Orthofix International N.V.'s (OFIX) CEO Bradley Mason on Q3 2016 Results - Earnings Call Transcript

| About: Orthofix International (OFIX)
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Orthofix International N.V. (NASDAQ:OFIX) Q3 2016 Earnings Conference Call October 31, 2016 4:30 PM ET

Executives

Mark Quick - Director of Business Development and Investor Relations

Bradley Mason - President and Chief Executive Officer

Doug Rice - Chief Financial Officer

Brad Niemann - President of BioStim

Analysts

Anthony Petrone - Jefferies

Jim Sidoti - