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Exactech, Inc. (NASDAQ:EXAC)

Canaccord Genuity’s Global Growth Conference

August 14, 2012 11:00 a.m. ET

Executives

David Petty– President

Jody Phillips – CFO

Analysts

William Plovanic – Canaccord Genuity

William Plovanic

Good morning. My name is Bill Plovanic. I'm a Managing Director and Senior Med Tech Analyst here with Canaccord Genuity. With us today we have Exactech. And speaking for Exactech is David Petty, President and Jody Phillips, CFO. Exactech is a player in the orthopedic market who has grown significantly over the past decade. I have actually – it’s the longest coverage company I have in my list. I have covered this company since 1998 in $25 million in revenue. So, it’s grown a lot over the years. For any disclosures regarding Canaccord Genuity and Exactech please reference the back of the conference booklet. With that I’ll hand it over to David.

David Petty

Thank you Bill, and just point out that when we met Bill, we both had dark hair and I have turned grey. I don’t know what that means, but you are ageing better than I'm, amen. So it’s my pleasure to be speaking at this conference, and I do see some familiar and friendly faces in the crowd as well as many new faces.

So, as I go through this and talk about the market and our growth rate versus the market, the portfolio, the pipeline by business unit for Exactech, a little bit about our management team and also the sales organization and Mr. Phillips will come up and talk through the numbers. I will apologize to long time followers for some information you may have heard before here in the beginning. But we will get to current data’s here pretty quickly.

This is an interesting way to think about Exactech with revenue as a backdrop going all the way back to the shortly after our founding in 1985. We started as a hip replacement company treating patients with arthritis of the hip with total hip replacement systems and develop modest revenue and then in early 90s developed a relationship with the hospital for special surgery in New York City to design a new total knee system that was in fact evolution of technology that had previously been marketed worldwide by a major competitor.

When we had access to this technology and launched the product in 1996 we knew of the small private company we did not have the financial resources to do justice to the commercial opportunity that would be available to us with this new Optetrak knee system. So we raised a little bit of money in an ITO, and that money allowed us to commercialize this knee system on the scale that we were capable of the company of the size we were at the time.

From 1996 to 2007 we went on a pretty good run of consistent growth as we expanded our hip replacement and knee replacement lines. Guidance of the biologic segment of orthopedics and ultimately the extremities market and picked up the distribution agreement for a bone cement product. That was all growth that was fueled out of operations and a little bit of debt with no further equity raised during that time.

Then in 2008 with a two small acquisitions which got us into the spine market and began a journey of having more direct operations outside the U.S., which I will talk about more later. That year by the way we grew 24% ex-acquisition, 38% with the acquisitions, and then with the rest of the world over the last several years we slowed down to a pace of about 8% to 10% growth rates, but yes still continue to outpace the market and in some segments we substantially outpace the market.

This is just a current look at second quarter to confirm what I have just stated about the Exactech outpacing market growth rates on a weighted average basis, certainly double the market growth rates in the second quarter of this year. Also point out that over 15 years time we do have a compound average growth rate of 17%. Even under the difficult environment recently we have managed to put forth strategies that allow us to continue to outpace the market.

The market in what we do like the market in most of the industries around the world has slowed down substantially. This slide looked a lot more attractive with respect to growth rates three or four years ago. It still remains very attractive. It’s a sable market and in most cases it looks to be growing slightly in most cases. And these are the segments of orthopedics that Exactech competes in. So we are in the larger segments with spine, knees, hips and biologics, and also in extremities which is growing faster. We are in extremities only with the upper extremity, specifically a total shoulder replacement system.

What that means in terms of the orthopedic segments that we are not in or slower growing and relatively smaller segments of sports medicine, trauma and soft goods. Soft goods being braces and casting materials and those kinds of things were usually office based sales.

This is a pictorial representation of those segments that we are competing in and the products that we offer with the associated growth rates for 2011, with the major core segments of our business hip, knee, and extremities growing either above market growth rates or substantially above market growth rates.

Biologics and spine coming in with a negative contribution on the top line in 2011, and I will talk a little bit more about that in a moment. The knee as that flagship product that stimulated the ITO and the growth for a decade or a decade and a half remains 39% of our total revenue. You see 1% growth for the first half of the year, but I’d like to point out that in the second quarter we were at 4% growth on a constant currency basis. So starting to see – and I’ll give a little bit of a rebound in the knee business relative to the market environment that we are dealing with. In our own instance we also have put a lot of effort in recent year – and last we would say 12 to 15 months focusing the sales organization on knee sales domestically and we are starting to see a very positive trend in terms of regaining – moving towards historical growth rates that have been so important to Exactech.

