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Orthofix International N.V. (NASDAQ:OFIX)

Q2 2008 Earnings Call

August 8, 2008 11:00 am ET

Executives

Dan Yarbrough - Vice President of Investor Relations

Alan W. Milinazzo - President, Chief Executive Officer, Director

Thomas Hein - Executive Vice President of Finance, CFO

Analysts

Vincent Resee [ph] - Wachovia Capital

Jeff Huntington - Jefferies & Co.

John Putnam - Dawson James Securities

Steve Ogilvie - ThinkEquity

Jim Sidoti - Sidoti & Company

Operator

Welcome to the Orthofix International guidance conference call. (Operator Instructions) I would now like to introduce Dan Yarbrough, Vice President of Investor Relations of Orthofix.

Dan Yarbrough

Good morning and thank you all for joining us today to discuss Orthofix International’s financial results for the second quarter of 2008.

During this call we will be making forward-looking statements that involve risks and uncertainties. All statements other than statements of historical fact are forward-looking statements including any earnings guidance we provide and any statements about our plans, beliefs, strategies, intention, expectations, objectives, goals, or prospects.

Factors that could cause actual results to differ materially from the forward-looking statements we make on this call include the risks disclosed under the heading Risk Factors in our 2010 Form 10-K and subsequent form 10-Q that we file with the SEC.

Presenting on this mornings call will be Orthofix’s CEO Alan Milinazzo and our CFO Tom Hein.

Alan Milinazzo

As you have hopefully seen we issued two press releases earlier this morning: one related to our exciting new agreements with Musculoskeletal Transplant Foundation or MTF and the other discussed our second quarter results. We will talk to you about both of those announcements this morning and I will also give you some details about an investor day we are planning for New York City on September 8.

Let me begin with the second quarter results. Total revenue of $130 million was within our range of expectations and represented growth of 5% over the prior year. Revenues in our orthopedic division grew an impressive 19% year-over-year. Within this division sales of our

Physio-Stim products were up 16%. As I noted in our previous call, this product has become one of the cornerstones of our revised orthopedic strategy.

The 16% growth in Q2 comes after Q1 growth of 11% which is a positive indicator for the full year. Also in orthopedics sales of our internal fixation and deformity correction devices grew 39%. Sales from these faster growing internal fixation and deformity correction devices made up about 26% of our total orthopedic segment revenue, which is up from about 22% of the total a year ago.

After exploring the potential divestiture of fixation assets earlier this year, we ultimately decided it was in the company’s and shareholder’s best interests to keep these products and accelerate our plans to include the profitability by focusing on higher margin products in targeted geographic areas. I am pleased to be able to report that through the execution of these strategy changes, we are beginning to see the positive impact noted above. Also, we were able to achieve these strong results due to our dedicate employee and sales force base which has remained with us as we have implemented our strategy.

Moving on to our sports medicine sector, revenue rose 9% compared with the second quarter of last year; however recall that we sold our infusion pump business at the beginning of this year in order to focus on our knee bracing and cold therapy businesses. Sales of those products continue to increase far in excess of the overall market at 14% year-over-year. We are benefiting from the successful launch of our new Kodiak cold therapy device earlier this year, as well as the continued success of our unique lines of fusion functional knee braces.

Over the last two years our sports medicine team has focused on accelerating the pace of new product introductions. As a result, looking into 2009 we have a number of product launches planned for this business which we expect will help us maintain an above average growth rate.

Looking next at our spine business we experienced some mixed results here in the second quarter. Our spine stimulation franchise reported another solid quarter with a 13% increase in sales as both our lumbar and cervical spine stimulation devices continue to drive above market growth in this segment even as our market share grows beyond 50%.

Finally, with regard to our spinal stimulation business, our dedicated sales force increased both the total number of physicians who prescribe stimulators as well as the number of prescriptions per physician. This is a key operating indicator we track to forecast future demand for our stimulators.

