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Greatbatch Inc. (NYSE:GB)

Q1 2008 Earnings Call

May 7, 2008 8:30 am ET

Executives

Marco Benedetti - Corporate Controller

Thomas Hook - President and CEO

Thomas Mazza - SVP and CFO

Analysts

Tom Gunderson - Piper Jaffray

Jason Mills - Canaccord Adams

Bob Hopkins - Lehman Brothers

Keay Nakae - Collins Stewart

Assaf Guterman - Lazard Capital Markets

Jeff Englander - Standard & Poor's

Operator

Welcome everyone to the first quarter Greatbatch Incorporated conference call. Before we begin, I would like to read the Safe Harbor statement.

This presentation and our press release contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 and involves a number of risks and uncertainties. These risks and uncertainties are described in the company's Annual Report and Form 10-K.

The statements are based upon Greatbatch Incorporated's current expectations and actual results could differ materially from those stated and/or implied. The company assumes no obligation to update forward-looking information included in the conference call to reflect changed assumptions, the occurrence of unanticipated events or changes in the future operating results, financial conditions or prospects.

I would like to now turn the call over to today's host, Corporate Controller, Marco Benedetti. Please proceed.

Marco Benedetti

Thank you. On the call today are Thomas J. Hook, President and Chief Executive Officer and Thomas J. Mazza, Senior Vice President and Chief Financial Officer.

In terms of today's agenda, Tom Hook will start by providing a few brief comments regarding our first quarter results and then he will provide comments relative to our major initiatives. After that, Tom Mazza will provide further comment on our first quarter results and we will then open up the floor to Q&A. As we have done in the past, we are including slide visuals that will go along with this presentation, which you can access on our website.

For your information, Tony Borowicz has taken a new role as VP of Finance for the Precimed orthopedics group. In the future, I will be your initial contact for any investor questions. Tony will continue to provide assistance to me in this role.

Let me now turn the call over to Tom Hook.

Thomas Hook

Thanks, Marco. 12 months ago we initiated our gap fill acquisition strategy to higher growth markets. We successfully completed seven acquisitions that diversified Greatbatch's revenue base, and significantly expanded our product offerings to customers.

First quarter sales of $122 million with CRM market concentration below 50% is clear evidence of accomplishing one of the prime objectives of our long-term strategy. We are focused on steadily improving operating profitability across Greatbatch to drive value for our shareholders. This is a straightforward process of consolidation, integration and optimization we have successfully implemented within Greatbatch over the last three years.

We will leverage this experience and the expertise from the acquired companies to drive core operating profitability improvement in the combined businesses. We have organized our improvement plans into a series of major initiatives and we are aggressively pursuing them.

I am pleased the acquisitions have generated more opportunities than originally contemplated and we are confident in our ability to deliver the projected financial performance for 2008.

Let me begin with a review of the carry-over initiatives from 2007. As previously announced, the closure of the Columbia facility and the expansion of the research and development center are scheduled to be completed in the second and third quarter 2008 respectively. We have made progress working with our customers on the Columbia closure and remain optimistic that, pending our final customer's successful regulatory approval, the facility will close by the end of the second quarter 2008.

Our new research and development facility allows to us co-locate our western New York-based research and development and product engineering and sales teams under one roof and exit a leased building.

In 2006, we started the initiative to rationalize our commercial manufacturing footprint and optimize the underlying cost structure of the commercial business.

As discussed in previous calls, we are in the process of constructing a new facility in Raynham, Massachusetts. This project is on budget and on time for completion in the second half 2008. This facility will approximately double our commercial manufacturing capacity and will include the use of semi-automated equipment to replace many of the existing manual processes. In addition, we are in the process of rationalizing and optimizing the remaining commercial locations including Suzhou, China, Peterboro, New Jersey and Orchard Park, New York.

A third group of initiatives focuses on newly acquired orthopedics business. This business has enjoyed tremendous growth and revenue over the past few years and has now experienced production constraints.

Current operations are located in several smaller facilities and, as a result, products are moving from facility to facility creating waste and extending production lead times. These delays in shipments are creating excess backlog.

Immediate focus for the operating team is reducing order backlog through implementation of LEAN manufacturing practices. Future plans will involve optimizing the orthopedics manufacturing system and consolidating the operations from the current eight facilities into an appropriate number of world class production facilities.

Our work implementing LEAN manufacturing practices at our metal forming and machine facilities has created available capacity. During 2008, we had begun to strategically in-source key components.

Our fourth initiative is to continue to pursue the in-sourcing of key components from the extended Greatbatch business that utilizes valuable capacity and reduce cost.

In 2004, we started production at our Tijuana, Mexico facility. Initial focus for this site was to launch an important customer transfer. During 2005 we announced the planned closures of our Columbia, Maryland and Carson City, Nevada facilities. To expedite these closures and minimize transfer risks to our customers, all processes were moved to Tijuana in their current configuration. As mentioned earlier, the completion of the last transfer of the Columbia facility was scheduled to be completed in the second quarter 2008.

