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ArthroCare Corp.(NASDAQ:ARTC)

Q4 Earnings Call

February 19, 2008 4:30 pm ET

Executives

Mike Baker - President and CEO

Mike Gluk - EVP and CFO

Cory Irvin - Director of IR

Analysts

Raj Denhoy- Bear Stearns

Mark Mullikin - Piper Jaffray

Ed Shenkan - Needham & Company

Bill Plovanic - Canaccord Adams

Joanne Wuensch - BMO Capital Markets

Brian Weinstein - William Blair

Madison Spencer - Morgan Stanley

David Lebowitz - SMH Capital

Steven Lichtman - Banc of America Securities

James Sidoti - Sidoti

Operator

Welcome to the Q4 2007 financial results and business conference call. During the presentation, all participates will be a listen-only mode. Afterwards, we will conduct a question-and-answer session. (Operator Instructions).

A rebroadcast of today’s conference will be available beginning February 19th `08 through March 4th ‘08, 6:30 EST. To access the rebroadcast please dial 800-633-9284 or 402-977-9140 and enter the reservation number 21374252. As a reminder, this conference call is being recorded Tuesday, 19th of February, 2008.

I would now like to turn the conference call over to Cory Irvin, Director of Investor Relations. Please proceed, ma'am.

Cory Irvin

Good afternoon, and welcome to ArthroCare's fourth quarter and year-end conference call. Joining us on this call, are Mike Baker, President and CEO of ArthroCare and Mike Gluk, ArthroCare's CFO. By now, you all should have seen a copy of today's press release, which was released earlier this afternoon. But if you haven't, it is available on our website at www.arthrocare.com. A live and on-demand webcast of the conference call is also available on our website.

Following introductory comments by management, we will open up the lines for a short question-and-answer session. In order to give as many of you as possible an opportunity to ask questions, we will accept one question and one follow-up per caller, after which we welcome callers to rejoin the queue. Before we begin, we would like to advise you, other than historical information, the matters we will be discussing today, consist of forward-looking statements. These statements are subject to the risks and uncertainties detailed in our Securities and Exchange Commission filings, including our 10-K for the year ended December 31, 2006. Actual results could differ materially. The statements made in this conference call are based on the information available to ArthroCare today and the company does not undertake any obligation to update or correct them before it's regularly scheduled call at the end of next quarter.

I will now turn the call over to Mike Baker, ArthroCare’s CEO.

Mike Baker

Thanks, Cory. With 2007 now on the books, I am happy to report that in Q4 we saw a very strong finish to what's proven to be a remarkable successful year. ArthroCare's fourth quarter and calendar year 2007 revenue came in above consensus at $87.5 million and $319.2 million respectively.

Revenues grew both on a sequential and quarter-over-quarter basis in each of our business units. Our strong fourth quarter is a good indication that the new products we launched this year have taken off.

Earnings per share was $0.50 for Q4 and $1.50 for the full year bringing us to the high end of our adjusted forecast estimates and consensus. We believe that the strong financial performance is a clear indication that the new products we launched in 2007 have quickly gained significant traction as they are driving the business forward. We accomplished all of our major financial and strategic objectives and we exited the year with considerable financial and strategic momentum.

In 2008 we intent to build on 2007 momentum by continuing to add innovative new products to our portfolio, across all product lines supported by key marketing and clinical initiatives to help drive awareness and growth, and ultimately to establish as the leader in our markets, in the minds of our customers.

Let's start with the quick review of the fourth quarter. As we previously announced we saw product sales in each of our business segments increase by more than 20% in the fourth quarter when compared to fourth quarter of 2006.

In our largest segment, Sports Medicine, we saw quarterly year-over-year growth of 22%, a very strong level of growth for business of this size. Our ENT segment posted growth of approximately 21% and our Spine segment products sales increased by approximately 53%. Altogether products sales grew by more than 25% in Q4 and over 21% for the full year.

First a few comments about Sports Medicine. In our Sports Medicine business, which accounts for approximately 62% of our total product sales, we believe that the product sales growth was primarily the result of market share gains driven by the new products that we launched in 2007.

In the Coblation product line, we launched the new Quantum controller platform, which represents the next generation of our technology. The Quantum system delivers the level of technology performances beyond our already best-in-class Atlas system. And then also brings customers' requested features to the market, which no competitive system can match. We also introduced several new advanced technologies Coblation lines, specifically designs to exploit the capabilities of the Quantum system.

In 2008, we plan to add four additional advance technology launches and an integrated intelligent fluid management capability to this system. That will expand the system flexibility and performance, and further distinguish us from the competition.

In the Opus products line, we made several significant additions, including the Magnum PI, the Perfect Passer and the twin lock anchor to what we believe was already the broadest and most advanced line in endoscopic tissue prepared products on the market.

In 2008, we intend to continue to drive our market share in this segment with additional Opus technology products.

In 2007, we also made major investments to strengthen our global distribution channel on the segments. Overseas, we increased our direct market presence in Spain, Australia, the UK and Germany. And then in the US we added additional direct sales representatives and significant increases in our investment in physician training.

We believed that these investments in the distribution channel significantly enhanced the impact of our new products in 2007. And we intend to continue to aggressively invest in our distribution channel in 2008.

In late 2007, we also saw the publication of a very significant piece of level one peer reviewed clinical science from Dr. Taverna’s Group at the Orthopedic Institute of Milan, in the journal of arthroscopy which addressed the use of our ArthroCare’s technology in shoulder surgery.

We believe that this landmark perspective of randomize clinical trials clearly demonstrated the potential patient benefits of adding a microtenotomy using TOPAZ technology to many routine shoulder surgeries. There are existing procedures codes for microtenotomy in shoulder surgery. And the reimbursement level for these codes are adequate.

Beginning this quarter, we look forward to taking this message into the marketplace and we believe that this could represent a unique opportunity to significantly improve patient outcomes in a very large number of surgeries and its significant highly proprietary opportunity to grow our business.

We also have some exciting scientific news in the foot and ankle area that I would like to spend a few minutes detailing. As most of you are aware, we have been using Topaz technology to treat tendinosis very successfully for several years now. Many of you have also seen the pre-reviewed data from Dr. Tasto’s group that was published in Arthroscopy in 2003 that showed that the use of Coblation and Topaz therapy causes a biological reaction at the cellular level and indicates a new renewed healing response.

We have seen similar biological changes driven by Coblation surgery documented in the peer-reviewed spine literature. For example, the Spine Journal in 2004 and again in 2007 published peer-reviewed research from the University of California, San Francisco. The documented changes in the spinal cord, and pro-inflammatory mediator production in this tissue treated with Plasma Disc Decompression therapy that indicated that the treatment had triggered a more robust healing response.

We have also consistently had reports of reductions in pain and improvements in the speed and quality of healing with Coblation issues across all of our clinical experience. This clinical experience and scientific data has led some foot and ankle surgeons to begin using Coblation devices to address a common clinical problem in their space.

The debridement of diabetic foot ulcers and the initial clinical results in this area have been remarkable. Diabetic foot ulcers are a significant medical and economic problem. There are an estimated 18 million people in the US with diabetes and approximately 5% of them will develop foot ulcers every year. Even if these ulcers heel, the recurrence rate is 66%. And a significant number of them ultimately require an amputation of the limb.

Foot problems are responsible for 15% of the hospital admissions and 25% of the hospital bed usage among diabetics. We are very early in our clinical experience but our customers are seeing chronic diabetic foot ulcers to have literally remained unhealed for years, peel after they have been debrided with Coblation devices.