Moving on to our implant business, revenue from our spine implant and biologic business was 9% lower than the second quarter last year due to a decrease in sales of our metal implant devices. That decrease was partially offset by an increase in biologic revenues. The decrease in implant sales is primarily a result of the ongoing transition of our spine distribution network. Our hybrid sales force now includes 17 direct sales representatives. At the same time we are continuing to take steps to strengthen our network of independent distributors.

Looking deeper into some key operating metrics for the quarter, there is some encouraging data. Although the total number of distributors in our spine distribution network has decreased year-over-year, the average sales per distributor were actually 5% higher. This would suggest that once our direct representatives begin to become effective, we should start to see the total business return to anticipated growth levels.

Another key operating metric in our implant business is the number of discreet physician customers using our products. We are encouraged by the physician interest in our implant and biologic products. During the second quarter we continued to see new physicians use our products; however it is evident that the ramp up of revenue from new accounts and new users has not met our original expectations at this time. This is due in part to the disruption we experienced directly after the announcement of the Osteocell product line being sold to Nuvasive. We believe the announcement we made this morning regarding our collaboration with MTF has the potential to play a key role in enhancing our ability to accelerate revenue in 2009. I will discuss this new agreement more in a few minutes.

As we discussed on our last earnings call we expected revenue from our vascular business to be down in Q2 as a result of inventory level adjustments at Covidien the US distributor for our foot compression product. We believe this inventory adjustment process has been completed and would expect to see improved revenue growth in this sector in the third quarter.

Summarizing our sales performance for the second quarter, although our spine implant and biologic business was below our expectations in Q2 we continue to be extremely encouraged by the performance or our spine stimulation, orthopedic, and sports medicine business units. Year-to-date about 73% of our total revenue has grown at an average of more than 14%. This handily exceeds the 10 to 12% growth projections I had forecasted for these businesses when I began to implement our organic growth initiatives back in 2006. We believe these growth rates reflect a positive impact of a number of strategic activities that have taken place over the past several quarters: these include product launches, distribution enhancements, and key management initiatives focused on driving our top line across all segments of our business.

Moving onto second quarter earnings, our reported earnings per share of $0.34 was above both our range of guidance and above the consensus estimate. This reflected the positive impact of our strong revenue growth in our stimulation, orthopedic, and sports medicine sectors. Excluding non-operating items related to our strategic initiatives and corporate relocations our adjusted net income was $0.39 per share and our adjusted net income excluding specified non-cash items was $0.67 per share.

As this morning’s earnings release indicated, though we are maintaining our total revenue guidance for the year, we are revising the components of total revenue generated from our various business units. We now estimate the total revenue from our spine division will be between $250 to $260 million, broken down between stimulation revenue of $139 to $144 million and implant and biologic revenue of $111 to $116 million. We are increasing revenue guidance for our orthopedic business to $128 to $134 million and we are also increasing guidance for our sports medicine business from $94 to $96 million.

Additionally, we are revising our full year 2008 earnings guidance as a result of non-operating costs associated with both our previously announced acquisition of the intellectual property from intelligent implant systems or IIS and today’s announcement regarding MTF, as well as the expected operating impact of our ongoing initiatives to transition and strengthen our spine distribution network.

Our new estimate for the full year 2008 reported EPS is $0.65 to $0.75 per share; this includes the costs we incurred in connection with the fixation asset divestiture we explored earlier this year, which totaled $0.23 per share and it also includes payments associated with the IIS and MTF transactions that we estimate will total approximately $0.43 per share as well as an expected corporate reorganization expenses of about $0.12 per share.

Our new guidance for full year adjusted net income, which excludes these non-operating costs, is $1.43 to $1.53. Our revised guidance for adjusted net income, excluding specified non-cash items, is $2.53 to $2.65.

Obviously we are disappointed with the lower earnings guidance for the second half of 2008, but we continue to believe the steps we are taking to enhance our spine distribution network and the investments we’re making in new spine implants and biologic products, both from organic and inorganic perspectives, are necessary in order to create a unique broad based portfolio delivered through a dependable, high quality, distribution network.

