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Exactech, Inc. (NASDAQ:EXAC)

Q3 2012 Earnings Call

October 31, 2012 10:00 am ET

Executives

R. William Petty – Chairman and Chief Executive Officer

Joel C. Phillips - Chief Financial Officer and Treasurer

David W. Petty – President and Director

Analysts

Bill J. Plovanic – Canaccord Genuity, Inc.

Jeff Johnson – Robert W. Baird & Co., Inc.

James Sidoti – Sidoti & Company

Operator

Good morning, ladies and gentleman. Thank you for standing by. Welcome to Exactech’s Third Quarter 2012 Results Conference Call. During today’s presentation, all parties will be in a listen-only mode and following the presentation, the conference will be opened for questions. (Operator Instructions)

I would now like to turn the conference over to Dr. Bill Petty, CEO. Please go ahead.

R. William Petty

Thank you, Douglas and good morning. And let me first say that we know a little bit about the storms in Florida and we know that some of you have been impacted by Sandy and our hearts and minds are with you and hope everything in your areas get back to normal as quickly as possible.

I will begin our conference with the disclaimer. The release contains various forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. They represent the company’s expectations or beliefs concerning future events of the company’s financial performance.

The forward-looking statements are further qualified by important factors that could cause actual results to differ materially from those in the forward-looking statements. These factors include the effect of competitive pricing, the Company’s dependence on the ability of third-party manufacturers to produce components on a basis which is cost-effective to the company, market acceptance of the Company’s products, compliance costs and the effects of government regulation. Results actually achieved may differ materially from the expected results included in these statements.

We believe that the third quarter for Exactech was a good one. For the third quarter of 2012, Exactech had revenues of $51.3 million compared to $47.3 million in the third quarter of 2011. This is an increase of 8%. Net income was up 95% to 2.6 million, which represents $0.19 per diluted share compared to $1.3 million or $0.10 per share in the third quarter of last year.

For the first nine months, revenue was $165.1 million, which is an increase of 8% over $152.3 million for the third quarter in 2011. Net income for the first nine months in 2012 increased 27% to $8.9 million or $0.67 per diluted share, compared to $7 million or $0.53 per share in 2011.

Turning now to segment performance, our knee implant revenue was up 2% to $18.2 million. The Extremity Implant revenue increased 25% to $12.2 million. Hip implant revenue rose 16% to $9.2 million, and Biologic and Spine revenue increased 10% to $5.9 million.

Other products revenue, which includes a number of catchalls, but more importantly our cement product line was actually down 9% to $5.6 million, however our cement performance was actually quite robust for the quarter.

For the nine months segment performance; our knee implant revenue rose 1% to $60.7 million; extremity revenue up 29% to $37.2 million; hip implant increased 25% to $30.5 million; Biologic and Spine was actually down for the nine months, 2% to $18 million; and other products was also down to $18.7 million, which is 10%.

We’re quite happy to be reporting another strong quarter. Again, we outperformed our peer companies as we reported improvements in all major categories of our business, led by our Extremity and Hip segments. We also recorded a welcome improvement in our Knee business, which is our largest operating segment.

Growing strength in our Spine products line primarily drove a 10% gain in our Biologic and Spine segment revenue. With the 27% increase in year-to-date net income, we’re now beginning to experience the operating leverage for many of our investments over the recent period.

I’m now going to turn it over to Jody, who will give a little more operational and financial information. Jody?

Joel C. Phillips

Thank you. Dr. Petty. Good morning everyone, and thanks for joining us for the third quarter earnings call. We are happy to share with you what we feel was another quarter of solid growth for Exactech. In order to review our third quarter operating performance, I will review major elements of the income statement and then comment on a few of the balance sheet items.

First, I would like to give a little bit more detail in terms of the constant currency impact on our third quarter revenues. We stated in the release that on a constant currency basis, our revenue growth was 10.5% as compared to the 8% that was reported.

When we break that down by segment, the Knee growth on a constant currency basis was 4% as compared to the 2% reported. Hip growth was 18% compared to the 16% reported. Bio Spine was 12% versus 10% reported. Extremity revenues was a growth of 26% on a constant currency basis versus the 25% reported, and in the Other area that includes instrumentation as well as the Cement that Dr. Petty referenced, this area would have experienced a 6% decrease on a constant currency basis as compared to the 9% that was reported.

And I will also comment that this particular area was most impacted by the $1 million in reduction in sales due to the inventory return agreement from our former Spanish distributor.