As with most of the things here pictures are worth a thousand words and we have a picture here in the presentation that you can [click] to you and a patient story that will give you some idea of what we are taking about.

The picture on the left hand side is of the right great toe of a 48 year old Type 1 diabetic with a full thickness two centimeter by two centimeter diabetic ulcer. The wound had refused to heal despite 18 months, 18 months of conservative and standards surgical treatment.

In September of last year this wound was debrided again, this time with the Topaz Coblation devices. One month later the wound showed signs of improvement and it was again debrided with the Topaz device. The improvement continued and no further debridement was necessary. By December the wound had healed completely and the patient has now returned to normal shoes and normal activity, a remarkable and unexpected outcome.

In 2008, we will be organizing a larger number of clinical investigations around this indication, which obviously has the potential to significantly augment the already promising Coblation and Opus applications that we were pursuing in the foot and ankle area.

This may also ultimately pave the way to the broader application of Coblation technology to wound care. We will be following this carefully and we expect to have more data to report as the year progresses.

This initiative is a good example of how we have grown our business. We are focused on owning robust technology platforms that can be used to develop multiple innovative surgical applications. We use innovation to establish ourselves as leaders in the minds of our customers and this leadership position allows us to see and understand the opportunities to use all proprietary technologies to improve procedures and meet unmet medical needs.

We’ve seen this strategy play out before in the development of the ENT and Spine businesses and now you are seeing it play out with Topaz . At any given time, in each of our businesses we have a portfolio of ideas like this one that we are evaluating and systematically moving towards commercialization.

Since 1997, we built the Sports Medicine business from a single controller platform and six wands to a global business with literally 100 of products and market share leadership positions in the key Coblation and endoscopic tissue repair segments of the Sports Medicine market.

We've grown this business rapidly but we continue to see a great deal of growth potential ahead of us, as we've penetrated less than 10% of the market opportunities that we conservatively estimate to be in excess of $2.5 billion.

Turning now to our ear, nose and throat business we saw product sales in Q4 of just over 21% which is a little lower than we had expected. It doesn't appear that any one thing had accounted but rather a combination of a number of smaller things.

There were some continuing impact from the recent Gyrus PK tonsil launched particularly in the first of the quarter. Although we don’t see any indications that Gyrus is actually gaining in remaining for commercial traction.

Also we had an especially strong showing in Q4 2006, which made for a difficult quarter-over-quarter comparison in terms of the percentage growth from year-to-year. However, it is also clear that the large [lower] products sales growth rate in this business was due to the fact that several of the initiatives that we expect to drive growth are taking longer to play out then we had originally anticipated.

In Europe, we are finally beginning to see growth in tonsil penetration in some key bellwether countries but it's taken longer to develop than we expected. In the UK for example, the physician training has taken longer to get started and it's gone slower than we had originally anticipated.

We are very intrigued by the potential opportunity that pediatric turbinate reduction may offer, particularly given the increased concerned over the use of systemic cold and allergy medication in children which has recently been in the news. We are seeing increased utilization in this indication, but we believe that we will need strong clinical evidence to make this opportunity a reality, given the natural conservatives in the pediatricians.

We now have a prospective randomized trial underway, that could provide that evidence and we expect to complete that trial before the end of 2008. To help drive this initiative we are also developing a new line, optimized for pediatric turbinate that we intend to launch mid-year.

We continue also to see a great deal of interest in the ENT community in the use of coblation in the surgical treatment of sleep disorders. A lot of revenue contribution from this initiative is negligible today. We have additional clinical studies in physician training scheduled for 2008.

Of all of the initiatives in the ENT business, our sinus program may be positioned to make the largest near-term contribution. We recently released our first coblation line, optimized for sinus procedures, the first ICD, and the surgeon feedback so far has been very positive.

In Q1, we'll be launching this new one line along with a new version of the Stammberger Foam product into the large and growing sinus market.

Since 2001, we've grown this business rapidly and built it into a market leader. As we look to 2008 and beyond we continue to see significant opportunities for growth in this market where we penetrated less than 10% of an opportunity that we now estimate to be approximately $1 billion.

However, for now we are going to maintain a relatively conservative estimate for near term ENT growth, as the comparisons will naturally become more difficult as this business grows and it's usually difficult to predict it right in which initiatives will play out, particularly in medical specialties that are conservative by nature.

So we will be conservative in our expectations and only raise our expectations when we have clear visibility as to timing. That being said we will continue to grow the business and we remain very excited about the potential of ENT as a growth driver for the future.

Now to spine segment, this includes both our spine business unit and the interventional therapy business. While this is the smallest of our business segments, representing just under 15% of our total product sales, it is currently our fastest growing segment and it contains some of our largest potential opportunities.

In the fourth quarter product sales in this segment again grew rapidly. With year-over-year quarterly revenue growth of 53% and approximately 68% for the full year.

Several years ago we made the strategic decision to focus more of our efforts on this segment on our customers who are spine and neurosurgeons. Because, we believe they have the opportunity to apply our technology in a much broader array of procedures than the pain specialist that made up the bulk of our early customers.

As part of the strategy we significantly broadened our product line, restructured our distribution channel and we have redoubled our clinical efforts. We believe that this shift in strategy has paid off. We have grown the business rapidly and whereas three years ago less than 25% of our revenue in this segment came from customers who were spine and neurosurgeons. Today we estimate that over 75% of our revenue in 2008 will be from procedures performed by this key customer group.

The largest potential opportunity in this segment and the fastest growing product is the treatment of metastatic bone tumors with our cavity technology. We estimate that there are currently over 500,000 patients annually who develop these crippling and life threatening tumors, which translates into a potential market opportunity of more than $1.2 billion.

Our clinical results today have been outstanding, with most patients getting almost immediate pain relief. And as those of who are familiar with oncology know, metastatic bone tumors are so incredibly painful that these patients are often unable to function and in some cases even unable to continue with their primary cancer therapy. Our device is the only FDA approved device to debulk this type of tumor, which is important since the debulking or literally removing a portion of the tumor allows the surgeon to safely augment the bone with bone cement which reduces the change of a life threatening fracture.

In 2007 we significantly augmented at our distribution channel in this space and our presence is growing rapidly in an increasing number of leading cancer centers nationally.

In 2008 we will be adding significantly to our distribution capability at launching new coblation products, distill out the cavity family and allow us to effectively treat a great percentage of the tumors that we see.

Longer term we expect this family of devices to be just the first in several families of Coblation products tailored to various applications in surgical oncology as we seek to build this business out and to establish a leadership position in this market. And we expect this business to be a key part of our overall growth story.

In our core Spine business, our recently introduced MD Spine wand represents the largest market opportunity. We believe this product addresses the market opportunity in excess of $1 billion and we've received strong positive feedback from the surgeons who have the opportunity to evaluate the product today.

We believe that this product has the potential to make the surgery faster and easier for the surgeon and to improve the long-term outcome for the patient by significantly reducing the damage to the annular wall during the procedure.

PDD is the oldest and smallest of the major commercial opportunities in spine segment but it currently represents the majority of the revenue in this segment. We also saw a good growth in PDD sales in both the domestic and international markets in 2007, driven by an improving reimbursement environment and increasing clinical credibility.

In 2008 we expect to see this improvement continue particularly in the US. And US sales in this product line should actually exceed international sales at some point in 2008.

Our clinical results for this product have continued to be excellent. And we saw a number of key peer reviewed presentations and publications in 2007, including our first look at the data from our US based prospective randomized trials. All of these trials, including the prospective multi-center randomized trials, document success rates of approximately 85% in properly indicated patients and the trials with long-term follow-up showed that this success is durable.