Moving on to some other key financial metrics from our press release, our consolidated gross profit margin for the second quarter and year-to-date were 73% and 73.2% respectively. This is a 20 basis point decrease when compared to the respective periods. The decrease is primarily due to a higher portion of total sales coming from outside the US where margins tend to be a little lower than those in the US as well as a higher amount of US biologic sales, which also tend to generate lower than average margins. The decrease also reflects the continued negative impact from currency. We expect these trends to result in a revised full year gross margin ratio of 72 to 73%.

Our effective tax rate in Q2 was 28%, which is below our 33 to 34% full year guidance. The lower tax rate in the second quarter was primarily the result of lower projected taxable earnings from US source income which carries a higher tax rate than foreign sourced income.

Finally, in connection with our revised earnings expectations for the remainder of the year, it is likely that we may not meet the financial covenants in our credit facility as measured at September 30 and December 30 of this year. We have already begun discussions with our bankers regarding a waiver or amendment to the credit facility during the third quarter. Obtaining a waiver or amendment could result in fees or additional interest expenses from our lenders and this impact has been included in our revised earnings guidance for the remainder of the year.

As planned, we have proactively ended our relationship with some spine distributors this year and we are encouraged by the quality of the new distributors we have been able to attract in each case. We believe these changes will enhance our network going forward. We have also been successful in achieving the planned build up of our direct sales force this year, which will allow us to now focus our efforts on accelerating the ramp up of revenue associated with these new hire’s and continuing to work through the negative impact of the announced sale of Osteocell and the offsetting benefits we expect to see from our new partnership with MTF.

We are committed to building a spine business that will produce sustained, long-term growth as part of this attractive and highly valued segment of the orthopedics industry.

I want to spend a few minutes discussing the other press release we issued this morning announcing our new collaboration with MTF to complete the development and launch a unique stem cell-based allograft. We are very excited about this project for a number of reasons. First, MTF is by far the largest and most highly respected tissue bank in the United States. In fact the foundation is a national consortium comprised of academic medical institutions, organ procurement organizations, and tissue recovery organizations. They are truly experts in supplying life-changing grafts for transplant that are derived from the gift of human tissue and they have unique expertise and scale associated with the research and development needed to fulfill their mission.

MTF history of successfully partnering with companies to make treatments available to surgeons around the world provides Orthofix with a very compelling opportunity. Over the last 20 years they have distributed more than three million tissue grafts for transplantation. We began discussing mutual opportunities with MTF approximately one year ago and through those discussions we learned of MTF’s considerable pre-existing project work and interest in stem cell based allografts. These discussions and relationship that have been built in the last year have resulted in the agreements we announced today.

Our collaboration with MTF calls for us to invest up to $10 million toward the completion of the development of the stem cell based allograft designed to enhance bone growth in a number of orthopedic settings. Six million of that has been paid up front and the two remaining payments are milestone based. After completion of the development phase we will work together to make the new allograft available to spine and orthopedic surgeons around the country.

Importantly, Orthofix will not be involved in the procurement, processing, or storing of tissue as part of this collaboration. We are leaving that to the experts. Orthofix has obtained exclusive global marketing rights for the allograft in all fields of use and will receive a marketing fee for the tissue distributed.

I believe this partnership will build on the success we have had in creating one of the most exciting new product segments in the spine space. Physicians recognize the pioneering work that we have done in bringing a novel stem cell-based therapy to the market and the partnership with MTF increases the potential for us to bring even more clinical options to those surgeons in both the spine and orthopedic settings. We are incredibly excited about the potential that exists in this new collaboration.

Along with the expected launch of this new bone growth allograft resulting from our collaboration with MTF, we are also currently planning to add several other new products to our spine portfolio in 2009. These include a new pedicle screw system, a highly unique dynamic stabilization device and two new interbody devices.

Internationally we are currently launching our inner spinus spacer in select European markets and we expect regulatory approval for our Advent Cervical Disc in Europe before the end of 2008. We believe these new products will serve to further differentiate our spine portfolio in the market place and provide catalysts for our direct and independent distributor sales representatives to track even more physicians to our customer base.

