird

Okay. That’s helpful. And is there any dependence on a rebound in the knee business or do you really -- are you indifferent to where that growth comes from as long as it nets to getting to that upper single or double-digit level?

David Petty

What's probably more important than which product line it is, is the market. The U.S. business obviously is a key there in terms of the profitability with that rebounding to a 5% growth which is first quarter, I think, in a year where we have had real growth in the U.S. That’s most significant. So as that expands possibly even up above 5%, that gives us more opportunity for leverage. But knee, hip, extremities, all of those are very profitable product lines in the U.S.

Jason Bednar - Robert W. Baird

Okay. All right. And sorry if I missed in Jody, but is it fair to assume that you guys had an extra selling day -- extra billing day that provided 100-150 basis point tailwind in the quarter?

Joel Phillips

You know, Jason, you guys are much better at evaluating that than I am. I have struggled with the holidays and the Easter bunny and all that stuff, but I guess if everyone else that reports on the calendar quarter basis had one less selling day, we did as well.

Jason Bednar - Robert W. Baird

Okay. That’s fair. And then on the pricing side. I again understand you are a smaller player, but just curious if you could discuss maybe the level of headwinds that if you guys are seeing on the pricing side. I think you mentioned down 2% for knee. But any specific color you could provide for hips or even extremities.

David Petty

Well, so did -- there are lot of requests. One of our sales management people says that we don’t get RFPs anymore we get DFP, demands for price. And so that activity is out there. I will say our team is very effective at negotiating price, maintaining price, holding price. And I think we have been in a situation when our competitors have reported meaningful price decreases, we have been relatively stable over a period of time, a couple of years. But we do have that pressure. I don’t have the hip numbers in front of me. The knee actually, domestically in the first quarter was minus three. So that’s as tough as it’s been on us and we are obviously focused on working hard on it. I wish I could tell you what the hip number was. And our extremities pricing remains, I think stable. It continues to be -- we continue to enjoy pretty good pricing in shoulders though. That’s I think coming more on the radar screen of the different economic buyers and the hospitals. So I don’t know that I have been terribly helpful in giving you that answer but we are focused on it and we think our team does a good job of maintaining and holding pricing.

Operator

Thank you. (Operator Instructions) And I am showing no further questions at this time. I'd like to turn the conference back to Dr. Bill Petty for any closing remarks.

William Petty

Thanks to all of you for joining in our conference call. Thank you for your interest in and confidence in Exactech and thank you Elisha, and hope you all have a great day and a great reminder of the week.

Operator

Ladies and gentlemen, this does conclude our conference call for today. Thank you for your participation. You may now disconnect.

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