We believe that the increasing scientific and clinical creditability of this therapy is helping to drive improvements in reimbursement globally. And we expect to see additional peer-reviewed presentations and publications in 2008.

We also significantly strengthened our distribution capability in this business in 2007 adding both direct reps and a number of focused distributors and we intend to continue to significantly reinforce our distribution channel and broaden our product line with additional coblation products in 2008.

So while much of the focus in 2007 was on our PDD business because of it’s recent growth, it really represents only the beginning of our ambitions in Spine and Oncology markets. Going forward we believe that the Spine segment has the potential to be a source of significant growth of the company as we have barely scratched the surface of market opportunity, which we believe to be an excess of $3 billion.

Finally a few quick comments on the Coblation side. Our ArthroCare’s coblation technology was featured predominately in a new book published by the National Academy of Science. This book is a very comprehensive survey of the state of plasma science and our technology is highlighted among the section on low temperature plasma.

I am also pleased to announce that we are working with BeamOne on their effort to built and operate a new e-beam sterilizer facility in Costa Rica. This will be the first sterilizer facility available in country of Costa Rica and once this facility is operational we will able to significantly improve our time to market and reduced our inventories of finished goods by taking more than three weeks out of the supply chain.

In summary, 2007 was a very successful year for us. We've made significant strategic progress in all of our businesses and we accomplished all of our external financial objectives. We remain focused in our core strategy of developing, highly proprietor products and therapies that can improved the quality of patient care across the spectrum with the markets in which we participate.

We are entering 2008 with significant momentum and with the conviction that we have a strategy in place that will produce significant increases in shareholder value. We expect the growth drives for 2008 to be much the same as they were in 2007, an aggressive and ambitious product development plan, and breakthrough clinical research to establish new indications based on our proprietary technologies and a continued investment in strengthening our distribution channels in each of our businesses.

We have made and our continuing to make the investments that will allow us to sustain a rapid rate of topline growth, while continuing to systematically expense margins and grow earnings faster than revenue.

So with that I'll turn the call over to Michael Gluk to run through the financials and our forecast for 2008.

Mike Gluk

Thanks Mike. I'd like to start the discussion with a brief review in the fourth quarter results and then move onto some additional guidance for 2008 calendar year and the first quarter.

First the fourth quarter results. As indicated in our earnings release, total revenue grow up to the quarter was 25% above the 21% run rate for the calendar year. And on a constant currency basis this amounts to 24% for the quarter and 20% for the year.

This fourth quarter growth was due in particular to a very strong showing in our largest business Sports Medicines and growing strength markets outsides the US. For those of you who remember how our quarterly seasonality plays out, the fourth quarter is by far the strongest of the year. Our first and third quarters are the weakest.

Though we are very happy with the topline strength we saw in the fourth quarter, this level of the growth should not be annualized into a new run rate for 2008 and in particular in the first quarter.

Sports Medicines revenue increased 22% versus fourth quarter 2006, with double-digit growth rate in both major product lines, Coblation and OPUS.

ENT revenue increased 21% over fourth quarter 2006 and 10% sequentially over the third quarter, primarily on strong seasonal tonsillectomy sales in North America.

Spine business revenue increased 53% versus fourth quarter 2006 with strong growth in both US and international product sales. In 2008 we expect PDD sales in the US to exceed European sales and the cavity and microdiscectomy 1 to be the fastest growing spine product.

Sales outside the America’s increased 22%, led by strong sales in Sport Medicine Coblation lines, Opus products and a 37% increase in the spine business unit revenue.

Turning to product margin. As you recall our strategy in 2007 was to obtain gross margin improvement and then partially reinvest portions of the gain, in sales and marketing initiatives. The fourth quarter followed that game plan with net product revenue gross margins increasing 4 points over 2006 and 3.2 points over the third quarter, due to improved product line mix, wherein operating margin for the quarter exceeded 20% which represents a five point increase over the prior year’s fourth quarter margin of 15%.

With gross margin improving above our original expectations, we accelerated some of our plans for 2008 sales and marketing programs into the fourth quarter. As a result, total operating expenses increased $8.7 million versus Q4 2006, including a $7 million increase in sales and marketing and a $2 million increase in R&D, which were partially offset by a decrease in G&A. Overall, operating expenses represented 56% of revenue, versus 57% of revenue in the fourth quarter of 2006.

The other income and expense line is a $1.4 million favorable to Q4 2006 reflecting higher cash balances in 2007. It was the favorable impact of the dollars 10% decline against the year.

For the quarter our tax rate was 20%, reflecting the final adjustments to original estimates for such items such as R&D spending and in-play option exercise. This rate is significantly higher than Q4 2006, due to the impact of the delay in passing the R&D credit in 2006.

The impact of the lower tax rate on the quarter was between $0.015 and $0.02 per share. For the calendar year; the calendar year tax rate is 22% equivalent to 2006 and slightly below our calendar year guidance of 23%.

Putting it all together, net income for the quarter was $14.5 million with 78% increase over the prior period and resulted in the total of $0.50 per share. For the calendar year the revenue growth and gross margin improvement exceeded our original guidance, demonstrating fundamental strengthen across all business units.

As we've indicated earlier in the year, operation expense increases were focused in sales and marketing and R&D as we continue to expand product offerings in distribution capabilities, for the 36% net income growth for the year exceeded our guidance of at least 30%.

I would like to spend a few moments now on the balance sheet. First, our cash on hand at $39 million reflects the completion of a majority of what I call the stock repurchase activity at December 31st. The acquisition of this DiscoCare for $25 million and borrowing $60 million from a credit facility.

In terms of our liquidity position, it remains strong with sufficient cash on hand to run the business, positive cash flow each month and an additional $40 million available to us in the credit facility. Relative to the share repurchase program, as of December 31st we had purchased 1.3 million shares.

By early January, we purchased approximately 1.5 million shares at an average price of $47.59 per share, which makes the program clearly accretive to earnings for 2008.

Going forward, ArthroCare expects to continue generating cash in excess of what is required to organically grow our business. Our EBITDA in 2007 was over $75 million, CapEx of only $20 million and we expect to see an acceleration of this trend in the future. As a result we will continue to look for opportunities to return capital to the shareholders in an economically attractive manner.

Inventory: Inventory increased to $10.2 million or about 20% since December 2006 on a sales increase of 21%. But about approximately one half of that increase is short-term related. First, to facilitate implementation of SAP in the first quarter of 2008, the Costa Rica facility worked the last two weeks of December when the facility is traditionally shut. It was closed for the first week of January.

The result of this is a build up of approximately $2 million of inventory in December 2007, which did not occur in December 2006. We also created $1.5 million in additional safety stock for high-volume items that buffered any unexpected SAP transitional issues.

These inventory increases are expected to be absorbed in the first six months of 2008.

Also, approximately $1.7 million of the increase in inventories from Spine 1, acquired in the DiscoCare acquisition, these lines have been purchased by DiscoCare for delivery to facilities for already planned surgeries.

The $1.7 million in inventory represents inventory at market price and will be small during the first quarter. Accounts receivable totaled $70 million at December 31st, 2007, compared to $62 million at December 31st, 2006.

This 13% increase in receivables is within our expected range. However this will increase our US Spine business and expand our international direct sales. It is likely that our accounts receivable balances will be slightly higher on an ongoing basis than they have been in past.

Now for the annual feet on the street update. As of the end of 2007, in North America, in Sports Medicine we had 275 feet on the street versus 250 at the same time last year. In our ENT business, we had 65 feet on the street versus 55 at the end of 2006 in US Spine business including interventional therapy. We had 123 feet on the street versus 75 at the end of 2006. In the rest of the world Sports Medicine, we have 43 direct reps and 212 distributors.