As we move into 2009 our spinal implant portfolio will broaden and give us a number of potential entry points into new accounts

I would like to make a few more points about Q2 before I open the line to questions. As you will recall, on June 30 we announced the promotion of Brad Mason to the position of group president North America. His main responsibility is to identify and enhance the synergies between the company’s spine, orthopedic, and sports medicine businesses in the United States. This will include accelerating ongoing initiatives designed to optimize the integration of Blackstone Medical. His experience in successfully developing both a sustainable new product pipeline, along with maximizing the effectiveness of a hybrid network of direct representatives and independent distributors in a highly competitive market underscores his ideal fit for this important position.

As we think about the next 12 to 18 months, the strategic investments and distribution and customer programs in our spine implant biologic businesses are fundamentally important to providing what we expect will be a platform for sustained long-term growth in this attractive and highly valued segment of the medical device industry.

We will look forward to providing more detail on our strategy, product pipeline, and distribution initiatives during our investor day we have planned for September 8 in New York City. Dan will be providing details for that event in subsequent communications.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Vincent Resee [ph] from Wachovia Capital.

Vincent Resee [ph] - Wachovia Capital

My first question is going to be on the turnover and kind of transition that you still have going on with your spine division. Specifically you gave us 17 direct reps, I mean how many feet on the street do you have and what percentage of that is around exclusivity now?

Alan Milinazzo

I don’t think we’ve given a feet on the street number before, but as you know we’ve talked about exclusivity in the past and we don’t have a tremendous number of independent reps that are exclusive. The direct reps we’re hiring are exclusive, so I would tell you we have 17 exclusive reps out there in the marketplace right now. The rest of the network, as we bring them on, we seek to bring them on as exclusive reps.

Vincent Resee [ph] - Wachovia Capital

How is that kind of proposition brought up with, what is it that attracts them to Blackstone at this point considering all of the things that you guys are going through?

Alan Milinazzo

I think the potential that exists for us over the next several quarters and years is still very evident to those that are in the middle of the spine business. It has certainly been a tough go from an investor’s standpoint here, but on the spine front I think we still have an ability and in fact we’ve had tremendous success in attracting new distributors and direct reps. We’ve got 38 distributors right now along side of 17 direct reps, so I think the potential for a highly differentiated biologic product, we think that the medal portfolio that we’ve got in development, the number of products that we have coming out as well as some of the existing products that are out there, we have not had an issue in terms of attracting people for product purposes.

Vincent Resee [ph] - Wachovia Capital

In the past you have given us a percentage of your spine business that was biologic. Could you give that to us again?

Alan Milinazzo

It’s in the range of 25% give or take. You want my next total biologics right?

Vincent Resee [ph] - Wachovia Capital

That’s correct. You’ve never given us the product line guidance there.

Then in your trauma division you guys have kind of streamlined things if I’m not mistaken. Can you just talk to us a little bit more about those initiatives and also from a market perspective, have you guys seen any change in trends recently, particularly there’s been some discussion of potential impact of oil driving down accidents because of people not driving as much.

Alan Milinazzo

I think for us, when we were exploring the divestiture, we said that if we kept the business we had a strategy to make it more profitable and focus down on certain key areas we thought we could drive revenue and profitability. So we really began that early in the year and it’s really bifurcated by geography. In the US it’s around Physio-Stim as a cornerstone, as I mentioned the 16% growth in Physio-Stim on top of an 11% quarter prior, so that’s working well; but our deformity correction devices are also doing very well.

Internal fixation overall is doing well and outside the US really the strategy has been to consolidate down to certain markets where we feel as though we can have a bigger impact, not being as broad from a focused standpoint, being more focused on key markets.

So those two initiatives in combination with some very high quality managers, we went through this process and we had 100% retention which speaks to the commitment of that team and the leadership in those organizations.

Industry trends, we haven’t seen anything affecting our business negatively at this point. We don’t see any procedural issues in trauma, at least given our limited share it hasn’t been anything we’ve noticed.

