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Greatbatch Inc. (NYSE:GB)

Q2 2008 Earnings Call

August 5, 2008 2:30 pm ET

Executives

Marco Benedetti - Corporate Controller

Thomas J. Hook - President and Chief Executive Officer

Thomas Mazza - Chief Financial Officer

Analysts

Jason Mills - Canaccord Adams

Tim Lee - Piper Jaffray

Keay Nakae - Collins Stewart

Jeff Englander - Standard & Poor's

Stanman - Man Investment

Operator

Welcome everyone to the Second 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 this conference call to reflect changed assumptions, the occurrence of unanticipated events or changes in the future operating results, financial conditions or prospects.

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

Marco Benedetti – Corporate Controller

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 comments regarding our accomplishments for the quarter and then provide an update relative to our major strategic initiative in MRI Technologies. After that, Tom Mazza will provide a financial overview and further comment on our second quarter results after which 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.

Let me now turn the call over to our President and Chief Executive Officer, Tom Hook.

Thomas J. Hook - President and Chief Executive Officer

Thanks Marco and I would like to thank all of you for joining our second quarter 2008 earnings call. As you will note from this mornings release we are pleased with the financial results for this quarter. Furthermore, we are excited by the execution and progress we continue to make toward our long term strategic initiatives which include increasing the diversification of our sales mix, driving new product development and innovation during sales growth and improving the operational efficiency throughout the organization. We reported a record quarter with sales of a $141.6 million which represents an 81% increase over the second quarter of 2007 and a 16% sequential improvement over the first quarter of 2008. The benefits of our recent acquisition were reflected in the diversification of our sales mix as well as improved profitability as our adjusted operating income grew to $14.2 million during the quarter which is a substantial increase over the first quarter of 2008, Tom Mazza will provide additional detail in the financial results later in the call.

Over the past year we have worked diligently to find and complete strategic acquisitions that will improve the overall diversification of our business. These acquisitions offer significant opportunities to leverage the core operational and product development strengths of the company to significantly enhance our long term growth and profitability. This diversification strategy has helped to expand our opportunity within a variety of new markets including orthopaedics and therapy delivery.

As part of the acquisition, we are able to add preparatory technologies and product line to our portfolio as well as strategic manufacturing and product development capabilities. In addition, we expanded and diversified our global customer relationships. Although, the acquisition has clearly diversified our customer based and reduced our concentration of the few key accounts that also created additional opportunities to sell a broader portfolio products across multiple provisions within these key accounts instead of simply selling to give us cardiac rhythm management business with one of our key customers we now consult to orthopaedics modulation or therapy delivery businesses combined. We’ve taken great strides in diversifying Greatbatch and we will continue to integrate these new businesses and look for ways to drive both near term and long term revenue gains.

The key element of our strategy is focused on streamlining our operations and optimizing our production. In Greatbatch we have a history of successfully optimizing and consolidating our operations. We’ve already identified and implemented several key initiatives to enhance the operating performance of these new businesses and move them closely to our operating model.

As evidenced by the substantial proven and our adjusted operating margin this quarter, over the first quarter of 2008 we have begun to realize several of the benefits immediately. We’ve approach this initiative on several different fronts and then want to provide an overview of our plan for the next 24 months.

First, let’s review some of the initiatives and accomplishments in both the medical and commercial facilities. As of last month, the Columbia manufacturing facility has been closed. We have completed the expansion of a new research and development center in Western New York near Buffalo thereby illuminating the need for at least facility. In addition, we are in the process of finalizing the construction of the commercial manufacturing plants in Raynham, Massachusetts, the opening ceremony scheduled for later this month. This will enable a significant capacity increase over the Kent Massachusetts facility.

During the quarter we announced that will discontinue manufacturing operations in Suzhou, China in the third quarter of 2008 and our operations in Orchard Park New York will be consolidated into existing listening our facilities.

Given the significant increase in our size, we’re working aggressively to rationalize our supplier base and to take a more strategic approach with these relationships, essentially allowing us to contract more effectively and increase our buying power.

Additionally, we have begun integrating our cost to company into a common ERP platform with three of the acquired companies already completed Enpath and Quan Emertech scheduled for completion in the third quarter of 2008. This will allow us to continue to centralize our back office finance and our IT functions.