In ENT we have 18 direct reps and 100 distributors and our spine business unit has 13 direct reps and 85 distributors.

Moving on to 2008, ArthroCare's business outlook for fiscal 2008 is as follows. The company expects total revenue growth of at least 20%. By units, Sports Medicine expects growth in the low to mid-teen, ENT is expected to grow at least 20% and Spine is expected to grow at least 40%. We are forecasting continued improvement in both product and operating margin and for earnings to grow faster than revenue.

We anticipate the gross margin will improve by one point with much of the improvement coming in product mix. We also anticipate 100 basis point improvement in SG&A leverage. The other income and expense line is expected about $750,000 per quarter of net expense in 2008 reflecting interest expense and FX rates.

Finally the fully diluted share count is expected to average $28.2 million for 2008. Anticipating the passage of the R&D tax credit in 2008, we anticipate our tax rate for the year will be 24%. As you probably know Congress has not yet passed that 2008 R&D credit. This could result in the company’s reporting significantly higher tax rates for the first quarter of 2008 and lowering those tax rates as we grow through the year. Finally ArthroCare expects 2008 GAAP diluted EPS to be in the range of $1.92 to $2.00 pre share representing growth of 27% to 33%.

Moving under revenue and earnings for Q1 we expect revenue growth for the first quarter in the range of at least of 20% versus Q1 2007, with individual business unit revenues inline with calendar year guidance.

Inline with the trends in our business earnings per share margin will not reflect the pro rate share of our calendar year guidance.

Specifically the expense of the Costa Rican holiday shutdown falls into the first quarter this year. We also have some additional integration expenses associated with our acquisition.

First quarters traditionally included the lion share of our trade show and marketing material expenses. And this year it's not different and again we hired a significant numbers of sales and marketing people to support the growth of our spine and cavity products in the first quarter of the year.

As a result the company expects first quarter earnings per share to be in the range of $0.30 to $0.33 per share, which is over a 25% increase in the mid point, compared to earnings in the first quarter of 2007.

Finally the company expects the margins will improve significantly in the second quarter and that we will exhibit margin growth through out the year.

With that I will open the call for the questions.

Operator can you please take questions from our listeners?

Question-and-Answer Session

Question-and-Answer Session

(Operator Instructions)

Our first question comes from the line of Raj Denhoy. Please proceed with your question.

Mike Gluk

Hi, Raj.

Raj Denhoy- Bear Stearns

Good afternoon guys, hi. Curious if I could ask a little bit about the expenses in the first quarter. I am trying to get a sense of how to quantify them, you talked about the Costa Rica plant being open for two weeks in December and then shut here for one week in January, I guess and then also the acquisition integration expenses. Is there a way to quantify the impact of those on -- I guess in the case of the Costa Rica plant on the fourth quarter and then also for both them on the first quarter?

Mike Gluk

Yes. I don't think there is -- I guess the only thing that would have been impacted the fourth quarter is the Costa Rican plant shut down being moved from one place to the other.

Raj Denhoy- Bear Stearns

That's right.

Mike Gluk

And for that's not a big enough number to have moved the needle on EPS I don't kind of believe that maybe…

Raj Denhoy- Bear Stearns

But the margins would have -- the gross margins I guess would have been a bit better because the plant was open?

Mike Gluk

The gross margins in Q4 would have been a little bit lower and they would have been little bit higher in Q1, but when you get on to the EPS lines, its not a big enough thing to make a big difference there. The acquisition integration expenses, that's probably a bigger number and that, that's going to -- that will probably have more impact on Q1 numbers. I don’t know Mike -- if I am mischaracterizing it, please correct me.

Mike Baker

No. I think that's right. I think Raj, without going into the specifics, what we've given you is an indication that -- all told our earnings for the first quarter are going to look a little bit like our earnings for the first quarter of last year did in relation to how it rolled out for the entire year. So in that 30% to 32% range, obviously there is an impact that happened in product margin as result of the plant shut down, moving and there is some impact in G&A expenses associated with the acquisition expenses involved. And the rest of that is just normal…

Raj Denhoy- Bear Stearns

Sure.

Mike Baker

That was marketing happens in the first quarter.

Raj Denhoy- Bear Stearns

I guess where I am trying to get at there is -- I think the number that you guys are guiding towards is a bit lower than what we and I think other folks will be looking for. Just trying to get a sense of how much these -- extraneous issues, the Costa Rico issue and the acquisition integration expense are responsible for that. And how much could be some underlying effect. It doesn’t sound like your -- you have much detail that you can provide us to help us walk through that?

Mike Baker

Here is a good historical things to look at -- we always have a little bit of hockey stick on our earnings quarterly because of the way the sales and marketing expenses roll out. If you go back to the last time we hit an acquisition in Q4 was Opus and we had a steeper hard hockey stick that year than we normally do, because we had the integration expenses in Q1.

While this is not as big deal as Opus, but you are going to see a similar effect it does make the earnings growth rate over the course of the year, steeper than otherwise it would be.

Raj Denhoy- Bear Stearns

Okay. There was also one that I had missed…

Mike Gluk

This is exactly the, to be honest this is exactly the discussion we had with analysts first quarter last year which is we really need to point out there is a significant amount of expense here in the first quarter in the sales and marketing line and that our earnings for the first quarter were going to be partially lower then we would have expect them to be and people did adjust their model and I think, essentially we are talking about the same order of magnitude in the first quarter of this year that -- with the added small cost of the Costa Rica facility.

Raj Denhoy- Bear Stearns

Okay. Last just may I ask you one other way, some of us like to also run our models so that we exclude a lot of the acquisition expenses from them, so we get a better sense of how it looks on an ongoing basis. Can you at least quantify what some of those acquisition expenses might be here in the first quarter?

Mike Baker

No, we don't have a number what we can release. I'll go back and looked to see if there is something that, that makes sensibility, but we don't have anything like that prepared.

Raj Denhoy- Bear Stearns

Okay. And then just one follow-up I guess its sort of unrelated but again just not sure if I could ask later. Are there any update on a legal activities going, any additional subpoenas or law suits that the company might be a party to hear, that have risen up in the last several weeks?

Mike Baker

We're not a party day any law suites to slight some of the rumors to contrary. We do received subpoenas pretty much routinely, we usually get one or two a week and they request for transformation in law suits in which we are not a party and we respond to them in due course and we haven't seen anything unusual in that regard.

Raj Denhoy- Bear Stearns

So, no investigations, nothing new here.

Mike Baker

No.

Raj Denhoy- Bear Stearns

Okay. Perfect thanks.

Operator

Our next question comes from the one of Mark Mullikin. Please proceed with your questions.

Mark Mullikin - Piper Jaffray

Good afternoon.

Mike Baker

Hi, Mark.

Mark Mullikin - Piper Jaffray

I guess may we just to follow-up on Raj’s question on the first quarter guidance. Can you provide maybe a little bit more detail as far as your expectations by line items gross margin the sales and marketing ratio. I think that might help people get a better feel for what's going on in the first quarter?

Mike Baker

Mike is frantically flipping through what the chart he had prepared to just see if he can find something that will help you.

Mark Mullikin - Piper Jaffray

I think it will be really helpful that, what you're expecting for product gross margin and the sales and marketing in line. So what…

Mike Baker

Hey, Mark.

Mark Mullikin - Piper Jaffray

Yeah.

Mike Gluk

Kindly give me a second to flip through to my book.