Vincent Resee [ph] - Wachovia Capital

Unfortunately my last question is also on spine. You differentiated from an investor standpoint, from an industry standpoint. From an investor standpoint it seems to be a consolidating industry right now. I’m just curious how you guys kind of fit into that overall landscape and maybe if that is an improper way to look at it you could correct us on that.

Alan Milinazzo

I think, don’t be disappointed to ask us spine questions. We’re excited about what we’re doing in spine right now, although it’s been a tough year for us I think we’re really doing the right things to establish ourselves for growth in ’09 and beyond, so we’re delighted to be in this space. We think we’ve got a very good strategy emerging. How we play in the consolidation of spine space, certainly at this point we view ourselves as very focused internally on executing on the key initiatives that we’ve got on our plate.

Obviously the MTF initiative is critically important to us and we didn’t think that we were capable of doing something like that on our own, so we kind of put a list together of the things that we thought were critical in a partner in that space and MTF hit virtually every one of them for us; so we’re going to use kind of our next 12 months or so to focus internally on getting the distribution system in order, releasing some outstanding new products that we think are going to further differentiate us on top of our stimulation business, which is again a unique asset in this business.

Our plan is to keep our head down, execute on our current strategy, look for opportunities like Intelligent Implant Systems or INSLING, which are tuck-in, but important tuck-ins for us and kind of keep ourselves internally focused in that regard.

Operator

Your next question comes from Peter Bye with Jefferies & Co.

Jeff Huntington - Jefferies & Co

This is actually Jeff Huntington for Peter. My first question has to do with Blackstone and the sort of revision of guidance. Is this really primarily due to the distributor turn over and sort of production out of them, or are there other factors that you’re seeing in the market place.

Alan Milinazzo

We have been moving from a distributor to a hybrid model. Our distributors that we’ve brought on this year have actually performed well. As I mentioned, we’re up 5%, but the distributors that we’ve taken out proactively, we replace with direct reps and we’ve not having the traction initially, partially as a result of the negative impact. The Osteocell/Nuvasive news created some distractions for our sales group, so that set us back a little bit. There are some other, it’s a little bit more difficult today.

There is Vincent’s question earlier about the competitive market. You might get evaluations in the hospital, but then you’ve got to queue up to be in a committee to be approved to be brought into the hospital, so those are the factors that we would say that really contribute to the revised guidance on the revenue side.

Thomas Hein

Also again, from our earnings release and other information, recollect we are going to invest in the third and fourth quarters $10.8 million in the contract R&D to bring both the MTF product and the ISS product to market.

Jeff Huntington - Jefferies & Co.

Great and congratulations on the MTF agreement; I just have a quick question in terms of the second half of ’09 timeline for commercialization and the US launch. Is that a realistic goal and can you give us a little bit of detail in terms of where MTF is in the developmental process?

Thomas Hein

As I mentioned, we have been talking to them for about a year and they had already done a significant amount of work in this area, given their expertise. At this point, we really can’t give you any more detail as to when we would complete the development stage. I can tell you that we’re looking to launch this in the second half of 2009, but beyond that I really can’t give you any more detail.

Jeff Huntington - Jefferies & Co.

Can you give us any assumptions on type of regulatory approval you’re going to pursue or what type of rating process the product will undergo?

Alan Milinazzo

We’re going to talk in more detail about the MTF program, but we don’t view the regulatory process, this is the same process that Osteocell has gone through. It’s a tissue-based product.

Jeff Huntington - Jefferies & Co.

Last question in terms of the gross margin guidance reduction, from Q1 now to Q2 for the rest of 2008 is this primarily due to a change in the international mix? I know there’s a number that you gave us in the press release and that you went over and can you give us a break out of international sales versus US sales for the quarter?

Alan Milinazzo

I’ll let Tom dig through the international piece, but the things that we noted really contributed in somewhat equal parts. You’ve got the currency issues, again we do a fair amount of manufacturing in Europe still, although we have, over the past two years, moved manufacturing our of Europe and into lower cost locations, but we still maintain a fair amount in Europe.