Just looking at the companies that we have acquired, we’ve seen enormous amount of capabilities and opportunity that can be realized. At the high level we believe we can align our R&D spending with the right growth market opportunities, generate additional sales volume cross selling and other initiatives, implement manufacturing initiatives and supply chain improvements and will generate immediate gains and provide ground work for future improvement, as well as leverage opportunity in source key component parts. We currently spend approximately 8% of our sales revenue on annual basis in research development and engineering. So we are very focus on technology innovation. This investment in R&D will unable us to maintain our leadership position in core markets, got new market growth opportunities and potentially provide additional cost savings across our growing portfolio. We will reinvest some of that money in an appropriate level not only to drive profitability but obviously to drive future prices augments as well.

One recent example of our success is our investment at MRI compatible technologies. This suite of products consists of three parts, first, nonmagnetic component materials design to mitigate diagnostic imaging artifacts. Part two is an advanced EMI proximal fit filtering to shield implantable post generator some strain appearance in noise and an MRI environment. And the third part that we will highlight today is our enable technology which addresses patient safety for anyone with an active implantable medical device that must undergo an MRI procedure.

Our new product is designed to eliminate the potential for lead wire tip heating and minimizes the potential negative impact on the performance for certain implantable medical devices. We are currently completing the developing of our enable Brady Pacing lead wire which incorporates this technology and realize a significant product synergies resulting from our acquisitions of Enpath Medical and Quan Emertech in late 2007. Initial rounds of testing or functional prototypes have proven our technology is effective in blocking MRI specific frequencies harmful the patients with implantable medical devices.

With 35 million MRI procedures performed in the United States on yearly basis, 50 to 70% of active implantable medical device stations requiring an MRI in our lifetime, you can see there is a definite market and a need for this type of technology.

In May of 2008 we announced the execution of a letter of intent in which the Sovereign group will leverage our enable technology for the future cardiac rhythm management devices. At the same time, we continue explore and develop similar relationships with other customers in both the CRM and neuromodulation space and they are exited to share the positive results obtained during our last rounds of testing. Lead wire system is just one aspect of our goal to continue to deliver innovative solutions for our customers and improve the functionality safety and efficiency of our products.

Based on our current portfolio in research and development activities we feel we are in a strong competitive position for future growth and profitability. The acquired markets are going faster than our stored cardiac rhythm management market and remain confident that the diversification strategy was the right move to make. We are hopeful that CRM business can deliver future growth opportunities given continued underlying product demand and our ability to deliver innovative new products solutions. We are moving aggressively to ensure we consolidate our operating profitability and take advantage of increased market growth across all of our product lines. We’re evaluating and looking for cross selling opportunities amongst our customer base and continue to leverage oru technology as we worked toward selling more customized components and lead systems in a future. In the meantime we remain dedicate to executing on our long term plan, streamlining our operations and integrating in developing a new product lines.

I will now turn the call over to Tom Mazza to review the financial results.

Thomas Mazza – Chief Financial Officer

Thank Tom and good afternoon. Sales for the second quarter were inline with our expectations and reflect to the contributions of our recent acquisitions. We reported approximately 142 million revenue. Of this record amount, acquisitions contributed over 64 million. Excluding acquisitions sales for the second quarter of 2008 increased by 1% over the prior year which is primarily due to higher Electrochem sales offset by slightly lower sales of CRM products.

Second quarters sales for the implantable medical components business segment were a 121.5 million, an 80% increase over the prior year quarter and a 90% increase over the first quarter of 2008. IMC results for the second quarter 2008 include revenue of 56.8 million from our recent acquisitions. The cardiac rhythm management and neuromodulation product lines reported revenues of 64.8 million, a 2% decrease compare to the second quarter of 2007, however, a sequential increase of 11% from the first quarter. The second quarter benefited from the increased adoption of our Q Series high rate ICD batteries as well as higher feedthrough and assembly revenue. However, these benefits were mitigated by lower demand for coated components, due to a customer recall unrelated to Greatbatch products, and lower capacitor sales. You will recall that the second quarter of 2007 includes an increased level of capacitor sales due to a customer supply issue in the first half of 2007.

Second quarter revenues for the Therapy Delivery product line were 15.8 million, compared to the prior quarter revenues of 16.5 million. This 4% decrease was primarily due to lower sales of introducers and leads.

The Orthopedic product line reported 41.0 million in sales for the quarter compared to 27.8 million in the first quarter of 2008. This quarter's results include the full impact of Chaumont manufacturing facility, which was acquired in February 2008. The sequential increase also reflects our efforts to clear the bottlenecks existed within the Orthopedic manufacturing operations, which were delaying deliveries to our customers and negatively impacting our sales and operating profitability.