I would like to say when – as goes the knee, so goes Exactech. We can do really great things with extremities business and hip business and we are, and when we are growing the knee even 7% to 9% the business looks totally different. We can start to get some real leverage and deliver on operating profit growth more effectively.

How are we going to do that. We are in the process of launching two major new knee systems. There are two ways that a surgeon can approach replacing an arthritic total knee. One is to keep the posterior and cruciate ligament intact and try to keep that as a functioning part of the system that works with the prosthesis to help the patient recover their motion and relieve their pain. Another way is to remove that ligament and replace it with a mechanical feature that replaces the function of posterior and cruciate ligament. This new knew system offers both options with specific advantage in each and have a very unique benefit to the surgeon on the posterior stabilized side the one we remove the posterior cruciate ligament, and that it makes the procedure easier to do, it’s a lot quicker, more elegant, and it’s a concept that has resonated with surgeons as we have introduced it.

On the other side, one of the problems when surgeons replace the knee and retain that posterior cruciate ligament, sometimes they end up compromising it. Meaning in the doing of the surgery they don’t preserve it absolutely, they compromise it a little bit. That means they cut it with a saw or they cut it with a scalpel a little bit in order to get the procedure done. We found a way to manage the instrumentation in the approach to the procedure to absolutely protect that posterior cruciate ligament.

Another concept for surgeons who follow that philosophy that is unique. Then there is a whole list of things here that I don’t think in this audience we get the benefit out of my describing the details, but there is a lot here, a lot of new things in our knee system which combined with the focus with the field sales organization we believe is the right way to get ourselves to the high single digit growth rates or double market growth rates which is what we intend.

But t last thing listed that are only mentioned because it’s something that we are really looking at in the second half of 2013, a very unique approach to bringing a computer into the operating room to help the surgeon with alignment of the cuts of the bone to place the prosthesis. This is something that goes beyond the way we as an industry have been able to use computers in the operating room and something that we think will be very, very attractive. It’s last on the list because it’s last to come out of the pipeline on this particular list, and again I'm thinking in terms of the second half of 2013, but something where we believe will create value in the future for Exactech.

Hips, 29% growth in the first half, by the way either first half numbers has contracted to 2011 numbers I showed on the first slide of all of the products. 29% growth in the first half fueled by very strong growth in the United States and Japan and one market in Europe and also in Latin America representing about 16% of our business and are really, really exciting part of the Exactech success story currently. There are a couple of things that we think will help sustain that.

Our product launches, they are a line extension to the Element hip, that's just the trade name of the hip, it’s a hip that we have been very successful with and using something called a direct anterior approach to doing a total knee procedure.

All that means is that the surgeon access the hip joint in order to perform the replacement by coming in from the front instead of from the side and from the posterior approach, and that allows the surgeon to dissect fewer muscles and soft tissues so that when the operation is over and the patient is recovering they can recover more readily. It’s easier to recover and less painful and so patients are attracted to that. With the advent of the internet and surgeons looking on the internet about how to solve their healthcare issues, we have patients coming in and asking surgeons for anterior approach hip surgery.

We have special instrumentation that allows that to be done easily with the Element hip and we have surgical skills training labs to teach our current and prospected customers how to do this procedure. This is how we have attracted a lot of hip surgeons recently and how we are outpacing hip market growth rates at a rate of 5X.

We will continue to do that with this Element hip, with line extension that gives us the specific advantage over a major competitor. That specific advantages with this new version of this hip, the surgeon for their smaller patients has to take away less bone from the femur. Surgeons always are interested in preserving existing tissue structures and bone structures when they do a procedure like this because over many, many years should the prosthesis wear out or the patient develop a complication and need to have it redone, the surgeon would like to have that bone available for a second operation. So this is something also that’s attracted the surgeons.

New material, porous metal material on what we call the InteGrip acetabular or socket on the ball socket of the hip joint and a couple of other new products including a revision acetabular system. So lots of new things and lots of momentum hip business is healthy, sound, and strong.

The biologics and spine I noted a 13% decrease in 2011 and a first half decrease is 7%. That actually, if you look at it isolated to the second quarter on a constant currency basis is up 1%. Sale of that only to say we struggled with that business last year, particularly in biologics, and with the 1% second quarter constant currency we believe we stabilized it.