Our fifth initiative is focused on optimizing the production processes within the Tijuana facility to improve product flow, reduce lead time and improve internal product yields. Available capacity exists in Tijuana and the product line is taking place to determine the best products to utilize the remaining available space.

The sixth initiative involves deploying some of our best engineering resources on the identification and implementation of semi automation. Automation projects will focus on variation reduction which will lead to a reduction in both labor and scrap costs. Our focus for automation projects will be on products that are supported by anticipated underlying market growth. All automation will be flexible in nature and will match the high mix median volume requirement that is inherent in our business.

Seventh initiative is focused on our supply base and the creation of more long-term partnership agreements with key suppliers. Completion of the recent acquisitions has significantly increased Greatbatch's overall buying power. In addition, we have several engineering projects we are currently working on to support customer programs to utilize more cost effective materials. Overall, these projects will generate favorable purchase price variance over the next three years.

The eighth initiative, which is already underway, is the integration of all of the acquired companies onto a common ERP platform. This integration will allow for synergies to be realized across the organization. ERP system conversions of BIOMEC and IntelliSensing have already been completed. The next acquisition scheduled to be integrated in the second and third quarters of 2008 are EAC and the therapy delivery business, which includes both Quan Emerteq and Enpath. The time line for the integration of the orthopedics business is currently under development and is being prioritized in conjunction with the previously discussed operating initiatives.

Our ninth initiative will be to implement action plans to increase short-term and long-term revenue growth. Some of these actions are included in our operating initiatives, such as reducing lead times and order backlog within the orthopedics business. Other actions on increasing our cross selling opportunities with customers.

Our expanded product list successfully accomplishes one of the main objectives of our gap fill strategy. This expanded list will enable Greatbatch to offer not only component parts but complete systems to our customers. We also believe that the further adoption of our Q implantable battery technology will help increase our revenue potential. Our business development group will be charged with various objectives to support our operating income goals.

The tenth initiative is to continue to look for means to streamline operational and functional areas. Our focus will include prioritizing our spending, including research, development and engineering as well as implementing various cost-cutting measures to reduce costs and increase operating income.

In summary, our major initiatives are as follows. Complete the 2007 carry-over initiatives. Rationalize the commercial manufacturing footprint and optimize the underlying cost structure. Reduce order backlog and optimize the orthopedics manufacturing system. Fully utilize our Tijuana facility, in-source key components and parts. Move towards a flexible scalable semi automation for key processes, create more strategic partnerships arrangements with key suppliers, integrate all acquired companies onto a common ERP platform, implement action plans to generate short and long-term revenue gains, and finally reduce overhead by streamlining operational and functional areas.

I'll now turn the call over to Tom Mazza to review our financial results.

Thomas Mazza

Thanks, Tom, and good morning. Sales for the first quarter were in line with our expectations. We recorded over $122 million in revenue. Our new acquisitions added over $51 million in revenue. As anticipated, our acquisition strategy enabled us to successfully diversify our revenue mix from a combined concentration of approximately 85% in CRM to below 50%.

Given the slow growth level currently being experienced by the CRM market, our revenue growth and diversification has validated our strategic investments in the vascular, commercial and orthopedics markets. During the quarter, we completed the preliminary purchase accounting valuation for our Precimed and Chaumont manufacturing acquisitions. While these valuations and the valuations of the acquisitions made in the fourth quarter of 2007 are considered preliminary, the initial results are consistent with the amounts included in our EPS guidance ranges given in March 2008.

The first quarter results include one-time costs of goods sold charges for inventory step up amortization of $6.4 million and the write-off of in process R&D of $2.2 million which is included in other operating expenses. The discussion below will be based upon our results excluding these charges.

Adjusted gross profit for the first quarter was approximately $33.1 million, which represents an increase of $4.1 million over the first quarter 2008. Our adjusted gross margin was 27.1%, a drop of 10 percentage points from last year. In comparison to last quarter, the drop was approximately 4 percentage points. Approximately 8 of these 10 percentage points decrease in gross margin rate is related to the inclusion of the new acquisitions, which includes approximately $800,000 in incremental amortization and depreciation related to the step up in value of the tangible and intangible assets.

Other factors negatively impacting the gross margin rate for the acquired businesses include foreign currency exchange differences of approximately $500,000 and the impact of low volume due to bottlenecks at several of the acquired locations.

Turning to SG&A expense. Costs increased by $8.3 million, primarily due to the acquisitions made subsequent to the end of the fist quarter of 2007. It should be noted that additional amortization expense, primarily customer relationships and non-compete agreements and other non-cash expenses totaled over $1.3 million. On a percentage of sales basis, SG&A expense increased by approximately 2 percentage points, primarily due to these non-cash charges.

First quarter of 2008 also included approximately $1 million in net legal costs to defend patent infringement cases. RD&E expenses of $9.2 million, although up from last year primarily due to the inclusion of the acquired company, decreased as a percentage of sales from 8.4% to 7.6%.

Consolidated depreciation and amortization costs totaled $16 million for the fist quarter. This includes approximately $2 million in ongoing incremental amortization depreciation related to the step-up of the acquired assets. This also includes a one-time charge of $6 million related to the inventory step-up previously discussed.