Switching to our commercial business. Second quarter sales for the Electrochem business segment were 20.1 million compared to 10.9 million in the second quarter of 2007 and 19.6 million in the first quarter of 2008. The increase in sales is a result of the acquisition of EAC in October 2007 and increased demand in oil and gas market. As intended, our acquisition strategy has enabled 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.

Turning now to expenses. Our selling, general and administrative expenses increased 7.9 million over the prior year including 6.1 million related to acquisitions completed in 2007 and 2008 and approximately $3 million in incremental legal expenses related to a lawsuit from former Enpath Medical.

Research, development and engineering costs for the second quarter were 7.7 million, inline with expectations and lower as a percentage of sales versus the prior year. R&D costs also decreased as the company recognized the function as part of its overall plan to streamline operations during the second quarter of 2008.

Other operating expenses incurred in the second quarter of 2008 were 2.9 million and were primarily included cost in connection with various consolidation initiatives and the integration of the newly acquired businesses. We anticipate that these cost would continue and potentially increase over the next 24 months as we move aggressively to integrate our newly acquired businesses and consolidate resources to improve the overall operating performance of the company.

Adjusted operating income was 14.2 million, a sequential increase of 150 from the previous quarter and consistent with the prior year. Adjusted operating margins for the second quarter of 2008 were 10%, up from 4.5% for the first quarter of 2008, but down from 18.1% in the prior year period. Recent improvements in both operating income and operating margin were driven by operations streamlining efforts and increased sales.

As a result of the acquired in-process research and development write-off not being deductible for tax purposes and the expiration of the research and development tax credit, the effective tax rate for 2008 is expected to be approximately 37%. Ultimately our adjusted operating income translates to an adjusted earnings per diluted share of $0.30 in the quarter compared to $0.42 per diluted share in the second quarter of 2007 and $0.16 per share in the first quarter of 2008. These results exclude the impact of acquisition-related charges and facility consolidation, manufacturing transfer and system integration expenses.

More importantly, the progress made on our strategic initiatives and our results for the second quarter give us confidence that we are inline with our original range of expectations for the full year. We are continuing to guide in the 490 million to 530 million for revenues and on an adjusted EPS we are continuing to guide in the range of $1.20 to $1.50.

For CapEx, we are projecting a range of 50 to 55 million. We remain extremely confident in our ability to execute on our operating efficiencies and sales growth initiatives. While many of these initiatives are term in nature and will be completed over the next two to three years. We feel we can continue to improve on our operating profitability from the current levels by a couple hundred basis points a year over the next three years. We remain excited by the prospect we see for Greatbatch in both the year and long term, and we look forward to driving growth and profitability for the company and our shareholders going forward.

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

Question-and-Answer Session

Operator

Thank you, sir. (Operator Instructions). And your first question comes form line of Jason Mills with Canaccord Adams. Please proceed.

Jason Mills

Hi Tom thanks for taking the questions, can you hear me okay?

Thomas Hook

Yes, we can.

Jason Mills

Great. Tom your orthopaedics business was quite good in the quarter, clearly J&J reported out of their unit pretty strong second quarter results with, I believe the shoulder and health products. But I wanted to get a sense for whether we should expect to this level of sales, this run rate on a go forward basis or where there any onetime order your you mentioned that you were backloaded obviously and you got out from under that, is 41 million a good sales run rate or are there any onetime sort of back feel that we should back out to get to what we should expect on a run rate going forward?

Thomas Hook

Well, I assume you mean Tom Hook and Jason but I would say is just that will be sensitive to a few things, we highlighted after the acquisition that we’re going to focus on releasing some of the backlog that had build up in the Shamond plant and we’re going to work very hard to streamline operations there in which we’ve done a very job of making ground there, its certainly is an implemented 100% but we may ground – and we have to be sensitive to the translocation will have a shutdown in the summer months in Q3. So sometimes there is little bit of push, before than little catch up following it in terms of the year. But obviously we are learning more about that operation, we’re confident we have the ability to run on smoothly, I don’t think its dramatically above where we expected and although obviously from quarter-to-quarter be a little bit lumpy and we had very strong second quarter and we think it consistent with what our plans were over the calendar year and its coming in strong which is good news, I am not sure I can really give you a more color on that or I would feel comfortable as I am not sure we have the ability, you have to really be very predictive about that business. We’re just confident that orthopedics is growing healthy. Depue has got a very good products on bringing the market the (Korei and the Delpha) in particular we feel confident that we’re just going to do a very good job on the operating side of delivering for them and not let the backlog challenge their sales growth and we’re just going to focus on really pushing things through the plant for them efficiently and effectively.

