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Executives

Wendy Crites Wacker – Director of Corporate Communications

Brian Hutchison – Chairman, President and CEO

Tom Rose – VP, CFO and Secretary

Carrie Hartill – VP of Quality Assurance and Regulatory Affairs, Chief Scientific Officer

Analysts

Shawn Fitz – Stephens, Inc.

Dave Turkaly – Susquehanna Financial Group

Keay Nakae – Collins Stewart

Matt Dolan – Roth Capital Partners

Caroline Corner – Pacific Growth Equities

Steve Lichtman – Banc of America Securities

Jayson Bedford – Raymond James

Gregory Brash – Sidoti & Co.

Brooks West – Craig-Hallum Capital

Jon Robohm – Gagnon Securities

RTI Biologics Inc. (RTIX) Q1 2008 Earnings Call Transcript May 6, 2008 9:00 AM ET

Operator

Good day and welcome to the RTI Biologics Inc. first quarter 2008 results conference call. Today's conference is being recorded. As a reminder, all participants will be in a listen-only mode until the Q&A session at the end of today's call. At this time, I would like to turn the conference over to Wendy Crites Wacker. Please go ahead.

Wendy Crites Wacker

Good morning and thank you for joining RTI Biologics for our first quarter 2008 conference call. Today we will hear from Brian Hutchison, Chairman and CEO, who will discuss operational highlights and future activities for the company, as well as Tom Rose, Executive Vice President and Chief Financial Officer, who'll provide an overview of our financial results.

Before we start, let me make the following disclosure about forward-looking statements. The earnings and other matters we will be discussing on this conference call will involve statements that are forward looking. These statements are based on our management's current expectations but they are subject to various risks and uncertainties associated with our lines of business and with the economic environment in general.

Our actual results may vary from any statements concerning our expectations about future events that are made during the course of this meeting, and we make no guarantees to the accuracy of these statements. Accordingly, we urge you to consider all information about the company and not to place undue reliance on these forward-looking statements.

Now I'll turn the call over to Brian Hutchison.

Brian Hutchinson

Good morning, everyone. I hope all of you had a chance to see our release this morning. I'm very pleased with our performance in this extremely busy quarter. We have been able to continue our positive momentum in revenues that we have seen over the past five quarters while improving our gross margins and overall profitability.

The first quarter of 2008 has been historic and transformational for our company as we successfully completed our merger with Tutogen Medical on February 27. Integration of these two companies is progressing extremely well. I would personally like to thank all of our employees for working together and bringing each area of the company together as a team. We've laid out a very aggressive integration schedule with a focus on coming together quickly and effectively while ensuring that we provide excellent service to our recovery agencies, our distributors and our surgeons.

I'm happy to report that we have met all of our early milestones in combining the two companies in the past month, including integration of almost all non-processing functions and locking down many of our forecasted expense synergies. Because of this we have increased the previously estimated pre-tax expense synergy by $1 million to $6.5 million to $7 million.

As we noted in this mornings press release, our first quarter results include revenues from Tutogen from February 28 through March 31, 2008, as well as the impact of purchase accounting adjustments and restructuring charges associated with the transaction as Tom will detail later in this call. Even with the merger and integration activity in the first quarter, we maintained focus on executing our business plan and drawing on all of the strength of the merged company to deliver results.

The impact of this has resulted in quarterly revenues of $29.9 million representing 36% growth over the same period last year. Net income for the quarter of $645,000 or $0.02 per diluted share were substantial improvements over the same period 2007. However, as we review the results, if you remove the purchase accounting adjustments and restructuring charges associated with the merger, we achieved net income of $1.1 million or $0.03 per diluted share.

While our overall results are positive, there are two areas that are performing extremely well that I would like to highlight, sports medicine and surgical specialties. Our sports medicine group continued to excel increasing revenues by 71% over the prior year period. Quarter end shipment volumes have reached all time high leaving sports medicine to become our largest revenue segment this quarter.

This is a very important fundamental achievement for RTI sports medicine implants are in high demand clinically, and because of our direct distribution model sports medicine yields the highest return of all of our lines of implants. At the AAOS meeting in March, we launched our first– our line of fresh-stored osteochondral allograft. Fresh OC allografts are to date the only proven solution for restoring cartilage in large defects. Fresh-stored OC grafts are a scarce resource and under great demand from surgeons. The first of these grafts was implanted yesterday. I'm told the procedure went very, very well.

The launch of fresh OC helps to further expand our line of cartilage restoration implants, which also includes BioCleanse meniscus and the Sterling Wedge. We now have an even broader portfolio of sports medicine solutions to assist surgeons in providing the highest and safest level of care for injured athletes. We believe the favorable trends that we've seen over the past year in sports medicine will continue. Increased level of available tissue, growing demand and new implant offerings will drive significant growth in this area in 2008.

Our surgical specialty segment reached revenues of $1.6 million for the one month of combined operation. This compares to Tutogen's monthly run rate in Q1 of prior year of approximately $600,000 representing an increase of approximately 167%. Of particular note, in that unit volume for hernia repair and breast reconstruction implants increased approximately 300% for a combined operation over the same period of the previous year.

Davol, our distributor in hernia repair market, and Mentor Corporation, our distributor in breast reconstruction market will continue their successful rollout of our AlloMax and NeoForm implant. AlloMax and NeoForm continue to perform very well clinically, providing surgeons with enhanced handling characteristics and properties of elasticity, which is a significant issue particularly during a repair.