Additionally the mix of sales coming from Europe is higher, our spine business is doing well in Europe, our orthopedic business is doing well in Europe and so revenues generally coming out of there have lower ASPs and then finally you’ve got the mix issue in the US where you’ve got a higher percentage of biologic products than metal products with our spine business and so those are really the three key drivers. I’ll let Tom answer the second part of your question.

Thomas Hein

The international sales, the $34 million of the $130 reported for the second quarter and that’s been growing with the growth of the orthopedic business, because international is principally orthopedic oriented and the biologic mixed in coming in earlier which, again, has been growing for us.

Jeff Huntington - Jefferies & Co.

Has there been any of those sort of items that are affecting the GMs has anything drastically changed from Q1 to Q2 or anything that sort of pushed that revision further or is it just sort of across the board everything has continued in those trends?

Thomas Hein

Yes the trends have discontinued, that’s exactly right.

Operator

Your next question comes from John Putnam with Dawson James Securities.

John Putnam - Dawson James Securities

Turning to the biological area, will you be able to deliver biologics based on your old contract consistently, if you are able to launch the MTF product in the second half of ’09?

Alan Milinazzo

Our plan is to continue to distribute the Trinity product, the Osteocell product into 2009 and if we commercialize the MTF based product in 2009, we have contemplated that there will be a period of time when we would be selling both products in the market place, so that could happen.

John Putnam - Dawson James Securities

But, you won’t run out of Trinity before you’re able to sell the MTF product?

Alan Milinazzo

That is not our expectation. If you look at our working capital we’re putting a lot of money into buying inventory in Trinity right now, so we expect that the inventory that we have and the inventory that we expect to receive would cover us through that time.

John Putnam - Dawson James Securities

Just talking a little bit more about the spine business, do you think you’re losing market share in the metal part of that business?

Alan Milinazzo

Yes, our business declined so that’s right. Again, I would look at it as more of a transition where you’ve got new reps coming in. The business that we were enjoying from distributors that have transitioned out, we’ve put the ball in the hands of direct reps and so that business where those distributors were selling, we’re opening up new accounts, we’re opening up new users as we said. We haven’t got the ramp of business yet from those new reps, so we haven’t been able to cover what we’ve taken out. I would say it’s the loss of market share in metal.

We do expect to have some positive impact in the cervical area. Some of the recent news out there around the cervical area, we think we may be able to capitalize on because we’ve got a very nice line of cervical plates, as you know, in conjunction with Trinity we think that’s a compelling value proposition.

John Putnam - Dawson James Securities

On the direct sale force, what are your plans over the next couple of quarters with respect to adding people?

Alan Milinazzo

We’ve got 17, we accelerated that, we got them in earlier in the year than we anticipated. We have a few areas that we are still looking at adding people in. I’m going to probably step back as Brad Mason sorts through exactly what he sees as an opportunity there. He has been in this role about a month.

The collaboration between our stem organization, which is performing at a phenomenally high level and Blackstone is increasing virtually every week, so we will evaluate our needs. If we feel like we need to add some reps in certain geographies we’ll do that thoughtfully, but at this pointing time I would say we are sitting where we are and assessing. We are letting Brad get some sense of what he wants to do with that.

Operator

Your next question comes from Steve Ogilvie with ThinkEquity.

Steve Ogilvie - ThinkEquity

I wanted to ask on the orthopedic growth, it’s just so impressive. Did you say how much of that was FX and maybe if you don’t have that exact number, maybe what percent of the orthopedic franchise is international?

Thomas Hein

The total was $2.9 million, the majority of that is, in fact all of it is international in terms of the FX, and I think we said earlier $24 of the $34 million of the $130 million is international.

Steve Ogilvie - ThinkEquity

That $2.9 million, is that all in orthopedic?

Thomas Hein

The majority is orthopedic, yes, because again the majority of our foreign operations are orthopedic oriented.