Adjusted operating income amounted to $5.6 million, which represents a decrease of $6.5 million from the first quarter of 2007. For the first quarter, this was below our anticipated run rate for the year.

However, the initiatives outlined by Tom Hook give us confidence that our adjusted EPS results for the year will be in line with our original range of expectations. While we are pushing hard on all of the initiatives outlined, initiatives that are expected to have an impact on 2008 include the following. Clear the bottlenecks that exist within the orthopedics manufacturing operations, which are delaying deliveries to our customers and negatively impacting our sales and operating profitability. Reduce operational and functional overhead. This initiative was started late in the first quarter and will continue into the next three quarters. Align our R&D spend with growth market opportunities. Finalize the closure of the Columbia manufacturing facility, complete move of the commercial production facility from Canton to Raynham, complete the expansion of the R&D center, generate additional sales volume from cross selling and other initiatives, implement LEAN manufacturing initiatives and supply chain improvements that generate immediate gains and provide groundwork for future improvement, take advantage of opportunities to in-source key component parts.

We believe that the recent acquisitions offer us a great opportunity. It is up to the Greatbatch team to capitalize on that opportunity by successfully executing the major initiatives outlined here.

Let me now turn the call back over to the moderator to take questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Tom Gunderson. Please proceed.

Tom Gunderson - Piper Jaffray

Hi, good morning. I'm just going to focus real quickly one question or series of questions on the gross margin cost of goods line. You gave a number of initiatives. You outlined that it had gone down and obviously to get to earnings estimates it needs to go up. Can you give us a sense of these initiatives, if we should look at these as incremental quarter to quarter to quarter such that we'll see improvements in gross margin? Or is this going to hang low for three to six months and then everything sort of comes together and gets fixed in the fourth quarter and we get a great margin there? Can you give a bit more granularity there?

Thomas Hook

Sure. This is Tom Hook. I'll give you a big picture view. The nice thing about the ten initiatives that we've outlined is they were implementing them as we are talking, and they bring benefits to us really starting second quarter, and those benefits are recurring quarter to quarter. As more of the initiatives reach the implementation point, and we're doing many of these in parallel, it'll build us more momentum faster towards the end of the year.

So my expectation is to see tangible results starting in the second quarter and building in momentum towards the end of the year. A very aggressive set of initiatives that we've deployed both the acquired management teams and the core Greatbatch team together on. And we obviously expect improvements immediately, as well as seeing them build over the course of the year as more of them are fully implemented.

Tom Gunderson - Piper Jaffray

Tom, which of the initiatives do you think has the biggest basis point impact on gross margin and when do you think that initiative would be finished?

Thomas Hook

To, I think if we're talking about the long run, clearly the best opportunity we have and what the purpose of the gap filling strategy was for is to, A, diversify us in the higher growth markets and to, B, sell more completed systems to our key OEM customers rather than just individual products that we can peak for on a one-on-one basis. In other words, we can drive a lot of value for our customers to do more of the complete picture because we more effectively utilize our capability and capacity now.

Now that's the real big value but it's a long run value. I'm sure that you also want to know what is the short-run value, and that's the list that Tom Mazza had briefly reviewed in his comments where we've consolidated some of the functions that we have organizationally. We are squeezing costs out at the supply chain and overhead. We are doing more comprehensive cross selling to customers. All those things will help us in 2008 to drive better improvements in the business.

And clearly now that we're into the markets that have higher growth opportunities in therapy delivery and orthopedics, we can leverage the opportunities for growth better than we can in the cardiac rhythm management market which tends to be a little more stagnant and more challenging to pick up business there, because they are not as healthy a market growth as there has been historically.

Tom Gunderson - Piper Jaffray

Thank you.

Operator

Your next question is from the line of Bob Hopkins of Lehman Brothers. Please proceed. Mr. Hopkins, your line is open.

Thomas Hook

Why don't we try to take the next call since Bob's line may not --

Operator

Yes. The next question is from the line of Mr. Jason Mills of Canaccord Adams. Please proceed, sir.

Jason Mills - Canaccord Adams

Tom, I'm wondering when you say long run, could you give us some perspective on sort of what sort of time frame you're looking at and how we should measure your progress during that time frame? We've talked a lot about gross margins. I agree that in the near-term, it's probably the most glaring area where you'll see improvements just on the P&L, but you've talked most predominantly in the past about operating margins. So perhaps you could -- for us sort of dummies out here just speaking for myself I suppose, you could lay out sort of a time frame that we should be looking at whether it be a 24-month project, a 36-month project, it's never complete, but I think you know where I'm going and then how we should measure your performance over that time frame starting with today and starting perhaps with where operating margins are if that's the metric that we should focus on as we've been told to do in the past?

Thomas Hook

Certainly. Thanks, Jason. I will not deviate from saying we will talk about operating income is what we want everyone to focus on, but clearly because there's going to be questions on gross margin with the acquired businesses and what the overall mix of the company is, and that that really does tie to many if not most of the initiatives I've talked about today.

Jason Mills - Canaccord Adams

Right.