With the current and significant increase in tissue availability to meet the strong demand of these tissues and the leadership positions of our distributors in hernia repair and breast reconstruction, we anticipate this segment will achieve the highest percentage growth rates for RTI in 2008. We also continue to pursue our xenograft strategy for hernia repair on a global basis. We are in the process of compiling five years of European usage data from our Tutoplast bovine pericardium product to support our marketing effort for the U.S. market.

We plan on launching our xenograft product in the latter part of this year. In the spine area, we did experience a slight decrease of 8% in revenues for the quarter and we continue to see softness in orders as we enter Q2. These results are below expectations largely due to inventory reductions by our largest distributor. We expect the spine segment to rebound later in the year with the launch of new implants.

In the second quarter, we are on schedule to ship large quantities of a new lumbar implant to Striker. We launched a cervical line extension with Orthofix in April, and we are on track to launch a lumbar graft with them mid year. Additionally, we are working on two cervical constructs for Zimmer for launch in the second half of this year. We are already developing approximately three additional xenografts to launch with Striker and Orthofix, which could launch as soon at the second half of this year.

As you review our results for the quarter, you will note that the spine segment, while still important, has been reduced to around 30% of the company's overall revenue for the quarter. For the full year, we expect spine segment to represent approximately 25% of overall revenues. This is right in line with our focus on increasing diversification of revenue categories, decreasing reliance on any one category to reach our growth goal.

Revenue diversification is a primary reason for the business changes RTI has made in the past two years particularly including our merger with Tutogen. The breakdown of these different revenue categories in our first quarter result very much illustrates the kind of revenue balance we have been targeting and is on target through the breakdown that we anticipated pre-merger.

On the international front, our revenues more than doubled for the first quarter. As a result of the merger, we now have a significant presence in more than 20 countries and considerable tissue sourcing and processing capability in Europe. This presents us with the opportunity to distribute our broad biological offerings through this established and extensive distribution channel.

At this point, I'll let Tom discuss our financial results.

Tom Rose

Thank you, Brian. Revenues for the first quarter of 2008 were $29.9 million, as compared to $22 million in prior year increase of 36%. This includes $6.4 million of revenues for the 33 days of Tutogen operations post-merger. First quarter net income was $645,000 or $0.02 per share, compared to $134,000 or break even per share in the prior year. As mentioned in the press release, we recognized $433,000 of cost after tax associated with the merger for a decrease in income per diluted share of $0.01. The press release provides details of the various revenue categories compared to Q1 of the prior year.

In summary, spot medicine revenues were $9.2 million for the first quarter of 2008, an increase of 71%. Spinal construct revenues were $8.7 million for the first quarter, a decrease of 8%. Revenues for bone graft substitute were $4.8 million in the first quarter, an increase of 7%. Dental revenues for the one month of combined operations were $3.5 million, an increase of 46% compared to Tutogen's results for the same time period last year. And surgical specialty revenues for the one month of combined operations were $1.6 million, an increase of 167%, compared to Tutogen's results for the same time period last year.

Gross profit margins for the first quarter 2008 were 46% compared to 37% for the same time period last year and up from 44% in the previous quarter. Higher percentages of sports medicine revenues, continued improvement in productivity and the higher margins for the Tutogen markets were the primary drivers of overall margin improvement.

Gross margins were negatively impacted by $235,000 or approximately 1% due to purchase accounting adjustments in the period. Valuation adjustments to Tutogen's opening inventory totaled $1.3 million and will be reflected in cost of goods sold ratably over five to seven months. As we discussed on our fourth quarter conference call, we shut down the processing operations for the first two weeks of January as we completed enhancement to the BioCleanse software system.

The shutdown reduced our production level for the quarter by about 10% to 15%. This negatively impacted both our gross margin for the quarter as well as revenue level. We believe gross margins for the year should still reach the 50% level even after purchase price valuation adjustment. The quarterly gross margins should improve on a linear basis as we continue to increase quarterly revenues for the remainder of the year.

In the first quarter, operating expenses totaled $12.8 million, an increase of $5.1 million over 2007. The increase was primarily due to the acquisition of Tutogen. As we continue the through 2008, fix marketing, general and administration expenses will range from approximately $10.5 million per quarter to $11 million per quarter excluding variable incentive compensation and the stricter commissions. Variable incentive compensation should be approximately 15% of operating income for the year. Variable distributor commissions are 42% on our U.S. dental business, and approximately 13% on our sports medicine business.

Research and development expenses were 6.4% of revenues for the quarter. We estimate that these expenses will be between 5% and 5.5% of revenue for the full year 2008. Included in operating expenses for the one-month period of combined operations is $60,000 related to amortization of identifiable intangibles associated with the acquisition. Our study to determine the ultimate allocation of the purchase price for these items is not complete, and this estimate may change in future periods.

Lastly, operating expenses include $368,000 of restructuring charges incurred by RTI as part of the merger integration plan. We estimate that we'll incur an additional $400,000 of similar charges during the remainder of 2008. When reviewing the balance sheet at the end of the quarter compared to December 31, 2007, and cash flow for the first three months of 2008, please note the following.

Our cash position at the end of the quarter was $18.9 million, compared to $18.6 million at December 31, 2007, an increase of $300,000. In addition to cash on hand, we have $5.4 million invested in certificates of deposit for a total of $24.4 million of cash and short-term investments on hand.