Steve Ogilvie - ThinkEquity

I wanted dig deeper into the distribution dynamics with your biologics. Could you maybe walk us through how much inventory you’re going to get? I mean you have the right to purchase 80% of what Nuvasive is now going to make of Osteocell and I imagine you ‘re going to stockpile through the end of the year, but if they make less do you get less, are there minimums? Then how far can you stretch that independent of what MTF does, how do you see kind of like the last day when you’ll sell your last cc of Trinity?

Alan Milinazzo

As you know supply on Osteocell has been kind of the challenge for us over the past couple of years, so in the past when we’ve had some shortages on supply it was a result really of inability to hit some of the production plans that they had. We understood that and I think that’s improved dramatically, as we said in our Q1 call. So we will take 80% of whatever they manufacture, that is our intent. If they manufacture les than they forecasted, as in the past, we’ll take that 80%.

Right now we have the right to sell that product through the middle of next year. Now there are some things under way that may give us the right to extend that time period, but suffice to say that at this point we would view June next year as the earliest date that we would stop selling Trinity and again, pending the outcome of some other discussions it may be longer.

Steve Ogilvie - ThinkEquity

You guys took some legal action, do you see if Nuvasive either is revamping or comes up with their own excuse as to reasons why supply isn’t good, are there recourses you feel you can take in order to get more?

Alan Milinazzo

I don’t see any reason why Nuvasive would do that. We have had good conversations and we feel like from our standpoint we certainly have other recourse if we needed it to, but it’s probably not appropriate to comment at this point, but from our standpoint we have no reason to believe what we’ve heard from Nuvasive, what they’ve said publicly.

Steve Ogilvie - ThinkEquity

In the development with the MTF, have you any insight into the patents? I mean it seems like in the hourglass market it’s pretty much free game and I just wondered as you step into stem cells in the processing, looking through those IT portfolios of what o’cyrus [ph] did, do you feel like that’s a minefield or do you feel there is still a lot of room to create a similar stem cell product?

Alan Milinazzo

We have looked at this very carefully and we don’t feel that we’ll run into any IP issues related to this allograft.

Operator

Your next question comes from Jim Sidoti with Sidoti & Company.

Jim Sidoti - Sidoti & Company

I’m trying to work on consolidated guidance a little bit. You kept the top line intact, but you took the bottom line down pretty significantly and I understand there is some pressure on the gross margin. Are there operating expenses that you expect now, in the second half of 2008, that you didn’t expect earlier?

Alan Milinazzo

A couple of things: one is with the accelerated performance of our stimulation business, the orthopedic business and sports medicine, we’re able to cover the shortfall that we’re anticipating in the spine implant area, so from that standpoint we feel very good about the performance of those businesses and our ability to not change the top line guidance; however we have made significant investments in Blackstone which we think will pay dividends for us both in this distribution system as well as some of the R&D areas that are going to be important in giving us not only unique biologic products, but also some of these metal products that are going to be very important to us from a profitability standpoint.

Thomas Hein

I would point you to the reconciliation of non-GAAP performance measures for the third quarter and full year at the back of our press release. You will identify under strategic initiatives again, as we noted earlier, we will incur in the second half of the year $10.8 million of R&D expense, corporate R&D related to the development of the new products under the MTF and ISS agreements, [interposing] $0.10 of additional reorganization costs we expect to experience in the second half of the year.

Jim Sidoti - Sidoti & Company

But when you talk to that $1.40 accretive $1.53 number, those expenses are all excluded out of that right?

Thomas Hein

That’s correct.

Jim Sidoti - Sidoti & Company

All right, because that number used to be $2 to $2.12 or something like that, so I mean there are definitely some other expenses in there now that weren’t in there —.

Thomas Hein

That reflects, as Alan noted, the additional pressure on gross margins for the balance of the year coupled with the expenditures that we are carrying related to the sales and marketing structure for our Blackstone business.

Jim Sidoti - Sidoti & Company

Okays so I think the answer then is the sale to marketing and the percent of sales is a little higher than you thought it was going to be a the beginning of the year.

Thomas Hein

It is.