Thomas Hook

We are in a very operationally intensive phase to drive that margin improvement at the operating income level but it's deriving from manufacturing systems improvements and throughput improvements at the gross margin line that's driving it. There is some coming from employment overhead and discretionary expenses more judiciously but a lot of it is operating based. So we're going to -- why the purpose of this call is to focus on that because we're fully deployed ongoing after it.

What I will highlight much to your question is we have overemphasized on this call what we're doing in terms of technology from the gap fill strategy. And as we started to close many of these deals in the second half of last year, we were able to do a redirection of our research, development and engineering resources in the company, which are much more distributed now to focus on coming up with more systems level solutions to drive sales to our key customers.

And fortunately, we just don't have to drive those systems level sales into the historic CRM market. We can sell those into customers in neuromodulation, the vascular markets, interventional radiology, orthopedics, etcetera where we have just as many opportunities if not more because of the growth potential in those markets.

So we are already starting on that. We've spent already six plus months doing those developments. We've been successful in capturing some key intellectual property. And our intention is that now that we've launched this operating initiative phase and we are talking to the operating initiatives and we are going to start showing our track record of improvement on that, our messaging in the second half of the year will start to highlight the technology areas that we are going to prioritize and we'll start providing milestones to those it will walk to.

There's a few areas that we've concentrated on. We're not ready to highlight them externally yet. We've had some key intellectual property, some patents issued in a few areas and we're really excited to be working with some existing customers and new customers on commercializing those. It's my expectation that, while we will not enjoy any revenue in 2008 for these types of programs, it will start to build on that revenue base starting sometime in 2009, and then we'll start to see system sales post that period of time for the future strategic direction of the company.

Jason Mills - Canaccord Adams

Okay, great. Let me ask one or two follow-ups and I'll get back in line. Just to follow up on that really trying to get, and I know at this point probably you're trying to avoid talking about exact numbers or goals for the out years. You haven't planned for them yet specifically. But you have talked about this year, for example, of 11 to 13% operating income margin. According to our numbers excluding the one-timers, you are roughly a little under 5% for the quarter. Are you still on track to be within that range? I believe you talked about EBITDA margins of 21 to 23% for the year. Are you still on track to be within that range? And then maybe give us some anecdotal comments about where we should be modeling if you can for the out years. And then just lastly for Tom Mazza, just with respect to the math in the quarter the $0.16, it looks like what's happening is you're taking your operating income, taxing it 36% but sort of excluding interest expense and other income and getting to that $0.16. Is that accurate and is that reflective of how you're setting your guidance of 120 to 150? It seems to me your number was more like $0.11 if we include the recurring interest expense, etcetera. Thanks, guys. I really appreciate it.

Thomas Hook

Let me give you a little bit of kind of the long-term view is that clearly the strategy for the gap building strategy was to what the opportunities we saw in the cardiac rhythm management market to enter new growth markets with our capabilities quickly to leverage them. We did that in a series of acquisitions. It got us the revenue that we needed, but we have to drive the integration and consolidations, which are currently underway to drive that operating income improvement.

So it is no surprise that post these many acquisitions, we have a lot of integration and consolidation work to do. It was expected, it was planned. And as we implement that, it is going to have a direct and tangible benefit to operating income that will only build over time as we continue to take more opportunities into deployment to consolidate and integrate. The same team that was successful in doing this in 2005 and 2006 are the same resources and professionals we have deployed in the acquired business in conjunction with the new management team. We have already seen a lot of good things happening already.

From a long-term perspective in 2008 guidance, we've given the guidance in February. We are comfortable with it. I think where we are at right now is we are not going to look out 2009 and '10 and talk what we are going to do at the systems level yet, which clearly would be an enhancement to what we are doing today. We realize because we are directing more research, development and engineering dollars to the systems level, we have to provide more visibility and color to what those investments are and we will do that in the future as we choose to identify the programs we are pursuing and the partners that we are pursuing it with.

Though, I think from an operational standpoint as we have a lot of operational work to do, we are focusing on that. Posting the results to what we've already guided that we would do and then we will talk about the new technologies from the strategic direction where we are making incremental investment for incremental gains in the out years at an appropriate time in the second half of the year. So we are not really comfortable providing much more on that at the present time and I'll let Tom pick up the question on the EPS.

Thomas Mazza

Yes, Jason. I'm not 100% sure where you are coming from, but let me just assure you this. I think part of it may be due to the way we're considering the taxes and EPS calculation which we'll be glad to explain in detail. We are assuming that the interest expense and the other income and other deductions will be in line with our initial guidance of $14 million to $15 million for interest expense. For purposes of your full-year modeling that would be a good thing to come up with our EPS guidance of $1.20 to $1.50.

Jason Mills - Canaccord Adams

Okay. So just to make sure I understand, so the $0.16, what tax rate are you using once you have a total of other income that adds, I think, net or subtracts net $1.6 million. So you get down to a pre-tax income line of $4 million, so to get to the $0.16, your tax rate is, what, 20% less then?