Accounts receivable increased to $16.1 million, as compared to $9.8 million at December 31, 2007. Day sales outstanding of the combined companies were 46 at March 31, 2008. Inventories increased to $59.5 million, as compared to $39.8 million at December 31, 2007. Inventory days outstanding for the combined companies were 249 at the end of the first quarter. At March 31, 2008, on process donor tissue totaled $15.2 million, tissue and process totaled $31.5 million and implantable donor tissue totaled $11.5 million.

Working capital at the end of the first quarter totaled $89.3 million, an increase of $18.7 million since December 31, 2007. Total debt is approximately $8.3 million. As we review cash flow activity for the remainder of the year, we expect that by the end of the year accounts receivable should average about 45 day sales outstanding. Accounts payable should average about 45 days of expenses and inventory should average about 260 days sale outstanding.

In addition, we expect depreciation and amortization expenses to be approximately $8 million for the year and capital expenditures to be in the $10 million range. Lastly, net operating losses of the combined company will be adequate to fund U.S. tax liabilities for the year.

In summary, our balance sheet and cash position are in excellent shape as we enter our second quarter. I'll now turn the call back over to Brian.

Brian Hutchinson

Thanks Tom. In the first quarter of 2008 has been a start of an exciting year for RTI. We look forward to more progress towards our goal in the second quarter, our first full quarter together as RTI Biologics. As a reminder, we do not provide specific guidance on revenues and profitability. However, as a general outlook, we believe we will continue the trend of increasing revenues, profitability and cash flows over the course of 2008.

We anticipate that we will see a similar growth pattern in 2008 as we saw in 2007, softer growth in the first half of the year with stronger growth in the third and fourth quarters. We foresee this growth pattern over 2008 as a result of increases in tissue availability and the rebound of our spine business, upcoming product launches and continued integration of distribution and marketing post-merger to achieve potential revenue synergies.

We have a diverse array of industry leading distributors in a variety of revenue categories giving us confidence that we can reach our goal of 25% growth rate in annual revenues for 2008. Although our spine business has slowed down and may only grow 3% to 5% for the year, our other businesses are all growing at rates which provide us confidence that we will meet the overall 25% growth rate goal. The shift in our business in our mix of business should also be positive to the bottom line.

Our key element of our success in 2008 will be substantially increasing our operating margins and earnings per share as the top line grows in favor of our more profitable contributing segments such as sport medicine, bone graft substitutes, dental and surgical specialties. Our management team is committed to this critical goal and we have the proper infrastructure in place to achieve it.

In the past few months, we have had several analysts initiate coverage on the company and we would like to extend a special welcome to them, as well as express our appreciation to all of the analysts covering RTI Biologics. We enjoy working with all of you. We have visited many investors in the past few months and hope to see many of you this quarter. In addition, at several road shows with our analysts, we will be presenting at the following conferences.

I'll be presenting at the Banc of America Conference in Las Vegas on May 14. Tom will be presenting at the Craig-Hallum Conference in Minneapolis on May 20. I'll be presenting at the FBR Conference in New York on May 29. Tom is going to be presenting at Sidoti Conference in Boston on June 3. Tom will be presenting at the Collins Stewart Conference in New York, which will be held July 8 through the 10. At this time, let's open up to questions. Stacey?

Question-and-Answer Session

Operator

(Operator instructions) We'll go first to Shawn Fitz with Stephens, Inc.

Shawn Fitz – Stephens, Inc.

Hi, Brian and Tom, good morning. Congratulations on the quarter.

Brian Hutchinson

Thank you.

Shawn Fitz – Stephens, Inc.

Hi, just quickly, when we think about sports medicine relative to the two-week production shut down, I tried to think that the impact across all your revenue segments is felt more heavily in the sports given the fact that there's no inventory?

Tom Rose

Yes, that's a correct statement. I think as we said in Q4, the shutdown would probably have the most impact on sports and it did.

Shawn Fitz – Stephens, Inc.

So Tom, you talked about 10% to 15% impact to production from the two-week shut down?

Tom Rose

That's correct.

Shawn Fitz – Stephens, Inc.

I guess it would be overly simplistic to assume that you could have done 10% to 15% more revenue in sports had it not been for this shutdown?

Tom Rose

Yes, I think that's – I don't think in addition to the lower levels of production, Shawn, with sports there still is some element of inventory build. So, I think it would probably – the impact would have been less than the 10% to 15% but it still would have been significant.

Brian Hutchinson

There was an impact, but I wouldn't go as far as saying it was total.

Shawn Fitz – Stephens, Inc.

Tom, is there anyway to tease out what the margin impact might have been in the period from that shutdown?

Tom Rose

No. I don't have an estimate for it, Shawn. It may have had a potentially up to 1% impact on the margin for the former RTI during the period.

Shawn Fitz – Stephens, Inc.

Okay, great. And then just as we think about your margins in your two largest business segments, spine and sports, maybe just compare and contrast the margin differences in those two businesses and maybe even quantify them in a general sense?

Tom Rose

Sure. Good point. With respect to sports, as Brian mentioned in his comments, it does yield the highest returns currently of all of our businesses. The average margins on those products are in the 65% to 70% range. As I mentioned in my comments, we do have about 13% variable commission below the line. That compares with our spine business that probably on an average yield 35% to 40% gross margin, again with no comparable selling expenses below the line.

Shawn Fitz – Stephens, Inc.

Right. Okay. Great. And Brian, Tom, just as we think about the spine segment, did you all have any major contribution from a revenue standpoint from your new distribution partners there?

Brian Hutchinson

I wouldn't say it was significant in the quarter. Obviously, the spine results weren't very strong, but we expect that as the year goes on, particularly third and fourth quarter, the new players will step up much more significantly.