Mark Mullikin - Piper Jaffray

Sure. Okay, with respective to the DiscoCare acquisition and how does impact the first quarter of the year. You mentioned the inventory, $1.9 million of inventory coming onto your books, does that than -- is that, basically mark-to-market and so will that depress the gross margin in the first quarter?

Mike Gluk

The answer is that they will a little bit and the number is 1.7 and that inventory that they had purchased for cases that were already scheduled, so that stuff gets market out to, to basically, mark-to-market is probably you are right, a good way to say it, which means as they go there is essentially no margin when it goes. So, yet there will be small amount of sales that will happen in Q1 that will have a very low gross margin on them that will contribute to making Q1’s product margin a little bit lower.

Mark Mullikin - Piper Jaffray

And that is factored into the $0.30 to $0.32?

Mike Gluk

Yes.

Mark Mullikin - Piper Jaffray

And what tax rate are you factoring into 1Q?

Mike Gluk

Currently, right now we are at 24%., Mark.

Mark Mullikin - Piper Jaffray

So you are not assuming a higher tax rate based on the R&D tax credit, not yet being passed through?

Mike Baker

That’s correct. So for the calendar year, we think we are going to be at 24%. Right now, for planning purposes, you can use 24%, if we don’t get it passed it will -- the number will be somewhere in the range of 28% like it was last year.

Mark Mullikin - Piper Jaffray

28, is that what you said?

Mike Gluk

Yes, that is what it was in Q1 last year, but we are kind of in the same boat of every other company in the US that takes advantage of the R&D tax-credit.

Mark Mullikin - Piper Jaffray

Okay. And the press release mentioned one of the drivers being increasing average selling prices, helping the fourth quarter. Can you quantify that just, overall in your entire business? How much did ASP's change from the fourth quarter of '06 on the same product. So, striping mix out, what was the pure price difference between the two?

Mike Gluk

It is actually more a mix than it is, price increases. It is pretty tough to get price increases in this environment. But we are seeing a mix shift which driven by the fact that our highest margin products also are our fastest growing products. So the Cavity product, which is the highest margin product for the company is the fastest growing product for the company.

The microdiscectomy product is a very fast growing product and it’s a very high margin product. The new Sport Medicine products that we released this year in general have better margins then the ones that they are replacing. So, we are seeing a mix of our sales to shift more than anything else.

Mark Mullikin - Piper Jaffray

So when you say in the press release the average selling prices improve there is -- you're talking about mix as well. Is that correct?

Mike Baker

Yeah. It really is much more mix than it is, the prices of the individual products haven't changed that much.

Mark Mullikin - Piper Jaffray

Okay. And the fourth quarter Sports Medicine growth, were there sales of generators in that number, I mean was that one of the reasons for the faster growth in the fourth quarter?

Mike Baker

No, there was quite a lot of generator, there was quite a lot demand for generators but as you know we typically place those generators with customers and then we amortize their cost over the useful life of the generator. What droves Sports Medicine growth in Q4 was very rapid growth in both the coblation product line and the Opus product line, and that was really driven by the new products that we'll released particularly in the back half of last year. We had a unusually large number of unusually important new product introductions that drove market share gain there is no other way to say it, we actually we're taking the accounts from competitors because they like the performance of the new products and that's what caused the acceleration in growth and obviously we don't expect the business to continue to grow at that rate but we do expect to see strong growth out of that as the reception that the new products are getting is very positive.

Mike Gluk

So, Mark for modeling purposes, why we don't we assume that SG&A expenses would be about 59% of revenue then in the first quarter. And then you got the tax rate , you got an EPS number and I think what you can understand at yes will be some lower gross margins in the first quarter and there is really three pieces to it, one is the inventory question we just went through.

The plant shut down for the week for the period in January. And then three of the factors that we are going through the SAP implementation. Maybe we are being a little conservative, there is going to be some start up associated with the whole enterprise. I hope you tot that/

Mark Mullikin - Piper Jaffray

Yes. I am sorry I want to make sure I caught that,. I mean the SG&A ratio in the first quarter? What's the percentage? 49%?

Mike Baker

59

Mark Mullikin - Piper Jaffray

59…five nine?

Mike Baker

59 versus 5, 6 in the fourth quarter.

Mark Mullikin - Piper Jaffray

Fourth quarter I am getting SG&A ratio of 45%, 45% to 46%. 38.9% sales in marketing ratio and SG&A ratio of 6.5%. So the math doesn't quite work out. You won’t get that $0.30 or $0.32 if…

Mike Baker

Probably due to things on decline.

Mark Mullikin - Piper Jaffray

Right I think it's -- it would be 49 if anything.

Mike Baker

Mike is once furiously flipping charts.

Mark Mullikin - Piper Jaffray

So I will just, I guess over on the '08 outlook relative to the international side of the business. How much in the international sales are you looking for in '08?

Mike Baker

I think the international business is going to continue to grow a little faster than it's US counterpart because we're early in penetration outside of the US than we are in the US and we saw the international business grow faster in '07 and I think it will probably do so again in '08.

Mark Mullikin - Piper Jaffray

Okay. And Mike, may be I'll just follow-up with you on the 1Q complexion after your call

Mike Gluk

I calculate 56% just like I said earlier, Mark, so you take all the expenses between gross profit and operating income and you add them up, and that was for the quarter it was $48.7 million divided by total revenues yet end up with 56% .

Mike Baker

No it should be 59%.

Mark Mullikin - Piper Jaffray

You are including R&D then, aren't you?

Mike Gluk

Yeah. All the operating expenses.

Mark Mullikin - Piper Jaffray

All the operating expenses below the gross profit line?

Mike Baker

Yes. And may Mike missed saying it.

Mark Mullikin - Piper Jaffray

I'm sorry, so it is 56% if I add sales and marketing, G&A and R&D?

Mike Gluk

That's right. The operating margins are lower by several points and then it will improve over the course of the year, kind of like it did this year -- like it did last year.

Mike Baker

Yeah.

Mark Mullikin - Piper Jaffray

Right. So the number is, I am sorry, is it 56% if I add sales and marketing, G&A and R&D.

Mike Baker

It was 56% in the fourth quarter and we're expecting something like 59% in the first quarter.

Mark Mullikin - Piper Jaffray

Okay, got it. Thank you.

Mike Baker

Well, maybe like Mike I don't have to do math when I answer questions that’s…

Mark Mullikin - Piper Jaffray

All right.

Mike Baker

Who's got the next question?

Operator

Our next question comes from the line of Ed Shenkan. Please proceed with your question, Ed.

Ed Shenkan - Needham & Company

Thanks Mike.

Mike Baker

Hi, Ed.

Ed Shenkan - Needham & Company

You gave us the breakdown on feet on the street, thanks very much. You guys generally just provide that at I recall at yearend. We don't get it each quarter, but as we go into the next year, you said you've already hired significant amount of reps, can you give us color on what areas they are in, are they heavier in one business unit than the other?

And have they pretty much all been added already, or should we expect more in the quarter or throughout the year?

Mike Baker

We will be hiring people pretty much over the course of the year and we will also be and that we will be doing that both in the US and internationally. And across all four businesses where we got hire implants in Sports Medicine, higher implants in ENT and in the spine and in the interventional business. Probably the fastest increases are going to occur in this spine and interventional businesses. But we did hire a lot of people in Q4 including hiring some people in Q4 that we originally planned hiring in 2008. But we still have some people left to hire.

Ed Shenkan - Needham & Company

And as far as trade shows coming up, we have got ANS coming up, orthopedic surgeons coming up. Can you talk about any activities that we should look for at those events or any other trade shows coming up that we should highlight?