Thomas Mazza

Yes. Because of the fact the way the in-process R&D and we also had in the first quarter about a penny or two pickup due to we actually successfully settled some rebate issues that we were getting from some of our states that's reported in the quarter which will be detailed in the 10-Q as it comes out. So there's a few things moving around in the tax line item.

So if you read the footnote on page 5 in our press release, for purposes of the EPS calculation, we're actually adding in the full-year impact of the in-process R&D charge as it would be tax affected at the 36% rate, which is the rate we're assuming for the full year assuming the R&D credits don't come back, okay which we know that the Congress is currently discussing. So we expected to get back to our original guidance of 34% to 35% if the R&D credits come back.

Jason Mills - Canaccord Adams

Got it. I am so sorry. I know you want to get to other questions. This is very important, I think, to how we calculate the EPS. So will the full year when we look at this nine months from now the full year tax rate, will it be sort of in that 34%, 35% rate and so really for the quarter, this quarter, I understand why you would use a lower tax rate or why it moves around, for the year it's going to be 34 to 35%. So shouldn't we look at it in terms of what the earnings would have been this quarter at that rate?

Thomas Mazza

For the year rate, including the in-process R&D write-off which is not tax deductible, we expect the rate to be approximately 39%.

Jason Mills - Canaccord Adams

39%?

Thomas Mazza

Because of the fact that the $2 million in-process R&D charge is not tax deductible.

Jason Mills - Canaccord Adams

Got it. Okay. Thanks, guys.

Operator

And your next question is from the line of Bob Hopkins of Lehman Brothers. Please proceed.

Bob Hopkins - Lehman Brothers

Can you hear me okay?

Operator

We can hear you great.

Bob Hopkins - Lehman Brothers

Okay, great. Couple of questions. First, looks like you lost a lot of margin this quarter given the weak cardiac rhythm management performance. We know the cardiac rhythm management market is basically not growing or growing in maybe the low single digits, but your battery sales declined in ICDs double digits and mid single digits in pacemakers. Why do you think your cardiac rhythm management performance as it relates to batteries is coming in so much weaker than the overall market?

Thomas Hook

Fist of all, we have to be careful on the base cardiac rhythm management business. There's a couple of big things we had in our favor in 2007. Specifically a large one-time high energy capacitor pull from a customer that didn't recur in 2008. And additionally in 2007 the first quarter, we had a product line that is in other revenue for us that was selling strong that in the first quarter 2008 is affected by a customer issue that is preventing them from buying those products from us.

Both of those issues have no relation to anything that Greatbatch is making or providing. We're just affected by it due to the decisions of the customers and addressing their issues. So the quarter-over-quarter comparison, besides normally just being lumpy, when we look at those line items quarter-to-quarter it doesn't really give you the true picture. It's fair to say that for us, the cardiac rhythm management segment of the business came in where we expected it to.

We've been seeing somewhat slower growth than anticipated in the market, certainly domestically but internationally, it's higher. But we've been planning conservatively in that business. Fortunately that business we've already done a good job of consolidation and if we get one more customer FDA approval, we will have closed the final facility that is in our planning for consolidation in CRM.

I think we're on the right operating footing with cardiac rhythm management. I do think it's going to be challenging for 2008, but I will think when we look at more of the individual assignable events out of it, I think we'll grow slightly greater than the market. I still think we have good opportunities for growth there. We are selling to all of the major OEMs and doing a very good job of picking up new projects as they're commercializing. But I don't think we will see double-digit growth until there's underlying market fundamentals that provide us more wind in our sails.

Bob Hopkins - Lehman Brothers

Tom, did either one of those one-time things that you mentioned that happened in the year ago period have any impact on batteries?

Thomas Hook

From a battery perspective, no, it's capacitors and other components that we sell but not to high energy or low-energy batteries. I think that from a battery line item is that we obviously don't sell to every single OEM. We sell a mixture of technologies on the high energy side, both the current SVO state-of-the-art technology as well as the new Q batteries. That's a lot of conversions of those. We had in the first quarter a light quarter, as well as we had some reasonably heavy pulls in the last quarter of 2007. But definitely, that line item was a challenging product line for us in the first quarter.

Bob Hopkins - Lehman Brothers

Okay. And then just for the first quarter overall, was this first quarter basically as you expected, is that what you're trying to communicate here on the full P&L, that it basically came in as you thought?

Thomas Hook

I think, as a management team just in general speaking for everybody here, we don't accept results that are unsatisfactory. We have a lot of work to do here to improve. It is true that we knew post the acquisitions we were going to have a challenging quarter with the amount of acquisitions in terms of number that we'd done and the amount of operating work we had to do. So that's not been a mystery.

So we were deploying plans starting in the fourth quarter to get prepared for this onslaught in the first half of 2008. And we've really viewed that we would have challenging financial results because the number of moving parts and number of initiatives we have to deploy. So while there's an expectation for it to be challenging, we're not satisfied in any sense with it. In fact it's really resulted in more effort and initiative supported towards doing these programs on a more accelerated basis, which obviously puts more expense and pressure on us earlier because we know the long-term benefits are there.

Bob Hopkins - Lehman Brothers

So it was below your expectations?

Thomas Hook

It was below my satisfaction level in line with what I expected us to do following all these.