Moving on, in the operating segment, as we commented in the release, our gross margin percentage expanded during the quarter to 70% from 68.5%. This was slightly ahead of our expectations, primarily due to the larger than expected U.S. mix during the third quarter. We continue to expect approximately 50 basis point increase in gross margin percentage for the fourth quarter, as we expect internal manufacturing cost reduction to continue to offset modest pricing pressure.

From a sales and marketing expense perspective the 4% increase was lower than sales growth, primarily due to lower bad debt expense, as a result of settling our outstanding AR with our former Spanish distributor, pursuant to the inventory return agreement. And these expenses were also reduced on a U.S. dollar basis due to the FX impact of our European costs.

The third quarter 2012 G&A expenses decreased 10% as compared to the third quarter of last year, as compliant spending continued to run at a rate that was roughly half of what we experienced in the prior year. For the fourth quarter, we expect G&A spending to be roughly flat with the prior year, as the comparative compliance then continues to be lower. R&D expenses in the third quarter increased 25% and are expected to continue to increase in the 20% to 25% neighborhood during the fourth quarter of 2012.

Depreciation and amortization expenses increased 2% for the quarter and this is also roughly what we expect for the fourth quarter. As a result of these operating activities, our operating margin increased 114% to 8.8% of sales versus 4.5% of sales in the third quarter of last year. And the third quarter effective tax rate of 40% was impacted by non-deductible operating losses in certain European markets in the seasonally slow third quarter. We expect that rate to be roughly in the range of 35% to 37% for the fourth quarter of 2012. The resulting net income of $2.6 million reflected a 95% increase. And the $0.19 per diluted share was at the high end of our expectations.

From a balance sheet perspective, total inventory increased by $4.3 million during the quarter, and again this was primarily due to the inventory return agreement that we reached with our former Spanish distributor. Our expectation is that total inventory will now begin to decrease over the next number of quarters and as a result, we are projecting that our total debt will decrease modestly during the fourth quarter and begin a downward trend through the first half of 2013 as well.

From a guidance perspective, we have narrowed our full-year 2012 guidance to revenues of $221 million to $223 million. This basically increased the lower end of our former guidance by $3 million based on the third quarter performance. And we also narrowed our diluted EPS guidance to $0.93 to $0.95, again increasing the lower end of that guidance by $0.02. This narrowing reflects the combination of the performance being at the high end of our expectations for the third quarter, as well as our stability in our worldwide business.

Our fourth quarter revenue guidance that we have now released on calls, the fourth quarter revenues of $56 million to $58 million which I believe translates to roughly 7% to 10% top line increase. And the EPS guidance of $0.26 to $0.28, I believe equates to somewhere between 75% to 95% bottom line growth for the fourth quarter. So those were all the prepared comments that I have at this time.

Douglas, we’re ready to open up for questions.

Question-and-Answer Session

Operator

Thank you, sir. We will now begin the question-and-answer session. (Operator Instructions) Our first question is from the line of Bill Plovanic with Canaccord Adams. Please go ahead.

Bill J. Plovanic – Canaccord Genuity, Inc.

Great, thanks. Good morning. Can you hear me okay?

R. William Petty

Yes. Bill.

Joel C. Phillips

Yeah.

Bill J. Plovanic – Canaccord Genuity, Inc.

Great. So just a couple of things, one, can you keenly explain a little more the inventory return? And then what was the FX impact in this quarter?

Joel C. Phillips

Okay. We basically for a couple of years now have been providing a sales return allowance in anticipation of a return agreement with our former Spanish distributor. Prior to the third quarter of 2012, we had basically provided a $3 million return. During the quarter we reached the final agreement with our former distributor and net total sales return was $4 million.

So, during the third quarter of 2012, we had an incremental return amount of $1 million. And at that time, we also placed the total inventory related to that turn back on to our books and that’s the reasons that we had a significant increase in the inventory. The impact on FX, again company wide as compared to the 8% revenue growth that we reported on a constant currency basis, the revenue growth would have been 10.5%.

And I outlined some of the impacts on the individual operating segments, the most significant one was Knee, which on a constant currency basis would have been 4% growth rather than 2%. And if your question was related to the impact on the bottom line, I would not consider it material, because as you know, we have pretty significant operating expenses in those markets as well.

Bill J. Plovanic – Canaccord Genuity, Inc.

So just one – clear on it, basically it was about $1 million hit, maybe $1.01 million on FX, and then another million on the return?

Joel C. Phillips

That is correct.

Bill J. Plovanic – Canaccord Genuity, Inc.

Okay. And then did the returns impact the gross margins at all? I’m sorry, I might have missed that.