Shawn Fitz – Stephens, Inc.

So, Brian, is it fair to say that your spine performance really reflects the old RTI business model, and really hasn't begun to see the manifestation of your new partnerships and the impact that could have on that segment?

Brian Hutchinson

For first quarter, that's correct.

Shawn Fitz – Stephens, Inc.

Okay. Okay, fine. Good. Last question, Brian, could you maybe just on the revenue synergy standpoints, we think about putting Tutogen and RTI together, could you talk again maybe about where the opportunities are for revenue synergies and when we might actually start to see those impact your financials?

Brian Hutchinson

They are relatively large in what I would call the surgical specialties area as we grow in recoveries of dermis products or those kinds of membrane products that we can use. That's going to show up as the year progresses, again more heavily loaded later in the year but it's going to show up as the year goes on. We expect to see some contribution to the sports side from donors that come in from outside the U.S. that could impact. So, we expect to see that. And then the third area that we expect to see is Gea is actually off site today at a spine meeting and will be holding some integration meetings late May in Europe, specifically targeted around moving some of the products that we make here in Gainesville through our channels outside the US. So, that's all ongoing and we expect that would start showing up in the second half of the year.

Shawn Fitz – Stephens, Inc.

So, Brian did I understand you correctly to say that this international pipeline of donors could be the first contributor to revenue synergies on a combined basis?

Brian Hutchinson

No. I think the first one is going to be U.S. donors contributing to the U.S. surgical specialty businesses.

Shawn Fitz – Stephens, Inc.

Okay, just last question. Can you provide any antidotes maybe in terms of how you all are doing on the supply side of that?

Brian Hutchinson

I think we are doing excellent. Roger and his team have fully integrated. They are focused. He's had them here to completely review their strategy and they are now executing. I think they're doing very, very well. That team is doing a good job.

Shawn Fitz – Stephens, Inc.

Okay. Thanks for your time, guys.

Operator

We'll go next to Dave Turkaly with SFG.

Dave Turkaly – Susquehanna Financial Group

Thanks, I'll try to keep it under ten or – just kidding here. When looking at your spine business in the quarter, you told us some of the new products you got. I think you said Stryker a new lumbar, new cervical with Orthofix and maybe some others coming. Can you remind us where your capacity stands and what percent of your capacity in the quarter you think you used?

Brian Hutchinson

Our capacity in the quarter was very low and we will not approach full capacity until probably late in the year. We certainly have at this time especially with increasing levels of tissue coming in, we have significant capacity, and in fact we'll likely bring on more partners as the year progresses. So, we feel pretty good about where we are. We feel very good about penetrating all of the partners we have, and we expect that we'll continue to balance out that line as we progress.

Dave Turkaly – Susquehanna Financial Group

And I think you have mentioned in the past something about units that you can produce in a year, a quarter and I know that my recollection was that you were somewhere around 50%. Maybe it's not – maybe capacity is not the right term but in terms of end-user shipment of what you can process or what you have available, the reason that you are outside of the Medtronic exclusive, you had something like 50% extra. Is that still the case?

Tom Rose

Yes, Dave, coming back to our capacity for spine constructs, our current capacity right now is easily in the $14 million to $15 million per quarter. You can see we were substantially short of that mark in Q1.

Dave Turkaly – Susquehanna Financial Group

Great. And then on surgical specialty as much color, as you might be willing to give us I know two good partners there. I think it's my understanding that the hernia one is doing really well, but is there any color you can give us in terms of the results in the quarter? Is Mentor still relatively small and is it really the Davol product that's doing well?

Brian Hutchinson

No. Right now, it's the other way around.

Dave Turkaly – Susquehanna Financial Group

It is –?

Brian Hutchinson

We're able to satisfy the demand better from Mentor, but I would tell you we are not able to satisfy their full demand for either group. We're not even close yet. So, we have got a long way to go there. I know that Davol is excited about the product and how it's performing clinically and want more. So, we are certainly working to achieve that and we expect that we'll do a much better job this year as more as we are more successful in recovering more tissue.

Dave Turkaly – Susquehanna Financial Group

Just to be clear, the revenue business is bigger with Mentor today or you are saying that your ability to satisfy their demand is better?

Brian Hutchinson

They're about the same right now.

Dave Turkaly – Susquehanna Financial Group

Okay. That's perfect. Thanks a lot.

Operator

Go next to Keay Nakae with Collins Stewart.

Keay Nakae – Collins Stewart

Yes. Good morning.

Brian Hutchinson

Good morning, Keay.

Keay Nakae – Collins Stewart

Tom, with respect to inventories noticeable pick up there. Can you help us understand what part of that increase is simply what you have gained from Tutogen and what part of it is actually new sourcing of the material?

Tom Rose

Obviously, Keay, the most significant part of the increase is the inventories coming out from Tutogen. But I would say in the quarter, we continued our trend of increasing the unprocessed donor material, which puts us into a better position with respect to production planning in subsequent quarters, and also on finished goods in the quarter we had a slight build as you can imagine of spine products that we expect to ship in subsequent quarters.

Keay Nakae – Collins Stewart

And just on the unprocessed maybe specifically skin as it relates to surgical specialty sales, how much of an improvement did you see there?

Tom Rose

I would say that not a significant improvement during the quarter because as the tissue has been coming in for the last few quarters, it is going out almost as quickly as it's coming in. So, it's not significant at this point in time. I think as Gea has mentioned in the past, we still have backlogs that we are working with on many of our membrane tissue.