Jason Mills

Thanks for that call Tom, I have a little bit of recall that I don’t know what it sounds like but that’s what I meant to say, I am sorry about that. So moving on from orthopaedics to CRM, the – a couple of your customers have already reported their calendar second quarter, it isn’t great relative to where we saw growth rates obviously in 2004 and 2005 temporary, but we have started to see some improvement here in the second quarter although you had a difficult comp and capacitors you were down year-over-year and I appreciate of you don’t breakout your trends by customers, but perhaps you could give us some color with respect to – I guess I will just mention it, Boston Scientific which advanced about moving some of their battery business in house in lap. In the ensuing quarters and I don’t know that has any impact or not, but one of your biggest customers at this point saying, dude, you certainly have good quarters. So I am trying to understand exactly where that business is relative to where the market is telling growth is the present time?

Thomas Mazza

Certainly, I try to give you may be a macro over relative that would helpful will be helpful I have seen a lot of encouraging signs globally and customers at the international markets are still healthy, domestic market seemed to be recovering, pacing, seems to be particularly strong and we have got a very good job of focusing on each of our key customers at delivering the products they need and also new product technology.

Now again, as we were not 100% at the time on all projects, so there is definitely competitive threats out there that have been challenging for us. I think comparable from us are particularly challenging this quarter for one of the things you pointed out as we had a one time pickup, though we call though in the first half of 2007 to sell the capacitors thus that we didn’t repeat.

Jason Mills

Right.

Thomas Hook

It's also important that you remember is that we have a very larger amount of revenue that’s tied up in coded components that has been suspended this year until we get kick off that product line with the customer that’s kind of going through the FDA loop right now and the product line to get it re-qualified. So there is kind of two effects both of which tended to be large, they are a little bit more challenging for us and I think it makes kind of -- it look our output and CRM look flat, but if you adjust for that actually, I think its consistent to look healthy that the market is coming back somewhat, maybe a little bit more on the pacing side than the tubulation side. But we see good activity with all customers and here we see a product development funnel fairly full as well with opportunities. I am so encouraged that we think the broader portfolio from adding any acquisitions opens up more opportunities than before. I would agree the management and neuromodulation, so I continue to see those as very good markets and is we have been very successful at partnering with some of the European customers as well at brining in new product technology. So overall I think we have been quite satisfied that the positive signs of the market are coming back. And although we are probably the numbers we are reporting aren’t really representative of that I think it's really clouded by those two special circumstances.

Jason Mills

Great.

Thomas Hook

That I think Eric, that will mislead you when you look at it.

Jason Mills

Okay. That’s really helpful color. This is a little bit hard to tease out of what you report. So just one final and I will get back in queue. Tom on the P&L, you mentioned in the press release you expect 37% effective tax rate for the year that would imply given what you reported to get to $0.16 in the first quarter and they why you reported here in the second quarter that for the back half of the year you will booking the tax of 50% each quarter, is that correct or perhaps you could help me in understanding that? And then secondly, you obviously did not pro forma out the $2.9 million litigation expense which I wouldn’t would recur, but perhaps you could correct me if I am wrong there and if that did not recur you are running at about 16 million SG&A which I am wondering is a good level to sort of model going forward on that line? Thanks guys, good quarter.

Thomas Mazza

Thank you. Yeah Jason, I think you are spot on, we will allow the analyst to figure out whether or not they want to give us credit for the 2.9 million, we don’t expect certainly to increase it, to continue at that level in future quarters. There will be some residual legal expense, but certainly not at the $2.9 million level. We expect our overall tax rate for the full year to be at 37% that includes the IPO and de write-off. On an adjusted basis, we are actually -- we should be on an adjusted basis be approximately 34% when you take out the in process R&D.

Jason Mills

Okay. So 34% is what your 120 to 150 guidance is predicated on and that guidance also leaves in the 2.9 million litigation. Am I right on those two points?

Thomas Mazza

Yes, you are. Correct.

Jason Mills

Okay. Thanks guys.

Operator

Your next question comes from the line of Tim Lee with Piper Jaffray. Please proceed.

Tim Lee

Good afternoon. Thanks for taking the question. Just want to followup on the orthopedic product sales and I appreciate this quarter variability that, I mean is there any backlog left at this point that we could see just continue to bullish in the third quarter or just any color on that front?