Bob Hopkins - Lehman Brothers

So basically you've got, for the year, if you're still sticking to your guidance and you think about the mid-point of your guidance. You got 90% of your earnings it will come to the next three quarters. I'm curious as to why you don't make the guidance range a little more conservative in light of the fact you've basically only earned 10% of what you need to for the whole year now that 25% of the year's gone?

Thomas Hook

I think it's fair also to say that about 90% of the initiatives are still yet to be deployed as well, Bob. And that kind of is the balance between the two is, I think we took a real hard look in November at what our year would look like, we in February obviously provided our year guidance into what we're going to do. That's really become our operating budget and mantra as a company and that's what we're going to pursue.

And from a deployment standpoint, as we sit here in May, we've done a great job in acquiring the businesses and actually delivering the revenue that I expect. We are not efficient in producing that revenue. We know how to fix the operating challenges.

So we're going to be very operationally focused to deliver the operating income and EPS for what our expectations are, and also that we believe is a satisfactory level of profitability. A lot of that will come in 2008. But a lot of those programs actually stretch into 2009 and beyond because of the long-term nature of them as well. So there's confidence in the management team to be able to deliver the results that we need for the year.

Thomas Mazza

Bob, if I could add a little bit of a bridge to that. I think we tried to highlight a couple of the non-recurring expenses that we thought were in the quarter. We basically had $1 million worth of legal fees and also exchange differential due to the Swiss operation selling in the U.S. about $0.5 million. That's about $0.5 million dollars that we're seeing in the quarter that we're not expecting to anticipate to repeat in the following three quarters.

Also, we didn't own the Chaumont facility for about a month and a half, so we get another month and a half of the operations at Chaumont. We had some during the quarter, I mean, we've had some specific scrap. In addition to having some bottlenecks in the production facilities, we also had some scrap issues at the production locations that the teams are working hard on curing. And clearly clearing up the bottlenecks at the orthopedic side should help us to get there as well, in addition to all the initiatives that we're working hard on.

Bob Hopkins - Lehman Brothers

Thank you very much, guys.

Operator

Your next question is from the line of Keay Nakae of Collins Stewart. Please proceed.

Keay Nakae - Collins Stewart

Yes, good morning.

Thomas Mazza

Good morning.

Keay Nakae - Collins Stewart

Back to some of the CRM product lines, did you lose share in ICD batteries or enclosures or feedthroughs?

Thomas Hook

I don't think that we've lost share. I think that as much as I would like to -- we've definitely been doing a good job of winning projects in terms of qualification of new designs, many of which obviously substitute for historical designs that we've made. I do think that the market growth rate, although it's recovering, is still slower than either what people would like to see in the market take place or what's actually occurring. There's a little bit different shift in model mix as we would like to be selling the higher technology, higher energy density, higher capability batteries.

And we see the implementation of those new products to be dramatically slower because of the slower underlying growth of the marketplace. And since obviously we sell year-over-year on an incentive system to customers, older products as they drive more and more volume and to have a declining cost profile whereas the newer technology tends to have a price premium. So a little bit of a differential there that occurs as well that's not in our favor. All those things we just have to be able to manufacture it to stay ahead of those cost reductions, but on the revenue line, it obviously shows.

Keay Nakae - Collins Stewart

Okay. So if we try to correlate this to say, one of your customer's St. Jude is actually doing better than the others in terms of its ICD sales. One reason why we would see your battery results, let's say, is because the unit volume may have been occurring but the product mix and the price to you guys is not favorable?

Thomas Hook

It's fair to say that. Obviously, there's not only that but there's a timing differential of when St. Jude's reporting their numbers and we're actually selling them a unit. Typically, over the year-end point, there's inventory adjustments to take place so there's variables that are beyond our control.

And we're typically manufacturing a product and selling it to a customer at least a quarter if not more before they're actually putting it in a device and reporting it as a sale. So there's a fairly significant time disconnect here that inventory, sales mix, price, all play into. And sometimes over the end-of-the-year point because of management of inventory positions both here and as well as at our customers, there can be fairly large adjustments in what that is.

Keay Nakae - Collins Stewart

Okay.

Thomas Hook

I think you understand, too, as we maintain safety stock over a long period of time in certain product lines like high rate batteries in order to appropriately manage the risk in the supply chain for these products as well. And as we make products to put into safety stock position, it's a shock absorber as we fill that and as customers decide to empty it out, they can do that at low or high rates because they know that safety position is there to leverage as needed.

Keay Nakae - Collins Stewart

Okay. Moving on to some of the other revenue line items. In orthopedics, you gave us a number. Can you give us a sense of what that growth looks like on a pro forma basis or alternatively, give us a sense for what portion of existing business you're able to retain or in fact grow?

Thomas Hook

I think it's fair to say that orthopedics is definitely a double digit growth market. We've been able to retain all the current customers. The really great thing in orthopedics is the Precimed acquisition, the Chaumont manufacturing facility acquisition from DePuy is very complimentary to what Greatbatch expertise has to offer. We're very good at manufacturing and manufacturing systems. So there's a direct and immediate benefit to deploying a lot of our integration resources on the manufacturing supply chain center of excellence fronts immediately into Precimed, which we've already done. There's a full time team to deploy that. Done a great job of scoping the six to eight manufacturing facilities that exist within Precimed.