Mike Baker

Well AOS is coming up here at the end of this month beginning next month and that’s a good show for both Sports Medicine and for the spine business unit obviously and we will have the interventional products I believe displayed there too. ANS is coming up later this year, there is some big spine meetings in Europe in the spring and off course the big academy meeting in ENT is in the fall and we will have new products and new clinical staff at everyone of those shows. I don’t want to list the new products that we expect to have at the shows today. But my philosophy on product development, we intend to be aggressive on new product development as we have been historically and I don’t like to go to a major trade show unless I have got something new and exciting to show the customers and we expect 2008 to be a lot like 2007 in that regard.

Ed Shenkan - Needham & Company

As far as finished goods inventories, it was good to hear that you are adding those because some times sales become lot faster than you guys expect. Can you talk about finished goods in each of the business units. Are you well prepared at this point in the year?

Mike Baker

We are in better shape then we were at this time last year. You are right. Some of there products that become big hits are difficult to keep up with sometimes. We have been -- we have struggled to build as many Quantum controllers as people want and I think there will continue to be very heavy demand for that, for at least the next several quarters.

And we are carrying extra finished goods right now especially in the fast moving products lines because when we do this SAP transaction there are transitions, there is a risk that we may have some issues with logistics during the kind of the transactions ands so we're actually moving some finished goods and pre-positioning them and have them in our country warehouses and our remote warehouses in case we have to shift from remote location in case we get problems with transition.

So but we do expect to work finished down over the course of the year and once we get to sterilize our online at the end of next we'll be able to take four or three weeks out of the supply chain which will allow us to reduce even further.

Ed Shenkan - Needham & Company

So you not expecting any stock outs here in all the product lines, first and second quarter?

Mike Baker

The stock outs cause a lot of excess stomach acid for me. So we are working diligently and try to prevent them.

Ed Shenkan - Needham & Company

Stay healthy Mike.

Operator

Our next question comes from the line of Bill Plovanic. Please proceed with your question.

Bill Plovanic - Canaccord Adams

Hi Mike Good evening. Can you hear me?

Mike Baker

Yeah. Very well. Go ahead.

Bill Plovanic - Canaccord Adams

Fantastic. Just a couple of questions, I mean that was a really big quarter on Sports Medicine, people have gone over it, but any big payments from Smith & Nephew litigation from the litigation, any stocking orders to them or inventory build by Smith & Nephew they could have impacted the quarter?

Mike Baker

No.

Mike Gluk

No, payments from them no unusual manufacturing, stocking or shipping activity to note.

Bill Plovanic - Canaccord Adams

Okay. And then in terms of the coblation in patents for the [J&J striker] convent they are paying you royalty when do those patents expire?

Mike Baker

That’s will see the very earliest patent is well expire sometime and I think I want to say 2014 but I could be wrong in that but the practical reality is that those licenses are in effect as long as they are selling a product nit infringing any of our patents, and we obviously have 100s of patent and large number of applications still pending which those products would infringe so we don't see a realistic sunset if you will on the royalty streams.

Bill Plovanic - Canaccord Adams

Okay. And then just Jeff on the Mark's question in terms of mix ASP versus volume I mean if you look at volume on disposable year-over-year what type of growth rate are you seeing on that relative to the overall reported numbers.

Mike Baker

While we are seeing mix improvements but we are seeing strong growth in volume, when we look at the number of products we have to produce or were to be produced we are seeing very strong growth that as well.

Mike Gluk

I think just qualitatively development in terms of Sports Medicine coblation products we have seen very good growth in Europe Sports Medicine coblation.

Bill Plovanic - Canaccord Adams

I mean if you are reporting 22% in Sports Med growth, I mean are you reporting 22% volume or is it more like a 15 volume with 6% mix price.

Mike Baker

I think we've haven’t broken out that way, but it's the mix hasn’t improve that much I mean it's really is volume driven.

Bill Plovanic - Canaccord Adams

Okay. And then on the DiscoCare inventory you have $1.07 million what's the ASP that you are assuming on that transition.

Mike Baker

Well, we market all up to our average selling price fill and so again we don't reveal individual ASPs by product line.

Bill Plovanic - Canaccord Adams

Okay, actually that is all I had. Thanks.

Mike Baker

Thanks Bill.

Operator

Our next question comes from the line of Joanne Wuensch. Please proceed with your question.

Joanne Wuensch - BMO Capital Markets

Thank you for taking my question, when I look into 2008 what kind of gross margin improvement, are you thinking over 2007? Particularly, because the fourth quarter gross margin was significantly higher than we were thinking about?

Mike Gluk

Yeah. Well, we'll see it at least a [12-point] of gross margin in the annual rate year-over-year. And the things jell well, we might see more than that, but we're guiding to at least 1 to 4 point of gross margin improvement.

Joanne Wuensch - BMO Capital Markets

So at least 74.7, 75%?

Mike Gluk

That will be 1 point, yes.

Joanne Wuensch - BMO Capital Markets

Okay. Then what are the plans to pay down the debt that you took on the $16 million?

Mike Gluk

We'll pay that off over the normal course of business, Joanne. So I would expect we will keep the cash we have in the bank through the first quarter and than take a look at where we are and start to pay it off as we get out of into next year.

So, we generate typically $3 million or $4 million of free cash, month excess cash. We'll build up our cash reserves a little bit and then starting in midyear, we'll start to pay down that debt.

Joanne Wuensch - BMO Capital Markets

Okay. So midyear to looked at that. And the final question is as we looked throughout the year the first quarter is going to be more depressed than usual for other reasons we've already talked about.

Should we just think of it as a nice quarter-by-quarter getting better or is there anything else sort of them in the second or third quarter that we need to think about?

Mike Gluk

I think you should -- in terms of the margins, you should see a nice ramp. Well, first of all, I think the first quarter of '07 really wasn't that different than I'm describing for the first quarter of '08 where many of the same reasons that we were adding to the spine business and we spent a lot in sales and marketing.

So that strategies is going to exist again in the first quarter of '08, and once we get into in the second quarter, you should see improved gross margins and operating margin. And that should improve the year moves on just like it did in 2007.

Joanne Wuensch - BMO Capital Markets

Okay. Thank you very much.

Mike Baker

Okay.

Mike Gluk

Thank you, Joanne.

Operator

Our next question comes from the line of Brian Weinstein, with William Blair. Please proceed with your question.

Brian Weinstein - William Blair

Gentleman.

Mike Gluk

Hi! Brian.

Brian Weinstein - William Blair

The $1.7 million, it seems to be a big number in my mind for preauthorized cases for DiscoCare how far out does that represent for booked surgeries, does that represent a month, does that represent 6 weeks, any comments on that?

Mike Baker

Well, it is not that a big number if you look at our spine business revenue, Brian, and it certainly will be absorbed very easily within the first quarter, we are not giving you a specific number.

Brian Weinstein - William Blair

Okay, and with the acquisition of DiscoCare and formation of [DRSEE] you have now bolstered your in-house reimbursement consulting capability pretty significantly. Do you now have, what you think you need here, or should we look for additional subsidiaries to be created or other acquisitions in this area in 2008?

Mike Baker

We are going to integrate the, integrate the acquisition into our existing capabilities and we will continue to add to it, I don’t think we need to make any more acquisitions in this area. We have got a critical mass of people now, but we are going to continue to add resources to it as we see it as a critical core competency particularly with the number of new therapies that were targeting this development.

Brian Weinstein - William Blair

Lastly, can you give some more specifics on why the market outside the US for tonsils is not taking off as you have hoped? You have mentioned for several quarters that the training has been a bit slower and the uptake has been a bit slower but what specifically are you doing at this point because this seems like as it has been in this industry (inaudible) for quite some time.