Keay Nakae – Collins Stewart

Okay. Back to spine, with respect to Medtronic, are we looking at a permanent low plateau here or what's your outlook in terms of your ability to sell to them?

Brian Hutchinson

You mean permanently staying low? I would say no. I think it's going to recover and I think it's going to recover in the latter part of this year. They're actually expressing interest in developing some new grafts, so I expect that that's actually going to grow as we go forward. And I don't expect it to stay flat or disappear.

Keay Nakae – Collins Stewart

Is that growth predicated on the new products or can you sell them more cervical products or what's driving your outlook there?

Brian Hutchinson

The dominant right now for us with them anyway is cervical and that'll continue on. But some of our lumbar products are now ten years old, so it's time to refresh them and I think that will happen. But we're working with them like we work with all partners at this point in time.

Keay Nakae – Collins Stewart

Okay. Thanks.

Operator

We'll go next to Matt Dolan with Roth Capital Partners.

Matt Dolan – Roth Capital Partners

Good morning guys. Congratulations on the integration progress.

Brian Hutchinson

Thanks, Matt.

Matt Dolan – Roth Capital Partners

First question on the dental and surgical specialty side, can you give us a feel for performance throughout the quarter, the run rate that you put up is well ahead of our expectations. Obviously, assuming we don't just take that number in the month of March and multiply it by three but maybe help us with more of a pro forma comparison to see how those two segments are tracking?

Tom Rose

I think the dental continue to have a strong quarter. The dental growth is – we are starting to see some acceleration with the international business as well as the domestic business. In dental as we look at the results for the quarter, we believe we are seeing some impact of the slower economy on the number of new surgeons coming on, and we are going to be watching that closely here in the next couple of quarters. But dental still continues to be very strong. On surgical specialties –

Brian Hutchinson

It seems to me, this is Brian. It seems to me that March you started to see a little bit of increase from tissue. But we expect that, we do expect that we will continue to grow from there. So, I don't think it's a one-time pop. I think it's going to continue to move up as we go through all of the membrane products that we can.

Matt Dolan – Roth Capital Partners

Okay. Very good. And then on the facility side, can you give us an estimate on your expectations for the timing of the integration of the Tutogen facility or for what you might bring in-house at RTI?

Brian Hutchinson

We stopped construction while we are on this call, but if you're in my office today you'll hear this whole week, it's a pretty loud banging going on. So, obviously we are building our buildings right now. We've got some dominos, if you will, a series of events that need to occur for the processing facility, so that actually will take place during this summer. We've got to be very careful there to make sure that we don't disrupt our flow or our contributions to our partners. So, we've got to make sure we plan this out well. We will expect to actually be out of that facility entirely sometime in the fall. So, it's all on track. I would tell you that integration work is going extremely well. I'm meeting about twice a week right now with the operations team which is really the only group left. Everything else is done.

Matt Dolan – Roth Capital Partners

Okay. And the savings associated with that integration is factored into the '09 run rate you gave us?

Brian Hutchinson

Yes, it is.

Tom Rose

It is Matt, but I think as we had mentioned in the past, until we actually get the plants fully integrated and we see the related staffing, we won't see – we won't be able to determine the ultimate cost savings relating to the integration of manufacturing.

Matt Dolan – Roth Capital Partners

Sure. Okay and then finally a question on supply. Bringing Tutogen in definitely helps the supply and with now with LifeCell, sounds like it's dropping certain procurement relationships out there. Can you tell us how you take advantage of the sourcing dynamic going on out there either from a cost or revenue synergy standpoint? Does it allow you to get more of those products that are in short supply like dermis and like sports medicine tissue and could that potentially accelerate particularly with more procurement agencies being essentially available to you?

Brian Hutchinson

At this time, it certainly helps at least starts the conversation. But if you get to understand, even in these situations where agency has been given notice that their services may not be needed in the future, it still takes a long time to turn them. And then Roger's group has to go out, Roger Rose's group has to go out and do training and create new, sometimes contracts to get these things done. So, that is all in process. At this stage I'm not jumping up to push revenue synergies up higher but we are certainly trying to drive everything we can.

Tom Rose

But just like on the expense synergies, Brian had mentioned that we've locked down many of our anticipated expense synergies as we plan the merger. As we look at the new procurement relationships and we look at the progress of the international procurement, we are able to start quantifying the impacts of those revenues synergies in the future. Again because of the timing of integrating these new procurement relationships probably not going to see a major impact in the current year but we are excited about the prospects as we enter into next year.

Matt Dolan – Roth Capital Partners

Okay, very good. Thanks a lot, guys.

Brian Hutchinson

Thanks.

Operator

Move next to Caroline Corner with Pacific Growth Equities.

Caroline Corner – Pacific Growth Equities

Hi, guys. Congratulations on your progress this quarter. First I would like to ask about the sports medicine business. You mentioned that there will be some new implant offerings throughout '08. Could you comment on some specifics there when we should expect what, and also along those lines, could you comment on any progress that you might have made with regard to bovine tendon and any idea of PMA track there?

Brian Hutchinson

Sure. On the new product side, the products that we are going to be driving were going to be the ones we had launched late last year, early this year. So, meniscus will see some other additional tendons, which we don't really identify as individual new products, but a lot of that's going on, and we are really excited about the offering that we have for these folks now and it's working as you can see in the results. In terms of the bovine tendon product, we are really – we're not ready to update that from what we talked about at AAOS. It certainly is one of our key projects and we are working on it as we've said we'll have some decisions late this year. So, we'll keep you updated there but we really don't have an update on that today.