Now, why did it go negative? It went negative because the two products that we sell in biologics, predominantly in the United States, are products that are used in conjunction with other procedures. So they could be used with the total joint replacement or a trauma procedure or a sports medicine application. And typically when hospitals are build for these procedures if it’s a total knee they expect to see total knee on the invoice. They don’t expect to see a PRPK which is one of our biologics products or a DVM bone paste. So, we got a lot of push back at the advent of health care reform related to these products. We’ve gone back and developed the economic arguments to go back and recover that business.

The biologics business has a few new products, most importantly over the long run making a major investment in cartilage repair technology. So that’s putting a little pressure on the bottom line, but it’s something we believe that's important for our future.

Spine, the name of the game with a very small spines business is to put enough new product out so that we can attract high quality independent sales agents. And, so as we just launched over the last three quarters, four quarters, a number of new products that puts us in a position to go out and recruit strong sales people.

The unique product where exclusive distributor in United States for a bone cement product line as well as this pre-formed spacer which is an antibiotic loaded spacer that helps surgeons treat very difficult, and an unfortunate situation when the patient develops an infection while they have a total knee replacement in place. So, this is an important product to Exactech.

Extremities, just a crown jewel of the company, back to the labeling area, it’s actually 19% of our business. 31% industry observers wrote just about three months ago that Exactech is pretty much lapping – I'm quoting directly, “pretty much lapping the field with extremities, outpacing the competition in a substantial way.” And we have been doing this now for about 3.5 years.

Number five, in terms of market share 10% and we do it because we have a better technology and these product introductions are intended to support that continuation over time with innovative technology to support our existing products.

Outside the United States, we are in about 40 markets. We have a combination of independent buy and resell distributors in certain markets and then I mentioned the entry into the French market back in 2008. We actually developed direct operations in China almost 10 years ago and in the U.K. seven or eight years ago. We now have direct operations in China, Japan, Canada, UK, France, Germany and Spain, and the other part of the business is this independent stocking model. We did, over a period of about two years, invest substantially with capital investments as well as pressure on the P&L in order to setup some operations in the European market. With the intention of leveraging that into top line growth and ultimately bottom line contribution basically in 2012.

I guess you’ve all read the newspapers. I guess the timing of our doing that in order to get back the leverage that we intended is put a little pressure on us, we still feel that we’ve made the right moves and in fact in some of those markets we sort of defy all the odds and we are managing to deliver growth and even profitability in spite of the troubles in Europe. We do have one market in Europe that’s given us a little bit of pressure.

Domestically, the sales organization, we are about 250. We are focused on developing the quality of the sales organization while at the same time increasing the number of feet that we have on the street. Management, to the extent that we have been successful, and I would argue that the data shows the Exactech has delivered value for our shareholders over decades as Mr. Plovanic said, we believe consistency and management is a good thing.

We have, among the founders and officers an average of 22 years experience you can see up here, and 28 years with industry experience and a broader leadership group that also has long tenure and a lot of industry experience. We think that that’s an important part of our corporate culture and success.

Now I’m going to turn it over to Jody, and I am trying to manage the time so we can do question here. If you take the ball and run with the right speed we will have some time for questions.

Jody Phillips

Thank you David and good morning everyone, thanks for joining us for the Exactech presentation my name is Jody Phillips, I’m the Chief Financial Officer. We are going to a review a few financial slides to give you guys a brief update on the current as well as the targeted balance of the year performance.

Our current guidance for full year revenues for 2012 is for revenues of between $218 million to $223 million. This represents a 6% to 9% increase for the full year versus the result in 2011. The second quarter revenues were $55.2 million, this represented a 7% increase on a reported basis and also a 9% increase on a constant currency basis. Our projections for the third quarter of 2012 are for revenues from $49 million to $51 million and this roughly represents growth between 5% to 8% on a reported basis and between 7% to 11% on a constant currency basis as we do continue to project on head wins due to the euro current exchange rates in the third and fourth quarter.

From an earnings perspective our current full year projections for net income of 2012 is for net income after tax of $12.4 million. Our current guidance is for earnings per share on a diluted basis of $0.91 to $0.95. We have pretty been on our plans for the first half of the year presenting bottom line increase of 11% on an after tax basis, so we have been able to deliver a certain amount of operating leverage. This has principally been derived from around 50 to 60 point gross margin improvement and this is despite the fact that we have experienced 2% average sales price decreases on a year-to-date basis. We also have been able to deliver a little bit of operating leverage on the operating expense line with current operating expenses on year-to-date basis running roughly 59% versus 61% in the first half of 2011.