Mike Baker

That has been solved and the penetration outside of the US is quite lower bit it is in the US. I think, in the US we are probably getting close to doing half the tonsils that are being done and the number continues to go up. In outside of the US, the number is well like 10%. And, so part of it is the training issue and in lot of the countries that we are targeting, we are direct in those countries and we are adding to our direct sales but the tradition trade that's knocked out down this fast as we have thought it was weren't so at this time last year and the training is not turning into cases as fast as it was pointed out in last year. So, I think that's something we're going to monitor carefully. We do expect it to begin to ramp this year, but it hasn't happened as fast as we thought it was going to happen.

Brian Weinstein - William Blair

So just a presence of having more direct feet on the street if you will in Europe and having them focus on training more is kind of solution here?

Mike Baker

That's what we think it is. And we've actually seeing that, that's biotic, we've added resources to focus on this, we do see the business from sign. What we really found it to in distributor market, it definitely does not go as fast as it does in direct market. Since we're going to see if our theory is correct in having our own people out there to drive the training and to drive the education process requisitions is actually a key to this and there is a course as you know in the US we are entirely directing EMG and have been ever since this ramp started and now we're starting to build their direct presence EMG in Europe.

Brian Weinstein - William Blair

Alright, great. Thanks Chris.

Operator

Our next question comes from the line of Madison Spencer with Morgan Stanley. Please proceed with your question.

Madison Spencer - Morgan Stanley

Hi guys, can you -- there seems to be like an elephant in the room, maybe can clarify it? You guys acquired DiscoCare on December 31st of '07, your subsidiary device reimbursement services shared a fax number with DiscoCare back in September and October and November. Can you just explain that? Were you guys the same company back then to have a joint venture with them back then?

Mike Baker

No, just a mistake on the website. Our device have been --

Madison Spencer

You mistakenly had the same fax number as DiscoCare? That's a coincidence.

Mike Baker

Yeah, then people developed their website for DRS they developed a website for this picture, I think they just put the wrong fax number on it. As soon as someone pointed out, we corrected it.

Morgan Stanley - Morgan Stanley

And it could be six months to notice that you had the different -- the wrong numbers.

Mike Baker

The DRS subsidiary to be clear was the people are located here in Austin, the subsidiary was established in a different place than DiscoCare. So do you have another question or is that it?

Morgan Stanley - Morgan Stanley

Yeah. But you didn't answer this question yet. It also says it's located in Stanford [device] reimbursement, is it located in Stanford?

Mike Baker

That's where it's incorporated, yes.

Morgan Stanley - Morgan Stanley

No, is it located here though?

Mike Baker

We have a facility in Stanford and that's where that's located just like our…

Morgan Stanley - Morgan Stanley

So the warehouse in Stanford is where you run it out.

Mike Baker

Operator, can we move on to the next caller please.

Operator

Our next question comes from the line of David Lebowitz from SMH Capital.

David Lebowitz - SMH Capital

Hi. Thanks for taking my question other shift subjects for a little bit. Quickly with respect to the Cavity SpineWand and the MD SpineWand, you had indicated they would be the fastest growers in your spine business next year and I am kind curious could you talk about what type of awareness there is of physicians of both these products and while they will be fast growers that's obviously we're small denominator, when does it become a material contribution?

Mike Baker

A couple with like to answer that. I think the awareness of both products is still relatively low because we're still relatively early in our efforts to educate the physicians about them. Taking them individually, first the Cavity SpineWand, we started marketing this about a year ago real aggressively and I think our presence has grown remarkably quickly into the leading cancer centers in the country.

And in spite of having said that, we started from a very small base. We have been building the distribution channel over the course of the year. The case volume has gone up very rapidly and taking together the MD SpineWand and the Cavity wand as we said in our Q3 call, the sales of those two products were actually responsible for the acceleration we saw in spine sales in the third quarter of last year.

So, if you thought the acceleration in spine sales in the third quarter was important, it was driven really by those two products. When will they become material enough to actually break out the interventional therapies business? That's a different business from the regular spine business. I don't know whether we're forecasting that's going to happen this year or not.

Mike Gluk

We'll see how 2008 goes and how the revenues grow in that business, but for the time being, we'll include it in the spine business.

David Lebowitz - SMH Capital

Sure. Sure. Just jumping over to the reimbursement issues as well, I know there has certainly been a lot of talk regarding reimbursement of spine and DiscoCare. And I am wondering if you could just talk to reimbursement of the spine business, particularly PDD and compare and contrast how that really differs from reimbursement in your other areas of business including Sports Medicine, ENT, just so we understand how things flush out between the groups?

Mike Baker

Sure. Well, we don't really see any significant reimbursement issues with the cavity product or MD SpineWand today. With PDD reimbursement climate, especially in the US has been relatively difficult at the beginning of that launch, because it is a brand new therapy and typically anything that's new is difficult to get reimbursement for it.

We've seen the environment for reimbursement for this therapy improved dramatically in the last three years starting in Europe where we had success in the large countries in Europe, we're basically their National Health Care Systems decided to establish recent reimbursement for the therapy. And that started the growth in the business as we got access to large numbers of patients overseas.

In the US, we began getting success with government payers like Department of Defense and followed on with success with workman's comp payers, but we have now established our PDD therapy as reimbursed on the large national worker's comp contracts.

And now to the last, your better I guess year and half we have been seeing increasing success with getting this therapy paid for by private insurers in US on a preauthorization basis. And we think that as the, what's really driving this is the increasing amount of very credible peer reviewed scientific data that is available for the support, a documentation of medical necessity and that help to drive positive reimbursement decision.

And I think we expect to see more of those presentation and publications this year including further data out of the prospective randomize clinical sub trail in US. And we ultimately expect to see broad-based reimbursement established by all payers in this country as we have seen in Germany and the UK and other major European countries.

So there is really nothing and nothing different about PDD then there is about any other medical procedure. You have to go through this process of accumulating enough data to drive a routine coverage position. And in advance of that if the patients who are having their procedure paid for by private insurance need to have a surgery, then they have to go through a preauthorization process.

David Lebowitz - SMH Capital

What type of lag time is there typically with such data coming out and actually getting official reimbursement from these private payers?

Mike Baker

Well, there are something to be clear, there are private payers that already have established routine reimbursement guidelines and lot of them haven't. And the lag time can be any where from the space of a few months to with some of them may take several years. And so we'll obviously be thinking strategically about which payers are the right ones to approach first as more of this data becomes available and then you sort of build on one positive reimbursement decision after another until you've got broad based routine reimbursement across the entire country with all payers.

In advance of that though you keep doing what we're doing right now, which is doing the extra administrative work that is required to put together a documentation to support a request for medical necessity, which is the basics for a preauthorization of a procedure that's not routine reimbursement.

And just to give you some color on this there are literally dozens of routine surgeries that are done everyday in this country are in the same boat that require a preauthorization and usually supported by documentation to medical necessity and that's the boat that we're in right now with most private insurance companies in the US with PDD therapy.

David Lebowitz - SMH Capital

Thank you for taking my question.

Mike Baker

You bet.

Operator

Our next question comes from the line of Steven Lichtman with Banc of America Securities. Please proceed with your question.

Steven Lichtman - Banc of America Securities

Thank you. Hi, guys

Mike Baker

Hi, Steve.

Steven Lichtman - Banc of America Securities

If you could talk a little bit about '08 guidance relative to spine and how you rolled up the 40%, you mentioned that the growth in MD SpineWand and Cavity would be fast I think the previous caller obviously pointed out that the base is lower. On an absolute basis will MD SpineWand and Cavity contribute more in the US than PDD do you think in 2008?