Caroline Corner – Pacific Growth Equities

Okay. Thanks. And then the xenograft hernia product, the bovine pericardium, you said in the comments that you are working on getting five-year data from the EU to use that to launch in the U.S. late '08. What kind of approval do you need in the U.S. markets there and what are you predicting for the timing for that?

Brian Hutchinson

Why don't Carrie answer that, she's just walking over here.

Carrie Hartill

I'm sorry Caroline. I didn't necessarily catch the whole of your question, but I think it was what is the opportunity relative to bovine pericardium products, which are already in the market in the EU. We actually have from a former Tutogen clearance one fact in case a hernia repair already cleared and another one in the works that would expand the offering to the mesh product to this proven particularly successful in the marketplace in Europe. And that project was kicked off just in the last couple of days to furnish that 510K. It should be a relatively rapid turn around because it's a simple line extension type 510K what we called a special with a 30-day turnaround. So, we would expect to be submitting that by the end of May, and then expect the 30-day turnaround. In terms of the dental products, Tutogen has submitted a 510-K, received a response from FDA with some specific questions. That response has back in now to FDA for just over two weeks and we've already got a couple of follow-up questions from them which is promising and that they're actively reviewing it as we speak and not waiting for the 90-day cycle and then taking a look at it at the last minute. So, I think that speaks to some extent to the relationship we have with some of the reviews particularly in the dental space.

Caroline Corner – Pacific Growth Equities

The mesh product that you mentioned is that a product that's a combination of the bovine pericardium with the mesh then, I'm not familiar with it?

Carrie Hartill

It's actually bovine pericardium, to simplify it it's with holes punched in it in a very regular pattern and the concept is that it actually helps to prevent adhesions and that the formation of something called seromas which is essentially fluid build up. It allows that fluid build up to release and not create pressure in the abdomen, which can cause (inaudible) of the procedure.

Caroline Corner – Pacific Growth Equities

Okay. Thanks. Then I also have another question, the cost savings you tightened that range to $6.5 million to $7 million in the 12 months post-merger. Can you talk a little bit about specifically where you are seeing higher levels of cost savings than previously expected perhaps?

Tom Rose

I think Caroline, the increase, and we talked about this at the academy presentation where we first forecast the additional synergies. The increase primarily relates to adding more potential synergies from the integration of the processing facilities. However, in addition as we said earlier, in the area of selling general administrative, the public company cost that we talked about, again those are all locked down as of right now. So, now our synergy focus is entirely on processing, but there's cost savings or whether it's efficiencies.

Caroline Corner – Pacific Growth Equities

Thanks. Then my last question just a housekeeping question. Going forward into the second quarter, what should we be using as an approximate share count?

Tom Rose

Yes, we did – it's good question. We did put that into the press release, and the weighted outstanding shares as we estimate for the quarter would be about $56 million.

Brian Hutchinson

$56 million, Caroline.

Caroline Corner – Pacific Growth Equities

Thank you very much.

Operator

We'll move next to Steve Lichtman with Banc of America.

Steve Lichtman – Banc of America Securities

Thank you, good morning, guys.

Brian Hutchinson

Good morning, Steve.

Steve Lichtman – Banc of America Securities

On spine, in terms of the comments on Medtronic you mentioned inventory work down. Is there any sense that you have in your conversations with them in terms of where they are from an inventory perspective, how much more there is to go?

Brian Hutchinson

We actually know where it is actual, so we expect light Q – it's always light in March and April, it's going to be light again this March and April. Then it starts to pick up May and it gets back full steam in June. That's where we stand with them right now, and we don't have – and we just think that's the way it's going to go.

Steve Lichtman – Banc of America Securities

So, as you look at the inventory, that's sort of the pattern you are anticipating?

Brian Hutchinson

Correct.

Steve Lichtman – Banc of America Securities

Got it, okay. And then in terms of new products you mentioned Orthofix lumbar medial, did you mention Stryker lumbar?

Brian Hutchinson

Yes, we have a lumbar for Stryker as well.

Steve Lichtman – Banc of America Securities

Okay, and that's around the same time?

Brian Hutchinson

Yes.

Steve Lichtman – Banc of America Securities

Okay. And then lastly, what's the capacity and/or interest in expanding partnerships on spine in particular? Is there interest out there, and if you see an appreciable or continued slowdown in one of your partners, do you anticipate potentially adding another?

Brian Hutchinson

We expect to add at least one more this year and maybe two, and there is significant demand out there. We have many companies that want to talk with us. So, there are a number out there.

Steve Lichtman – Banc of America Securities

Okay great.

Brian Hutchinson

And Gea is actually working on that with Robbie Lane right now.

Steve Lichtman – Banc of America Securities

Okay. Tom, on the gross margin obviously very, very good here. I assume there's not a change in terms of the break even level. So, on the incremental margin side, what should we be thinking about looking forward as we build our model?

Tom Rose

Sure. I think on the – for the rest of the year as we have been looking as a combined company, Steve, I did mention that I believe for the full year our margins will reach the 50% level and they are going to grow linearly as sales grow, and that's on the combined company basis. And we're still obviously digesting our fixed cost and variable cost ratio of the combined company and where it's going as we combine the operations. That being said, what I've said in the past with respect to RTI's incremental rate of 70% to 75% on sales above $25 million revenues above $25 million, that still holds true.