Jim Sidoti - Sidoti & Company

Then on the interest expense you mentioned that you may have to renegotiate some of the covenant. Just going forward to 2009 should we expect interest expense to stay about flat where it is in ’08, because you’re paying down some of the debt, or do you still think you’d be able to cut interest expense in 2009 from where it is in 2008?

Thomas Hein

No I think with the renegotiation of the covenants in the current environment you’d have to expect the interest rate and the interest expense to go up some.

Jim Sidoti - Sidoti & Company

I know someone asked this already, but I just want to make sure I understand the timeline for the new stem cell product. It sounds like you think you’ll have something completed, at least the development stage completed in early ’09 and then go through some kind of quick review process and have that in the market by the end of ’09 does that sound right?

Alan Milinazzo

Yes you know development process has been going on for some time. We expect that that will roll into a commercialization phase in which we would expect in the back half of ’09. It’s hard to be more specific than that, but that back half of ’09. At this point we are letting MTF with our activities in the development phase kind of run with the ball on this one. These guys are the experts. We believe if you set in your mind kind of the back half of ’09 as a time frame, again we have to get through the first part of this. This is the development activities, but if all goes well there then we would expect the second half of ’09.

Jim Sidoti - Sidoti & Company

With this product, what is the term of the distribution agreement? Once it gets out there will you have it for two years, five years, forever, can you tell us that?

Thomas Hein

Ten years. That was an important piece for us.

Operator

Your next question is a follow up from Vincent Resee [ph] with Wachovia Capital.

Vincent Resee [ph] - Wachovia Capital

With the potential adjustment that you guys had going on with your lenders because of the covenants issue, is there a risk you guys are going to need to raise some kind of financing?

Thomas Hein

Currently we believe, at least for the foreseeable future, we can generate sufficient internal cash flow to continue to finance both the investments in R&D and the investments in working capital to support the business. We think we can generate, currently, enough internal cash flow. Obviously we are going to have to manage our inventory closely, that’s going to be key to accomplishing that.

I think we ought to point out that we do note the potential covenant issues and amendment prospects in the third quarter. The other area that we will be discussing with our lenders and being sure we are clear as part of that covenant process is the possibility of any further impairment. I think as everybody recognizes the impairment as a result of evaluation tests, which are based on revenue projections, discounted cash flows of market statistics and with the reduction I the guidance related the Blackstone business, we do have the possibility that there could be a future impairment as we approach the end of the year and go through that year end process again.

Alan Milinazzo

Let me just say that at this time we don’t have enough information to know if there would be an impairment in ’08. As we prepare the budget for ’09 and other revenue projections this year, we may want to be prepared for that, but at this point we don’t have anything to tell you to factor that into your equation.

Operator

Your last question is a follow up from Steve Ogilvie with ThinkEquity.

Steve Ogilvie - ThinkEquity

On the vascular and other businesses I was wondering if there is any new perspective on that in terms of looking for potential acquires as you focus and that is something you’ve got investment opportunities in spine and orthopedics.

Alan Milinazzo

In the past couple of months we have actually kind of reorganized that group under the heading of the med/surg groups and we have taken some steps to enhance the top and bottom line performance there. We are mid streaming that implementation which I think is going to be the right move for the business and the employees.

We haven’t explored anything specifically. We remain open to ideas around that, but at this time we are not really actively looking. If someone were to approach us we would certainly entertain it, but we are running it as if we are keeping it. We are optimizing the revenue and the bottom line contribution.

Alan Milinazzo

Thanks for joining us today. Key messages I would like to leave you with today are that we continue to execute our core business strategies in stimulation, orthopedics, and sports medicine and we’re seeing very strong revenue profit results in all those segments.

Our spinal implants business, although financially short of our expectations, is showing some very positive signs, which indicate that we’ve taken the initial steps to rebuild our revenue momentum as we head towards 2009.

The exciting news about our collaboration with MTF further underscores our commitment to creating a strong spinal franchise over the coming years and we look forward to seeing many of you in New York on September 8.

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Source: Orthofix International N.V. Q2 2008 Earnings Call Transcript
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