Mike Baker

No, I don't think that they'll become a bigger product because we expect PDD to grow as well. But there are going to grow very rapidly. And I think by the time we get to this call next year, we'll probably going to be spending most of our time talking about those two products and the follow-on extension to those product lines because they just address much larger market opportunities.

Steven Lichtman - Banc of America Securities

And what gives you the confident on the MD SpineWand? Have we seen data to show the benefits versus more standard of care? What kind of feedback have you gotten? As there -- have been any top leaders that have talked about it? What gives you the confidence on the SpineWand?

Mike Baker

The indications on MD Spine Wand are that they are the [basic indications] for microdiscectomy, so there is no difference in indications. Ultimately, we do expect to see clinical publications that will provide some scientific evidence of what we believe is a very powerful value proposition, which is the improvement in outcome. And we believe that's going to happen because of the significant reduction in damage to the annular wall that you see when you're using MD Spine Wand as compared to using the older mechanical devices to do this. That's the value proposition that is intuitively very appealing to the surgeons who hear it and get a chance to see it, but we will ultimately want to document that in the peer-reviewed clinical literature and that will take time.

In the meantime, there is a second value proposition around this one that I think is does not require expensive clinical data to document and that is the fact that the wand makes to the surgery -- just especially the tissue removal part of the surgery a lot faster and easier for the surgeon and that’s not something that you needed to do a large clinical study to prove. You just have to get people a chance to try the product, and so we’ve product here that we think has the value proposition in terms of ease of use that is going to be appealing and it has a value proposition in terms of outcome that intuitively makes a lot of sense when you understand what the issue of annular wall damage is and what it means for the long-term outcome for the patient. But I do think it's going to be worthwhile for us to do some studies and document that as well.

Steven Lichtman - Banc of America Securities

Okay. On the Sports Medicine guidance, after 22% in the fourth quarter, the comps don't get really that much more difficult, why low to mid teens? What’s the biggest delta between what you guys posted in the fourth quarter-end and the full year for ’08?

Mike Baker

Will you take that mike?

Mike Gluk

Yes sure. We did have some good growth in terms of penetrating overseas markets in the fourth quarter of ’07

And so I think that in conquest accounts in the fourth quarter of '07 also. So, although, we don't have a lot of both those new customers in Europe and the new customers in US don't take quite as much -- ongoing customers don't take quite as much inventory as startup customers do.

So, we get a very conquest customer, we get a little better bumps in terms of initial order placement and we had a few conquests in the fourth quarter of '07. And we also had a lot of new products in the fourth quarter of '07. So the combination of those two things we just believe that, I guess it was an usually strong quarter. And the overall growth rate, we think is going to move back to the sort of mid-teens area.

Steven Lichtman - Banc of America Securities

Okay. And just going to that the P&L for '08, so just to confirm in terms of your sales force hires, were the majority of them, or are the majority of them going to be here in the first quarter. You mentioned they will be throughout the year, but is it front-end loaded?

Mike Baker

They are front-end loaded.

Steven Lichtman - Banc of America Securities

Okay. So -- I'm sorry, so last year we saw a high uptake in expenses in the first quarter and relatively flat over the next couple, is that something we should be thinking about in terms of absolutely levels?

Mike Gluk

Yeah. I think so, yeah. And we also have a lot of very heavy trade show activity that occurs in the first quarter too. So you can expect that the profile to look a lot like it did last year.

Steven Lichtman - Banc of America Securities

Okay. And then last -- just to be clear, so the Costa Rican facility normally or obviously would close at the end of the year, it did not this year and now -- and you shifted that holiday at the first quarter, and thus the gross margin impact that you talked about, just to be clear on that.

Mike Baker

Probably next gross margin, a little bit better in Q4 than it otherwise would have been and a little bit worst in Q1 and otherwise, it would have been.

Steven Lichtman - Banc of America Securities

Okay. All right. Thank you.

Mike Baker

Welcome.

Operator

Our next question comes from the line of James Sidoti. Please proceed with your question.

Mike Baker

Hi, Jim.

James Sidoti - Sidoti

Good morning. Can you hear me?

Mike Baker

We can.

James Sidoti - Sidoti

Good afternoon. A quick question on the spinal business. As we all know, there has been a lot written about that over the last six or eight weeks. Has that impacted anything out in the marketplace? Have you seen the market react to any of that or is that strictly a Wall Street issue?

Mike Baker

In my observation, this sort of the massive negative rumor campaign exists principally in the minds of folks on Wall Street. We have had some questions from customers about it, but it mostly it seems to be a question coming from folks in the investment community. Although I am encouraged that the last three sort of over the top negative things that were posted online, I have got no calls on any of them, which means that the rest of you guys out there may be as tired of talking about this as we are.

James Sidoti - Sidoti

If you look at your sales in January, the first half of February, have you seen the trends change considerably?

Mike Baker

No, I haven't seen any change in trends.

James Sidoti - Sidoti

And is it taking your sales management time or is it primarily your time and Mike Gluk's time?

Mike Baker

It must be a quality of life issue for Mr. Gluk and I.

James Sidoti - Sidoti

Okay. And then as follow up, on the $50 million note, Mike, when do you think you will pay that down? You think that will be done in 2008?

Mike Gluk

Yeah. We'll make a good dent in it during 2006. I think we'll keep note. Basically, we'll keep the borrowings through the first six months and start paying it down in the second half of the year is our plan right now.

James Sidoti - Sidoti

Okay. All right. Thank you.

Mike Baker

Thank you, Jim. How are we doing on time? We have time for one more question? Is there another question?

Operator

Yes. Our next question comes from the line of Bill Plovanic. Please proceed with your questions.

Mike Baker

Hi, Bill.

Bill Plovanic - Canaccord Adams

Hey guys. Follow-up was just on free cash flow in the quarter, what was it again?

Mike Gluk

Free cash flow?

Bill Plovanic - Canaccord Adams

Yes.

Mike Baker

What was the cash flow metric you gave?

Mike Gluk

The cash flow metric I gave was $52 million in cash from operations for the calendar year. I didn't actually give one for the quarter, but I think it would be in the $12 million to $13 million range.

Bill Plovanic - Canaccord Adams

You mentioned that you had paid for DiscoCare. Did you pay for DiscoCare fully upfront or is part of that backend loaded and it will come out in the K? But if so, kind of what's the balance on that?

Mike Gluk

We paid $25 million in cash and there is some potential earnouts later in life. You'll be able to look at the SPA when it's filed.

Mike Baker

Yeah. Even though this is not a deal we would normally post the stock purchase agreement on, I think we're going to post the stock purchase agreement on this at the time we file the K just so you guys can see that there is not anything terribly unusual or interesting about it.

Bill Plovanic - Canaccord Adams

Okay. That's all I had. Thanks.

Mike Baker

Okay. So I think we've run actually a bit over the time we have set aside for this. We very much appreciate you guys taking the time to dial-in in the call today. I appreciate all the good questions, and obviously, if you've got other follow-up questions or issues, give us a call, we'll be happy to talk to you. But in the meantime we look forward to getting into what we think is going to be a tremendously interesting 2008. And we'll be back to talk to you guys at the end of Q1 to report the results then.

So have a great day.

Operator

Thank you, ladies and gentlemen. A rebroadcast of today's conference will begin today, February 19th of '08, running through March 4th of '08. To access the rebroadcast, please dial 800-633-8284 and enter reservation number 21374252.

That does conclude the conference call for today. We thank you for your participation and ask that you please disconnect your line.

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Source: ArthroCare Corp. Q4 2007 Earnings Call Transcript
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