Thomas Hook

Yeah Tim, I would just tell you, the answer is yes, we still have ground to cover to continue to relieve that and you have to remember that also and obviously because the product launches are going on from our key customer out of Shamond are being received by the market very well and are being very successful combined with the fact that we have a little bit of summer shutdown there, which is typical in France. Operationally, we are going to continue to have backlog and we got the operating focus in some of the Greatbatch expertise working with the management team out there to continue to relieve that. So I expect that business to be strong for the second half of the year as well given that we are still going to continue to leadoff the backlog and keep up with the demand is being driven by the market for those products at our customer and we just have some of our best operating talent in that plant and focused on that right now exactly because of that. So we expect it to be good for the second half.

Tim Lee

Thank you. And in terms of the P&L impact or the Orthopedic business, I mean, should we think about that product category is than the corporate group less than the corporate gross margin? So as that does well -- I mean, does it put pressure on the gross margin line?

Thomas Hook

I mean, I will just say that from a gross margin performance standpoint, it's below what we find is going to be acceptable in the long run. So we know we have to make strive for operating improvements not only to drive return to ops, but also value to the customers so they drive more volume. So the initiative, the operating initiatives are squarely oriented within the Orthopedics business for some of the Greatbatch, historical Greatbatch manufacturing expertise to work in concert with the management teams and the acquired orthopedics business is to work together to improve overall margin performance and also performance for the customers. So as the two things combine because we do that right, we definitely want up growing as our customers grow and then we will do it more profitably and reward both ourselves and shareholders as well as the customers to continue to drive more business. So we are not where we need to be in the initiatives, there is multiple initiatives underneath that all the way through the supplier base and the manufacturing et cetera that are focused specifically on improving it to be able to drive the long term profitability that we expect in the company and we are not there yet in orthopedics.

Tim Lee

Got you. Thank you. And there is one last accounting one if I may. I mean can you just kind of walk us through how the upcoming change in the convertible bond accounting is going to impact your reported earnings numbers?

Thomas Hook

Yeah, we haven't finalized the calculation on that yet. We are discussing -- we are looking on it. Potentially it's going to add to the interest expense and the range of interest expense is really how the calculation will run. We don’t want to guess where really the range is at this time, but certainly it would show up as additional interest expense prior to in the normal line report. So but that range hasn't been determined yet and we would call it out and certainly give details and then probably once the literature and how the valuation is to be calculated is finalized and we pursue all of our other options regarding that as well as far as our call options and other things, we would then determine what the expenses and then call it out on the next call.

Tim Lee

Okay. Thank you very much.

Thomas Hook

Okay.

Operator

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

Keay Nakae

Yes, good afternoon. My first question pertains to your medical battery sales. Tom, year-over-year, were they up?

Thomas Hook

I think in general medical battery is obviously is kind of management Neuromodulation and I think we are focused on doing as we go forward is less on individual product line details and revenue report outs and more on the segments that underlie them and it's a little bit of a shift from a reporting standpoint for Greatbatch and I think that way it's a little bit easier for us t talk about the macro businesses and less about the individual product lines and specific projects that a lot of times we answer questions on. So we are going to kind of make a little bit of a shift there and not give as much color on those things because we tend to get individual questions on rather than on a global perspective that is where we are like to start having more of the focus on.

Keay Nakae

Alright. Moving on to Enpath and Quan. Was there -- the sequential decline there, is there anything notable?

Thomas Hook

Well I think the one thing we have to be sensitive to use is that the litigation has been a large distraction, some of the profit on the activities in terms of product launches which obviously because that’s washing through the course right now, and that has really hurt our ability to commercialize some new products. We’re behind – while we are ahead orthopedics we talked about, we’re behind in some of the therapy delivery stuff in terms of our plans. So we are obviously putting over and trying to use some more incremental engineering focus to get some of the new product development programs back on track from the timing perspective, but your regress will behind what our plans are and we are focused on pulling that back in to be stronger for the second half of the year, because we’ve gone up to a slow start.

Keay Nakae

Okay. When we think about your adjusted EPS guidance, as we move into the back half of the year, what’s the low hanging fruit in the back half of the year that either drives gross margin improvement or reduced operating expense as a percentage of sales to hit your adjusted EPS guidance?