Joel C. Phillips

Ever so slightly, probably not more than 20 or 30 basis point and that was primarily related to the instrumentation element of the return that did not have a material impact on gross margin dollars. Even though, it had a modest reduction in the revenues.

Bill J. Plovanic – Canaccord Genuity, Inc.

Okay. And then, have you quantified what the Med-Tech tax for you will be in 2013?

Joel C. Phillips

We have not put any specific numbers out there, but I think if you just apply the tax to most of our U.S. sales, which we believe it will be applicable to, you get to a number in the neighborhood of around $3 million. We’ve obviously been planning for this issue for a number of months now and we have a number of efforts going on both to comply with it and manage our reporting of it as well as, be able to continue to deliver operating profit growth next year. So it’s a pretty significant item as you can imagine to us, but it’s not like, it hasn’t been on our radar screen and we’re pretty, pretty good ways along in terms of preparing for it.

Bill J. Plovanic – Canaccord Genuity, Inc.

And then last question and I’ll jump off. On just the weather for the past couple of days, it’s been pretty challenging on the East Coast. Have you quantified this in the 2012, in the Q4 guidance?

David W. Petty

Bill, it’s David. We have not and it’s hard to be accurately predictive of how that will affect us. I would only observe that we’re at the end of the first month of the fourth quarter and depending on how quickly things get cleaned up, particularly in New York, I would expect that there will be time there, two months there, a month and a half or patients who would have been scheduled for surgery this week to be worked in to surgery schedules for those elective procedures throughout the rest of this quarter. So well, as a guess, I don’t expect it will have a major impact, but maybe a negligible one.

Bill J. Plovanic – Canaccord Genuity, Inc.

Great. Okay. Thank you very much.

Joel C. Phillips

Sure. Thank you, Bill.

Operator

Our next question is from the line of Jeff Johnson with Robert W. Baird. Please go ahead.

Jeff Johnson – Robert W. Baird & Co., Inc.

Thank you. Good morning, guys.

Joel C. Phillips

Good morning, Jeff.

R. William Petty

Good morning, Jeff.

Jeff Johnson – Robert W. Baird & Co., Inc.

Good morning. So Jody, I’m wondering if I could start with you just on G&A, obviously been down very nicely here over the last couple of quarters, margins are very impressive this quarter on the year-over-year improvement. How much of that has been some of the DOJ costs coming off and I know we had a big pickup last year, I think it was just in the first half of the year last year though and now some of those expenses have come off. So I’m just trying to get a sense for where G&A leverage may or may not be over the next deal couple, six months, 12 months something like that?

Joel C. Phillips

Okay. A large portion of the decrease is strictly due to reduced compliant spend and you are correct, the first half of 2011, the compliant comparatives were much higher. In the third quarter of last year, they began to decrease. So even against that decrease, we were able to reduce our total G&A spending. And so I think our non-compliance G&A spending is roughly flat and the G&A – or the compliance spending has been going down. So there’s still a little bit of opportunity for very flat or even slightly down G&A expenditures, at least through the balance of this year.

Jeff Johnson – Robert W. Baird & Co., Inc.

Okay. And I know Dr. Petty has always said, some of those – Dr. Petty, you’ve always said some of those compliance costs are just going to be now structurally remaining. So as we get into 2013, I guess, Jody, did I hear you correctly that you’re still seeing some leverage on the non-compliant side of the G&A line?

Joel C. Phillips

There is a little bit of leverage there as long as sales are growing at the rate that we are currently experiencing. We would expect our non-compliance G&A spending to grow at a slower rate. So there is opportunity for a leverage even outside of compliance spending.

Jeff Johnson – Robert W. Baird & Co., Inc.

Okay. And following up on Bill’s question just on the med device tax, one or two of your competitors or at least one of your competitors now is talking about capitalizing that in to inventory. And so by the time you turn inventory maybe six months later, the med device tax may not hit your P&L until six months into 2013. It’s just a timing issue, but any thoughts on whether or not that’s how it will impact your P&L?

Joel C. Phillips

Frankly, we have not – I don’t think there is enough guidance and we haven’t studied it enough yet to know exactly how much it will impact it. The $3 million statement is clearly based; it is applicable to a full year basis. We’ll be doing a lot of studying on it over the next couple of months and when we release our full-year guidance, for 2013, in February, I think we will have a little bit more clarity, but we’re planning right now that that’s going to be in full force for next year.

Jeff Johnson – Robert W. Baird & Co., Inc.

Okay. And I think it was at our Healthcare Conference, Jody, you or David may have commented that you thought there might be some initiatives to try to offset at least half of that tax. I think I’m remembering that correctly. I’m assuming that isn’t through price increases or anything like that. Do you have any kind of pricing power in the channel right now; is it more just through some things on the sales force side or how to think about that?