Our guidance for the third quarter represents the diluted EPS of roughly $0.17 to $0.19 and again the full year guidance been $0.91 to $0.95. There are significant expansion projected in the bottom line versus the second half of 2011 here, primarily due to easier comps but also due to continued operating leverage in the model.

From a balance sheet perspective, we have had some significant movements in the first half of the year. Our accounts receivable incurred a significant increase in the first quarter and then a significant decrease in the second quarter primarily due to large payments from the Spanish government. Our total debt during the second quarter actually decreased by nearly $10 million, we ended the second quarter with total cash of around $4 million and total outstanding debt of around $44 million.

Earlier this year we put in place of 5 year syndicated debt facility that use this capacity of around a $100 million, and our current projections are basically to be cash flow neutral to slightly cash flow for the balance of 2012.

To summarize, as David mentioned we have made a number of expansions over the last two or three years outside the US and we are starting to see the leverage and return from the those despite the difficult environment in Europe. We are pretty positive about that as we go into second half of 2012 and 2013. Significant capabilities with expansion of our sales force, we are seeing a number of competitive reps, highly qualified available, so we continue to try to effort to bring on high impact individuals on board there.

As David outlined we have a very robust product pipeline that we think will allow us to continue to produce top line growth that is a multiple of market growth rates, and we continue to think that there are opportunities in our supply chain that represents the fact that our gross margin expanded about 50 basis points despite the fact that we have experienced large joint ASPB crisis on year-to-date basis that’s primarily due to our internal manufacturing cost reduction efforts where we currently produce around 60% to 65% of our total unit volume that’s a number that steadily increases and a significant potential there with our shoulder system where we do not currently produce a large percentage of those components in-house. So while we expect modest pricing pressure to continue, we do think we can keep our gross margin stable to slightly expand them probably for the next six quarters.

So that is our presentation at this point. I believe we have a few minutes for questions.

Question-and-Answer Session

Unidentified Analyst

[Inaudible].

Jody Phillips

Fair question. The question surrounds the amount of our inventory being at $65 million and roughly 260 days. The orthopedic space is a capital intensive business, primarily due to the fact that all of the implant sizes are required to be consigned to hospitals. Exactech is of industry standard, they want to project our total inventory turns to currently be around one. We think industry standard is somewhere between 1.5 to 1.8, and it’s an area that we think over the next two or three years that we can make significant improvement. We’ve been relatively flat for the last three years while launching this major new knee system, and we think right now we are well positioned to grow revenues at a much faster rate than inventory grows. So we are looking to improve those inventory terms over the next two years.

Unidentified Analyst

[Inaudible].

Jody Phillips

Absolutely. David is closer to this space, so I’ll let David respond to this question, okay.

David Petty

Sure. I think in total joint replacement we have not yet gotten into the right answer about how the brain computer, technology, to bear for the purpose of making the procedure more effective in general. And we are still working at it. There are robots, there are custom cutting guides and there is traditional navigation. All of those have their different challenges. The robots have the challenges of the cost and also the time it takes. They can’t be accurate. I don’t want to comment specifically on MAKO but using that for a Uni, a partial knee replacement procedure and increasing the indications or frequency of doing that kind of procedure, because you have that technology available. It is probably not sustainable. And that’s all I think I should say about that.

The custom cutting blocks carry with them the advantage of being very accurate, but the disadvantage – the advantage of being very fast but the disadvantage of not being potentially as accurate, which could be problematic for patients.

Traditional navigation is something that hasn’t worked very well. It’s slowed the procedures down and they’ve had a big piece of equipment sitting away from the surgical field and the surgeons is turning around to reverence that and it slows them down, they’re drilling holes in the bone where they don’t need to, and then surgeons have not realized the value proposition of more accurate and faster.

This thing we’re calling GPS, that I mentioned, Guided Personalized Surgery, not calling it navigation for various specific reasons. It breaks through some of those barriers. Brings the interface with the computer and the camera into the surgical field, and the surgeon can customize his or her profile to do the surgery in the way that they want to while interacting with the computer live on the field, in the same field of vision as the operated knee that he’s working on.

Our goal is to deliver the accuracy, the speed and then make it also cost effective. There is a lot we have to do to make that happen. It is a big project that has software components, hardware components and mechanical interface components, and we will bring in all that together. As I said, we’re about a year away from that being a major contributor. But we feel very excited that we have come up with a better mousetrap.

Your ticker is showing zero, I don’t know if there is going to be a hook on there, but we’re happy to take more questions.

William Plovanic

No, I think we are just going to wrap it up, and we can take more questions in the San Francisco room across the hall. Thank you.

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