We know we can drive immediate improvement in releasing a backlog in that business to help increase growth opportunities and help us capture more opportunities with more orthopedics OEMs. Additionally, we know that we can do systems improvement within those facilities to just drive core cost reductions, some of which we can pass on to customers that allow us to pick up more business and grow even faster, some of which obviously we take to profitability.

But it's really a different story than cardiac rhythm management. There's a lot of work to be done over there. We have a capability we combine with the acquired company's capability and then both of us can work together to be a lot more effective at it. Because that double-digit underlying market growth, in addition to the OEMs having an active interest in outsourcing their supply chain, both of those factors weigh prominently in our ability to grow profitably in orthopedics at a much higher rate than we can grow in cardiac rhythm management.

So this is one of the fundamental pieces of why we did the diversification strategy to get into this higher growth market. We've got the resources to deploy into it and we're very aggressively pursuing it because we know the opportunities are there to capitalize on. And we know as we do the hard work, it'll have a direct impact favorably to gross market, operating income and earnings per share.

Keay Nakae - Collins Stewart

Sticking with orthopedics, you talked about bottlenecks in the manufacturing and possible consolidation. In terms of relieving the bottlenecks, help us understand both short-term fixes to relieve the bottlenecks, having to somehow manage the physical transfer from one facility to another? And then longer term as you look towards a consolidation strategy, I think you mentioned you currently have eight facilities, what do you take that down to and how long over what period of time does it take you to do that?

Thomas Hook

Certainly. I think if you look at the parallels of the base Greatbatch business, the orthopedics product lines are very similar to how we were doing feedthroughs. We had multiple production points and transfer points. By co-locating that all in the Tijuana facility, it's been very hard to consolidate it but it's been very valuable in terms of margin improvement. That process we went through feedthroughs is very similar to the process we're going to go through orthopedics. You first map the process, you're identifying what the constraints are in the process. You're immediately looking to relieve those constraints. You don't have to do any building construction or moves to do that.

It's a simple, straightforward floor level solution working with the manufacturing teams to actually identify constraints, solve the constraints, open up capacity and allow product to flow. That changes thinking and planning. We go with larger quantities per lot to manufacture. They're more economic order quantities for us to do. We put in place LEAN manufacturing systems to pull orders through the plant rather than forcing them through on special cases.

The second piece is really where we get into what is the ultimate facility that we should invest in, how big does it need? But we don't like to do that until we've already done an identification of what products we make and how to make them and then improving that on the floors that we already have.

So there's an immediate benefit really already in the second quarter we're going to realize on for the remainder of the year, just by doing those basic process mapping, constraint management, looking at the right systems to put in place. Clearly, we don't have the benefit of an Oracle ERP system currently in orthopedics or some of the businesses. As those come online, it only enhances our information that we can garner from the production data and allows us to make improvements more quickly. So there's a lot of things happening in parallel.

But without a doubt, we have to scope and plan what we want to do to consolidate these eight facilities which undoubtedly be most likely a Europe and a U.S. facility for orthopedics. But we don't have to do that until we understand the basics of the manufacturing system needs first. Then we'll decide what we need to do and we'll certainly be highlighting for discussion as well as illustration externally what we plan on doing for manufacturing systems going forward. You have a lot of capability in the company now to do it both within the orthopedics group as well as in the broader Greatbatch business to drive those improvements without really any construction at all.

Keay Nakae - Collins Stewart

Okay. Thanks. That was helpful.

Thomas Hook

Welcome.

Operator

Your next question is from the line of Assaf Guterman.

Assaf Guterman - Lazard Capital Markets

Hi, good morning.

Thomas Hook

Good monrning, Assaf.

Assaf Guterman - Lazard Capital Markets

Quick question on Electrochem, and can you break it out between the base business and EAC?

Thomas Hook

Electrochem from a business line you see broken out, the core business has been rebranded Electrochem. Just for clarity when you see this, we've taken the branding Electrochem and stretched it across the rechargeable battery product lines of EAC, as well as we've broken out the IntelliSensing wireless sensing product lines under Electrochem. So the core commercial power business we do actually report out separately from what we're getting from EAC. You can look in the presentation and see a little detail, as Tom Mazza highlighted.

Thomas Mazza

Just for your reference, commercial sales totaled for the quarter $19.6 million. The sales from EAC were 7.1 in the period, which means that the base business grew at approximately 7% for the first quarter, quarter over quarter.

Assaf Guterman - Lazard Capital Markets

Okay. Got it.

Thomas Mazza

So going in the future, it's going to become more and more difficult to break those out, because we're really looking for the cross selling opportunities. Our marketing team in the commercial group is pushing hard to get to wherever they were selling before the traditional Greatbatch product to sell the new AEC products, the rechargeable systems as well. So for the first quarter that's the numbers you were looking for.