Thomas Hook

Yeah, well I think there is a several things – in the second quarter we were doing many initiatives on overhead rationalization, R&D rationalization and then we had a partial quarter effect of those. We will get full second half effect on those and clearly we are existing the over headquarters building and that expense goes away, we will be shutting down Orchard Park and Suzhou in the third quarter which will feed into the second improvements because our costing that rolls up both new production SG&A in those area will be eliminated. There is other projects that we’re going to end up announcing, some of the projects that’s finally the Columbia, Maryland, finally close down in the second quarter, so we will obviously longer see from this point forward any expenses associated with that. And so, I think there is a variety of things that have already been done that we get still the second half of your effects, there is projects that we have announced and it started and are rolling out in this third quarter that will get a percentage of effect on the second half and there is also new projects that we kind of obtrusively referred to here as other consolidations and other overhead reductions and we haven’t announced the started yet that we will in this quarter, the third quarter, and those will rollout over the balance of the year and also contribute the profitability, and that’s – all of that I would say is more on the consolidation and rationalization. I still think our opportunity is CRM continues to comeback and we continue to be on the need demand on the orthopedics market in particular and get therapy delivery product introductions back on track that we will also be able to take advantage in those growth drivers, and so, they have a lot of confidence in that, that’s why we have maintained the $1.20 to a $1.50 EPS guidance since the beginning of the year and our revenue guidance consistent with that. So, even though we had a weak start in the first quarter, we still see the opportunities is very rich, we’re behind in the few areas, we’re ahead in the few areas, we’ve a lot of work to do with and its not a slam Doug, and clearly we had a strong second quarter, we covered a lot of onetime legal expense arguably which we will have a lot less in the second half. So I have still got good confidence we’re commit in the range as we said we would and hopefully that so to speak pieces there gives you a little bit more confidence that we really do have enough fruit low hanging and at the higher branches that we can get to between now and we had a year to deliver.

Keay Nakae

Okay, thanks for that answer. With respect to Orchard Park in China location facility that you’re shutting down. Can you give us an idea what the annual expense savings there is?

Thomas Hook

Yeah, I want to be a little bit careful on the individual locations in that. There is obviously employee sensitivities and other things that play here, and there was transitions we’re kind of been progress, but I think it’s a reasonable question that as these things are done in the third quarter we will give you a little bit of flavor on what that is in hard numbers, and kind of aggregated base to see, and kind of see where the savings are coming from, but I am a little bit uncomfortable breaking it down and kind of specific detail.

Keay Nakae

Okay. One final question for you, in the commercial battery business. Can you give us a sense of what the margins for EHC look like relative to your prior core business; are they higher, lower, or about the same?

Thomas Hook

I would say dramatically less, that business is much more materials fees and labor, it’s very, very complimentary to the existing business we have, when we have a lot of great opportunities to drive improvement there we picked up some exceptional technical people in an acquisition. They have some very innovative products and opportunities and then I think the sales opportunity follow us very rich on that side and what we need to do is, is we need to integrate that into one commercial business mindset under the Electrochem banner or brand name that use in that business.

We have centralized the management team. We have been centralizing sales, marketing and engineering. And as an integrated group, are going after the opportunities that EAC business has brought us very aggressively and I expect historic margins in that business to continue to go up as we operationally execute better. And then combined with that obviously we have the IntelliSensing acquisition that was in Orchard Park in New York, it is the minimus sales revenue, but it’s a great new product that’s really at the verge of completing some prototyping and customer sampling and we expect that to be a nice product line that could also be sold along with the EAC type products in the market place.

The good thing about that is, we've already got a jump in the commercial area. We're already into a single management team construct and pushing sales opportunities. And now that we've got the new facility, and the new investments there, we have the appetite to consolidate into those, and we also have the ability to meet demand as we continue to grow sales and we just didn't have that in Canton. So we have really good -- we're on solid footing on the commercial market, but a lot of work to do.

Keay Nakae

Okay. Thank you very much.

Thomas Hook

Hey, thanks Keay.

Operator

You next question comes from the line of Jeff Englander with Standard & Poor's. Please proceed.

Jeff Englander

Good morning guys or good afternoon rather. Just a kind of followup to Keay's, but a slightly different take, can you give some sense of what your expectations are in terms of the ability to kind of drive the improvement process without a lot a lot of bumps in the road. You did a very nice job this quarter, certainly above my expectations in terms of rectifying some of the things you saw in the first quarter, you talked about some of the low hanging fruit and some of the operational people you put in place, it sounds like you've been very aggressive in terms of some of the changes you've made. And I'm just wondering, what degree of confidence you can give us that this is going to have some linearity to it.