Steve Lichtman – Banc of America Securities

Okay. And that's for LEGACY RTI, correct?

Tom Rose

That's correct.

Steve Lichtman – Banc of America Securities

Then on the combined?

Tom Rose

The combined is the only really direction I can give at this point in time is as we start the year at this 46%, 47% if you add back the purchase price adjustments, and if we estimate the full year is going be 50%. Again I think we'll just see this linear relationship and grow up the margin along with revenue increases.

Steve Lichtman – Banc of America Securities

Okay. And then on MG&A, you anticipate some leverage here as we go into the back half?

Tom Rose

Yes. As we review the comments post-call here, try to be as specific as we could on the G&A numbers and the variable cost component of our marketing selling and general administrative just because as you put the two companies together, it's really hard to get to where the starting point. But as you can see, as I mentioned, the marketing general administrative, the fixed costs look like they're going to stabilize around $11 million a quarter, which has some – that number reflects some nice synergies compared to the combined businesses of last year and we are pretty comfortable with that number at this point in time.

Steve Lichtman – Banc of America Securities

Okay. And then lastly on the tax rate, it looks if you axe out some of the one time charges, a mid-30s tax rate is that right and is that a number we should be looking going forward?

Tom Rose

Very good question. The tax rate that's in the quarter is 38%.

Steve Lichtman – Banc of America Securities

38%.?

Tom Rose

And we are estimating that that will be our effective tax rate for the year. That rate is substantially down. I believe RTI's tax rate in the first quarter of last year was in the mid-60s, so obviously the 38% is very favorable. We still have tax planning opportunities that we'll be getting after the year progresses to try to bring that rate down. But I think 38% is a good rate for this year.

Brian Hutchinson

It should be noted though, we actually won't pay anything though we have NOLs so–

Steve Lichtman – Banc of America Securities

Right. So, at least from the P&L perspective 38% is a good number to use for next year perhaps even downward pressure – downward movement?

Tom Rose

That is correct.

Steve Lichtman – Banc of America Securities

Okay great. Thanks guys.

Tom Rose

Okay, Steve.

Operator

And we'll move next to Jayson Bedford with Raymond James.

Jayson Bedford – Raymond James

Good morning guys. I apologize if these have been asked. But just quickly the RTI gross margin on a standalone basis in the quarter, did you give that number?

Tom Rose

We didn't Jayson. The RTI is, as you look at the two companies for the quarter, my estimate is pretty hard to get to these numbers as we consolidate the roll-up so quickly here. Probably for the quarter, RTI's gross margins were about 44%, and the former Tutogen was in the 57% range.

Jayson Bedford – Raymond James

Okay. And the 50% guidance – sorry, gross margin goal for '08, does that include the inventory write off in the first quarter?

Tom Rose

Yes. It includes that $1million plus, that number is post the recognition of those purchase price adjustments which are $1.2 million.

Jayson Bedford – Raymond James

Okay. And then the dental was a little stronger than we had expected. I think you mentioned $3.5 million. Anyway you can break that out between the U.S. and OUS business?

Tom Rose

Let's see. The inside the U.S. for the period was about $2.7 million in U.S.

Jayson Bedford – Raymond James

Okay, that is stronger. Okay, and then finally, I think you had mentioned in the past a dermis product selling through your sports med channel, and I was just wondering where you stand with that product and what's the timing of that?

Brian Hutchinson

Later this year, is right now [ph] we expect, Jayson.

Jayson Bedford – Raymond James

Okay. Fair enough. Thanks.

Brian Hutchinson

Thanks Jason.

Tom Rose

Okay, Jayson.

Operator

We'll go next to Gregory Brash with Sidoti & Company.

Gregory Brash – Sidoti & Co.

Hi, thanks for taking my call. I just wanted to continue on with the dental question. You mentioned there you could see some slowdown with the economy, and I believe Zimmer mentioned that on their conference call also. You're still seeing some really strong growth. Is that just due to you grabbing market share here or how much of that due to now having a one distributor in Europe?

Brian Hutchinson

We've been tracking our growth in new customers per month and that has not flowed through the first quarter. The comments that we're seeing are being reflected by what Zimmer is saying and other dental companies that I've been reading about as well. With this economic slowdown, this surgery is elective in many cases. So, we're just saying what we're feeling from our major distributors, that if they slow down, we will slow down. So, we don't know exactly how much or when and we just met with them and they were still very optimistic about the year. So, I feel very good about it.

Gregory Brash – Sidoti & Co.

Okay. And then you touched on the merger of the two facilities here in the U.S. I just want to get your plans for moving BioCleanse into the Tutogen's German facility, so you get sort of ramp sales in Europe?

Brian Hutchinson

I think that's going to be a '09 event. There are rules and regulations that we have to comply with , and we've to figure out exactly what we want to process through BioCleanse there, which we have a pretty good idea of as of today. But that's going to take a little bit of time. So, you should be thinking '09 when that happens.

Gregory Brash – Sidoti & Co.

Okay. So, any contribution from RTI core products internationally '08 would only come from the bone paste?

Brian Hutchinson

That would be the main driver, not necessarily the only thing, but that would be the main driver.

Gregory Brash – Sidoti & Co.

Okay. All right, thank you very much.

Brian Hutchinson

Thanks.

Operator

And we'll move next to Brooks West with Craig-Hallum Capital.

Brooks West – Craig-Hallum Capital

Hi, guys.

Brian Hutchinson

Good morning, Brooks.