David W. Petty

Sure. I mean there are a couple of different initiatives that we’re working on that have to do with gaining more efficiencies in other parts of our business in order to cover the tax and really the statement we made was quite simply that our intention, our commitment to our shareholders is that we’re going to cover that tax and we’re going to grow our operating profit.

Jeff Johnson – Robert W. Baird & Co., Inc.

Okay. Thank you, David. That’s all I’ve got guys. Thank you very much.

Operator

(Operator instructions) Our next question is from the line of Jim Sidoti with Sidoti & Company. Please go ahead.

James Sidoti – Sidoti & Company

Good morning. Can you hear me? Hello.

Operator

You’re coming through Mr. Sidoti.

James Sidoti – Sidoti & Company

Good morning. Can you hear me?

Operator

Dr. Petty, did you mute your phone?

James Sidoti – Sidoti & Company

Is Exactech still in the call?

Operator

Your line is connected. Dr. Petty, did you mute your phone?

James Sidoti – Sidoti & Company

Do you want to give them a minute to call back in?

Operator

Ladies and gentlemen, we apologize for the interruption. Apparently, we’re having some technical difficulties. Just one moment and we will – we will resume with the conference.

Operator

Thank you, ladies and gentleman for your patience. The conference is back in session.

R. William Petty

And our apologies from Exactech as well. So we’re still here and available for questions. Is there anybody ask for the question?

Operator

We did have a question from the line of Jim Sidoti. Just one moment please. I’ll open this line. And Mr. Sidoti, your line is open.

James Sidoti – Sidoti & Company

Good morning. Can you hear me?

R. William Petty

Yeah. Jim, we were wondering about you.

James Sidoti – Sidoti & Company

Yeah. I thought may know it. I though may be you had hurricane just now, so…

R. William Petty

I’m not sure what hit us, but we’re good.

James Sidoti – Sidoti & Company

We’re doing fine in New York, power is a little bit of an issue, but other than that, everything else is fine. But back to your quarter, I’m sorry knee implant growth, you said 4% constant currency. Are you starting to see any sings of the trend there, because I know it’s picked up a little bit each quarter this year?

R. William Petty

It has. And I know you’ve pay close attention and you’ve heard us talk over the last 12 months or so about a real intensified effort. Particularly, in the U.S. market on our knee sales growth and really that effort has come in part from our focus on the part of our sales organization that we’re not committed to the knee. And frankly, we’ve added some knee sales agents in different parts of the country that committed to the knee and those new agents are delivering good growth and we are consistently adding customers domestically.

We also have the benefit of pretty strong performance particularly in Asia that’s helping that total number and we’re managing to maintain stability and even growth in Latin America. So, all of these things taken together have developed some real meaningful momentum. We’re certainly not satisfied with 4% constant currency growth in the knee and we’ll continue the intensity of our effort to grow that business.

James Sidoti – Sidoti & Company

The return you had from Spain, did that impact any of the segments other than the – any other product line?

David W. Petty

One of the things that prompted our change in distribution was that the former distributor really was a knee focused effort and we wanted to sell more of our products in the Spanish market. And so the knee if you – with the constant currency, if you had to add the effect of the return in there, the total knee growth without that return would be 6% rather than the 4% constant currency and the 2% reported.

James Sidoti – Sidoti & Company

So 6% is quite a bit better than what we saw just one or two quarters ago. Do you think you maintained that number in the fourth quarter?

David W. Petty

As of the last, let’s say, 2.5 years with the – I think it’s been very hard to be predictive of what the market conditions are. Certainly, we remain focused and we’re confident in our ability to deliver new customers, but I’ve gotten a little skiddish about trying to understand quarter-to-quarter what the market will do. And I think Bill Plovanic asked the question about the storm up your way and certainly we didn’t do surgeries in New York yesterday, we have customers in New York. I don’t believe that will affect us this quarter, but that’s yet to be determined.

James Sidoti – Sidoti & Company

Okay. All right. And then the improvement in the spine sales, I assume that we’ve anniversaried all the distribution changes on that side of the business?

David W. Petty

That’s part of it. I think also just executing our strategy of getting our own internally developed products on the market over the last year or so has allowed us to attract better sales people and so we’re seeing real – small dollars, but good percentage of sales growth and that’s reported together with biologics, which over the last 18 months or so has seen some economic pressure in all the discussion about healthcare reform and adding things like PRP kits and DBM bone paste to surgical procedures.