Thomas Hook

I mean, I think as much as I would like that -- you know, there's a lot of individual projects going on right now, they do have discrete numbers associated with them. I think it would be a misnomer to say that we're going to be able to get a linear behavior, that's going to be smooth. But that’s not to suggest that’s it's not predictable. We have very detailed managerial plans, that time out, the individual projects so that we do have predictability in the financial results, we try to stage the projects to be able to take and look at the overall work load and managerial load, be able to handle the appropriate number at the appropriate time. But the savings, because there is different opportunities and different projects for savings, and the quarter points, sometimes depending on the timing of the projects can spill shipments and revenues to different sides of the quarters, it's hard to get a real smooth linear relationship in terms of things like earnings growth. So as best we can, on the big projects, when we start those big projects, we go through the best we possibly can to talk to the magnitude of them, so that there is some color on why things are not going to be linear. I don't -- I only expect one, maybe two of those programs, most of them, I think will be smaller, scope programs, that we'll do, that are more individual facility shutdowns, we'll talk to them on a completed basis, and I don't think they're going to create a lot of major jumps in terms of numbers. So I think the progress, because we're a larger company now, there is more programs, we have more locations and there is more initiatives running, it will be smoother than history, while still on the big projects, we need to break out a little bit of color on those, so that there is some understanding as to why a shift would have taken place. And we just don't have any of those right now to talk to.

Jeff Englander

Great. Thank you, that’s very helpful. Also, and I apologies if I missed this, I had to hop off of call for a few moments, can you talk about any orthopedics as to how many may be in a quarter sense how long you expect the backlog to continue through.

Thomas Hook

My hope would be that there's two sources I think of pressure here, one is the successful product launches of our customers that drives a backlog, as well as what I would call historic backlog, it's there's and we're working very hard to relieve that backlog after acquiring the manufacturing facility to be a very good supplier for our customer. So relief of the historic backlog has been envisioned we wanted to be able to relieve that over the course of the year. Obviously, the successful product launches has exacerbated that situation, so I still think it will bleed off the backlog, the historic backlog over the course of the year, and I think we'll be able to maintain pace with the market growth in the second half of the year. So I expect that as we exit 2008 we are going to have that manage successfully with our customer. And we're making the investments both in the managerial team as well as the facility to make sure we can do that. So I don't expect it to result in blowout numbers in 2008, we're trying to do this over a 9 month period of time. We've made great progress in the first three months, and then we got six months left to go. And then we'll be more of a predictable synchronized rate with what the sales demand is going to be which obviously right now is quite healthy, but I kind of view that as an effect we're going to manage over 2008 and then I want to be more on a clean basis, working on new product developments with our key customers out of that facility for 2009. And that's essential to have it done in 2008 because of that.

Jeff Englander

Great, thanks very much. Appreciate the help.

Thomas Hook

You're welcome.

Operator

(Operator Instructions) And your next question comes from the line of Stanman with man investments. Please proceed.

Stanman

Good quarter, gentlemen, I have several questions, one, when I look at your current gross margin and your operating margins, it seems to me that we always talked about getting to 20% operating margin and you were almost there. If we move margins to normal 40 and the way you're moving on SG&A and R&D. It seems to me that we can expect moving toward a 20% operating margin in the near future. Do you kind of agree with my modeling?

Thomas Hook

Yeah.

Thomas Mazza

Stan, this is Tom Maaza. We basically have put out there that we think we can do 2% a year for the next three years, so it's going to add another 6% on the operating margin line, you know, can we do better than that? I mean, that's the goal post we've put out there for now. Clearly over the longer time frame, we get additional volume and stuff, potentially we could even do better than that.

Stanman

Alright. But, can I just add something, the model you put out last year before the acquisitions moved you to about a 13% top margin for 2008, and if my numbers are correct, in order to get $1.50, you need to be close to 12. So 12 and 6 make 18. And I'm talking about maybe a four-year frame, and I really would like to hear Tom answer the question. Tom Maaza.

Thomas Maaza

Yeah, I'd be happy to. I -- you know, in November when we talked obviously, there was two kind of basic assumptions there, what the mix of the business was going to be post acquisition, and what the per share accounting was post running those numbers and adjustments and digesting that down through the financials, so I -- obviously, we know we started out the first half of the year at, I kind of view that as, you know, first half year is the starting point. I see we have the programs and initiatives that sequentially improve that by a couple hundred basis points a year, we obviously have 2, 3 years of hard work to do. I would say that we are not -- we don't want to be optimistic with regards to growth in the underlying markets, because we think that can -- we're going to try to plan ahead for growth. We should be planning ahead for capacity. We should plan conservatively for growth, which is what we've done, so we don't want to rely on a lot of growth to come to us to be able to get these gross margin and operating margin profitability. We just have to do the hard work in the manufacturing environment to perform that, and that's what the couple hundred basis points is predicated on. It's not just driven by a big bowl us of sales over the course of the three years, it's driven by hard operating cost reductions and consolidations that drive technology adoption as well as elimination waste and manufacturing, we've already got a start on those things, we already shut multiple facilities down, we're already showing, it's not like I want to just wait to the second half to show progress. But you're absolutely right, there's a way for us to get back to our historical margins on the gross margin basis as well as get back toward the operating margin target of 20%, which will continue to say is a long term goal, and I will say, if you obviously were a big believer in us, and following us to that point, following the first round of consolidations, we obviously have diversified and become a broader company, but we have the operating talent and skills, we have a very talented operating team to deliver this on this round of consolidations.