Brooks West – Craig-Hallum Capital

Hi, I want to dig into the Medtronic relationship just a little bit deeper if I could. Can you Brian, can you give us some idea where Medtronic was as a percentage of revenue in the quarter and where you see them by the end of the year?

Brian Hutchinson

Tom's trying to find the number as percentage of revenues. Certainly with spine being only 30% of revenue and them being, they're still the dominant share of that number in the quarter. So, they are still going to be very significant to us. If you ask me the state of affairs, if you read their announcements for the last couple weeks, it was losing Michael DeMane and Pete Wehrly. There is a tremendous amount of history between our two companies and it's really between us and those two guys. They've put in some new people that frankly none of us know. So, we've got some work to do, but I would tell you the way we are viewing it here is, it's a chance for a fresh start. So, we are going to treat it that way and try and meet the right folks and get out there and continue to try to build. So, we've always said that we would like them to be less important to the company in terms of percentages because we don't want to be reliant on one segment or one partner. And we are getting there, and I would say in the first quarter we got there faster than we would like, we're getting there.

Brooks West – Craig-Hallum Capital

Do you see, sorry to cut you off, Tom. Do you see just on that note and that was going to be my next question, is that a net positive the departure of those guys given the historical rocky relationship with Medtronic? Or it sounds like maybe it's a net negative just because it's an unknown?

Brian Hutchinson

It's just unknown, so it's neutral. We just don't know. I just don't know how it's going to play out.

Brooks West – Craig-Hallum Capital

Okay.

Tom Rose

But Brooks coming back to your question, they were about 37% of the total business in Q1.

Brooks West – Craig-Hallum Capital

Yes.

Tom Rose

There's a component in spine and there's a component in bone graft substitute. Their percentage will be obviously quite a bit smaller as we in fact, I think as we get to the end of the year, they're going to be between 25% and 30% of our total business. I guess as you look at the relationship with them, they're still our largest spine customer and very important to us. We are here to meet their needs. The inventory adjustments, if you go back the last couple of years, sometimes we see them in Q4, sometimes we see them in Q1, and we really don't have any control over that. But I do think that as we mentioned before, they'll be coming down as a percentage of total revenues, but our strategy really is that the other businesses will just be going much faster. I don't perceive them shrinking substantially over the next couple of years.

Brooks West – Craig-Hallum Capital

So, you see them, to Brian to your comment in your closing comments, where you see spine growing I think it was 3% to 5% for the year, is that assuming Medtronic is basically flat or maybe a little down and the pick is up from new customers? Or are you going to see some growth in the Medtronic business?

Brian Hutchinson

Well, longer-term I expect to see growth but this year I expect to actually see down.

Brooks West – Craig-Hallum Capital

Okay. Okay. And then just an update on how the bone paste launch is going with Zimmer?

Brian Hutchinson

We just met with them last week. It was a very interesting meeting. A very, very large meeting. I was surprised how many people from Zimmer were there. The representation of all their business segments, and I would say it's going. I would say it's going slower than we would like and slower than they would like. And there's just a tremendous number of issues to overcome in terms of launching a biologic across all division all at once. We learned a tremendous amount going through the meeting with them last week. We have action items all over the place, both companies. I fully expect that's it's going to continue and be very, very successful. Where they have used it, it's been very successful with their reps. They like the handling characteristics, they like everything. They do need the full product which means they need the moldable product which we will have to them late Q2.

Brooks West – Craig-Hallum Capital

Okay.

Brian Hutchinson

We expect that will help them go faster, and they do have plans to go across all their divisions at this point in time. So, it's really just about execution.

Brooks West – Craig-Hallum Capital

And that's about what 1700 reps, I think?

Brian Hutchinson

It's huge. It's about that size.

Brooks West – Craig-Hallum Capital

Okay. How much of the international business in the quarter was LEGACY Tutogen?

Brian Hutchinson

The lion's share.

Brooks West – Craig-Hallum Capital

The lion's share. Okay. Okay, I think that'll do it for me. Thanks, guys.

Brian Hutchinson

Thanks, Brooks.

Operator

And, ladies and gentlemen, we've time for one final question. We'll go next to Jon Robohm with Gagnon Securities.

Jon Robohm – Gagnon Securities

Good morning, gentlemen.

Brian Hutchinson

Good morning, Neal.

Jon Robohm – Gagnon Securities

If the gross margin is going to get the 50% for the year, then if all quarters were being equal, I have to basically march it up two points every quarter?

Tom Rose

That would be approximately correct.

Jon Robohm – Gagnon Securities

Just as a first approximation? Okay. If we look at what you gave for the first quarter 44 57 RTI and Tutogen, what would that be if Tutogen were in for the full quarter?

Tom Rose

I think it would have been similar as far as at least the percentages. I think, obviously with their full volume for the quarter, our margin would have been at least a percentage higher.

Jon Robohm – Gagnon Securities

Good, just wanted to get it directionally right. Thanks very much.

Brian Hutchinson

Okay, thanks, Neal.

Operator

And that will conclude our question-and-answer session. At this time, I'll turn the conference back over to Mr. Hutchinson for any additional or closing remarks.

Brian Hutchinson

Thank you, Stacey. Thank you all for joining us this morning and as always you can find information about RTI on our Web site at www.rtix.com or by contacting our IR department. Thank you. Bye-bye.

Operator

Thank you. Once again, ladies and gentlemen, that will conclude today's conference. We do thank you for your participation.

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Source: RTI Biologics Inc. Q1 2008 Earnings Call Transcript
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