Assaf Guterman - Lazard Capital Markets

All right. Thanks. On the base business in general, it's down 8% this quarter and what growth rate are you factoring in your revenue guidance for the year?

Thomas Hook

We said the mid-single digits around 5% was the underlying market growth rate.

Assaf Guterman - Lazard Capital Markets

In general, for the base business in general, right?

Thomas Hook

That's correct. What we will call Greatbatch pre the seven acquisitions. Again, it's a little bit higher for the commercial pieces, a little bit lower for CRM, a little bit higher for neuromodulation as well as CRM outside of the domestic market. So it's a melded rate but 5 is a good one.

Thomas Mazza

Just so everybody knows, first quarter 2007 was a big number for us as well. So when we're doing the comparison, that's a tough period to do comparisons to.

Assaf Guterman - Lazard Capital Markets

Right. Then going back to your guidance and you expect operating margins to improve significantly over the next three quarters. Which line item, between gross margin, SG&A, where do you see most of the improvement coming from in order for you to reach this 11% operating margin?

Thomas Hook

It's a great question but I can say it is really going to come across the board. We have initiatives working every single line item for improvement because with seven acquisitions as well as two core businesses in commercial and implantable medical, there's opportunity across the board. Clearly, the opportunities in terms of gross dollars are in relation to the size of those line items.

Assaf Guterman - Lazard Capital Markets

Right.

Thomas Hook

Obviously cost of goods sold a lot bigger than the individual line items for research, development, engineering, sales, general and administrative. So there'll be proportional opportunities. But we knew going into these deals that we would have to do a lot of active integration consolidation. And it's happening at every line item and every executive is involved in the company doing it.

Assaf Guterman - Lazard Capital Markets

You think if all three line items have the short-term synergy potential, short-term meaning the next nine months in order for to you reach the 11% goal?

Thomas Hook

Absolutely, yes.

Assaf Guterman - Lazard Capital Markets

Okay. And lastly, quickly on the forward agreement that you mentioned there, the $0.05, could you elaborate a little bit there and talk a little bit about that. Where exactly are you showing that?

Thomas Mazza

It's in other income. It's below interest expense on our gains. You'll see it's approximately $1.4 million on the other income line.

Assaf Guterman - Lazard Capital Markets

1.4. So this is the 1.4. I assume that you have the same kind of protection going forward for the remainder of the year?

Thomas Mazza

This is related to a forward contract we put in place to buy the Swiss operations.

Assaf Guterman - Lazard Capital Markets

So it's not operational?

Thomas Mazza

Not operational. That's why it's in the other income line at the bottom.

Assaf Guterman - Lazard Capital Markets

Al right. I see. Okay. Thank you very much.

Operator

Your next question is from the line of Jeff Englander of Standard & Poor's. Please proceed.

Jeff Englander - Standard & Poor's

Good morning. You talked a little bit about, in the orthopedics some of the basic blocking and tackling. Can you talk a little bit more in some other areas where you kind of see the low hanging fruit that gives you the confidence that you'll meet the guidance for the balance of the year?

Thomas Hook

Yes. This is Tom Hook talking. I think I heard it was John but it was really hard to hear your question.

Jeff Englander - Standard & Poor's

It's Jeff Englander from Standard & Poor's. Is this better?

Thomas Hook

Much better, Jeff.

Jeff Englander - Standard & Poor's

You talked about the orthopedics business and really the execution issues and basic blocking and tackling. Can you talk about in the other areas where you see the low hanging fruit that gives you the confidence that you'll meet the guidance given the amount of the distance, as Bob referred to, that you have to go for the balance of the year?

Thomas Hook

I see the same optimism in the therapy delivery business for us. Clearly in CRM, we've got a challenging market. In the commercial market, we have a lot of good opportunities but we've got to get our facilities consolidated to drive capacity. So both of those are tough opportunities for the ERP. But when you look at neurostimulation, therapy delivery and orthopedics, they were the fundamentals in the gap filling strategy to get us into higher growth markets. They will deliver us more opportunities incrementally than the other markets for the reasons I've stated.

And it's up to us to design products, both at the product component level as well as the systems level for customers. But the component product level sales are what's going to drive it for '08. The systems don't come in until '09 '10. So we have a lot of opportunities to pursue current customers' cross selling and also we have a lot of products that we manufacture, we can leverage each of the expense line items to do more efficiently. We have a lot more purchasing power. We are going to sign more strategic relationships, lock in more materials pricing, and do a good job of leveraging manufacturing to squeeze out costs and scrap. Across the board, those things are going to drive improvements for us.

Jeff Englander - Standard & Poor's

Great. Thanks very much.

Thomas Hook

You're welcome, Jeff. Thanks.

Operator

And that does conclude today's question-and-answer session. I would like to turn the call back over to Marco Benedetti for any closing remarks.

Marco Benedetti

Thanks. I would like to remind you that both the audio portion of this call and slide visuals will be archived on our website at greatbatch.com and will be accessible for 90 days. Thanks everyone for joining us.

Operator

Thank you for your participation. That concludes today's conference. Have a great day.

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Source: Greatbatch Inc. Q1 2008 Earnings Call Transcript
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