We’ve had to go back and articulate the overall economic value of those additional things on invoices and stabilize the decline in growth in biologics. So we’ve seen, as we ended the quarter, modest growth in the biologics business and good percentage growth in the spine business and we expect a sustained modest solid growth prospectively in that segment.

James Sidoti – Sidoti & Company

And you’ve talked about sales force for both your knees and your spine business. Should I get from that that you’re actually increasing the size of the sales force or is this kind of an upgrade in the agency ahead?

David W. Petty

I would say the most important change there Jim is the qualitative improvement of bringing on sales people and sales agents from competitive organizations that have real experience and the ability to sell our powerful product line and I’m talking predominantly about what we call our large joint sales force, which sells hip and knee and shoulder and the biologics and bones in that products. The spine is a different sales force and that’s also growing. We have about 25 agencies selling our product spine.

We have recently changed the way we are counting the sales organization in the large joint part of our business, formerly, we were giving sales rep numbers only, not including the agent that run the sales organizations at the local level, who actually are also at least for Exactech very involved in the selling of our product. And so, we’d like to recalibrate everyone at – 303 total sales people currently reported, and that’s up slightly from the beginning of the year, but the most important thing is the qualitative improvement in that part of our sales force.

James Sidoti – Sidoti & Company

All right. Thank you.

R. William Petty

Thank you, Jim.

Operator

(Operator instructions) And our next question is a follow-up from the line of Jeff Johnson with Robert W Baird. Please go ahead.

Jeff Johnson – Robert W. Baird & Co., Inc.

Yeah. Thanks, guys. I have just two quick follow-ups here. David, usually do a very good job of kind of updating us on the pipeline anything, any product coming out over the next 6 to 12 months, do you really want to highlight here?

David W. Petty

I do. We’re in this sort of multiyear rollout of our new Optetrak logic system and big part of that system, the cruciate retaining side of that is really starting to go from a pilot into more of a full launch, as we enter the first half of 2013. We do have some line extensions in the tibial insert for logic both the – what we call a PSC or a posterior stabilized constrained insert and CRC or cruciate retaining constrained insert just adding capabilities too to our system in something new for the sales people to go in and talk about.

On the hip, I think, there is really sort of a rich line of new things that are coming out, that will be I think great for the sales force. The line extensions to the element adding a shorter next version of the Novation Element hip stem is going to give us competitive advantage over other companies to sell our product, large humeral head and liners in the Crown Cup. We know, we have a list of customers, who will begin using our hip, when we are able to launch that that is currently before the FDA and we’re hopeful to have that cleared in the first quarter. And our InteGrip Acetabular System, Porous Metal Acetabular System is in limited launch and will going to full launch in the first quarter of 2013. So I think all those things together really give us the potential to sustain meaningful momentum in our hip business.

The big revenue driver in the new technologies for shoulder is that Cage Glenoid, which is in limited launch going in to full launch in the first quarter of 2013, as is the case with the CTA humeral head in our shoulder business. And then spine of course, we’ve got the systems, the Proliant Pedicle Screw, Octane PEEK and Gibralt Posterior Cervical systems that have been launched about a year ago and the key thing going forward is a Q1, 2013 launch of our Silverbolt 2 MIS lumbar pedicle screw system.

Jeff Johnson – Robert W. Baird & Co., Inc.

Great. Very helpful as always. Jody, one last question, just on the sales force side, and hearing that the numbers have moved up a little bit, taking on some more experienced reps. I think part of that is you guys are maintaining your commission rate, while some of your competitors may be trimming them a bit. How do I think about the sales and marketing side over the next maybe 12 to 18 months? Does that grow in line with sales or is that going to have to grow faster than sales to bring in some of these reps?

Joel C. Phillips

Frankly, I think, we needed to grow slightly lower than our sales growth. That’s part of the area that we’ll be looking to offset some of the impact of the medical device excise tax, but it’ll be relatively close to sales growth, but maybe slightly below, if that makes sense.

Jeff Johnson – Robert W. Baird & Co., Inc.

Yeah. That’s helpful. Thanks guys.

R. William Petty

Thank you, Jeff.

Operator

(Operator instructions) And there are no further questions in queue. I’d like to turn the call back over for closing remarks.

R. William Petty

Thank you, Douglas, and thank you all for your interest. And again, we wish you the best in the Northeast impacted by the storm and that you recover quickly. And thank you for your interest and confidence in Exactech. Have a great remainder of the week. Bye-bye.

Operator

And ladies and gentlemen, that does conclude our conference for today. We’d like to thank you for your participation and you may now disconnect.

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