Stanman

So the mix of blue businesses, can give us the potential in time of the 40% gross margin which has been traditional, even with this mix, moving forward, possibly.

Thomas Maaza

Yeah, I think less in terms of gross margin than I do operating margin, because the flavor of businesses is different in each segment in terms of what we make. But I would agree with your statement that in the long run we can become a 20% operating income business and we can make these new markets that we've entered. We can use our operational expertise in concert with the technical and business expertise in the acquired companies and work together to obtain the 20% operating income number. And that is the long term objective and I say it long term, but I do mean to suppress that in Ernest with the consolidations over the next three years.

Stanman

Okay, second question on ortho, your competitor in outsourcing ortho has been growing over 20% a year. Double-digit, let's say double-digit, I know that you're -- the business that you bought estimate is a European based ortho business, I believe, do you see that type of growth rate for that particular business ortho -- the orthopedics?

Thomas Maaza

I think what we did, we tried to break out a little bit of color in terms of what we thought the underlying growth was going to come from in orthopedics, we said 10, 12%, I think a couple things we're conscious of up here is, we obviously like to do designs of technology in which we are able to do the research, develop those technologies and sell them out into customers. It tends to be a little bit different model than when we're actively functioning like a pure outsource or contract manufacturer, so the flavor of the business in orthopedics has two different elements with in great batch. The areas where we want to do more research and more innovation on, and we expect those to be higher margin products because we're making investments in those areas, I would say yes, there's certainly other competitors, in this market space that may have higher unit sales and higher sales in terms of growth because they're more well in established, they're in broader geographies and I think that's why, because we think we're very good at this, this is an attractive place for Greatbatch to be, we're not going to win 100% of the time, but we think there's plenty of opportunity out there for us to grow this aggressively at double-digits for multiple years, because we're going to put the operating and engineering system behind coming very good and there's more than enough room for another competitor in this marketplace that knows how to do it well. We'll never win the majority of the business, we'll earn our fair share and I want to be profitable in that fair share, so I'm -- we want good double-digit growth rate, but we want quality growth rate that comes with good margins that returns to the shareholders.

Stanman

Okay, my last question, on MRI, you indicate that it's a -- you have a proprietary; you have an intellectual property position on the MRI technology. You indicate that you've got a relationship -- development relationship. Do you have any feel at all for commercialization of the initial product utilizing your MRI technology and CRM and the type product?

Thomas Hook

I think we have a deal for it, but we will only commercialize through our key OEM partners, so we view it much like we would an individual component. A capacitor or feed through, we view as, it's a subsystem that we're able to do because of these acquisitions -- we can take the lead wire expertise combined with our filtering expertise and offer a more system solution, it speeds product development and allows us to partner more closely with OEMs. So we will only work through them at commercializing it, we’ve had very good discussion so far, it is very early in the game, its only been the last couple of months that we have actually done that. The systems testing that show them results we have a lot of work to do with them in terms of integrating it into their product plans, and I think while we are doing that we’re working with them to get a flavor of what that end market opportunity. So we’re kind highlighting it as a wonderful technology. We have not yet determined clinically and cant do that without our key customers helping with us and working together to say what the real value is and from a clinical setting over the long run in the overall market.

Stanman

Do you see a US manufacturer tying in with you at this point other than Sovereign?

Thomas Hook

I think we will able to an active discussion with every CRM and neuro modulation customers and we think it’s a very broad technology and we think its got opportunities everywhere. We’re working and understanding where we need to be from a cost and performance standpoint, in other word, what filtering is not important, what’s the cost of manufacture, obviously, we have to make sure we have a durable risk free design. So I think all those things we’re actively working on now and I do expect thus to make progress with customers in US markets as well both in a variety of not just in the CRM market but also neuro modulation space with arguably the more important.

Stanman

Okay. Thank you, good job gentlemen.

Thomas Hook

Thank you.

Operator

And that does conclude today’s question and answer session. I would like to turn the call 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 does conclude today's conference. You may now disconnect. Have a great day.

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Source: Greatbatch Inc. Q2 2008 Earnings Call Transcript
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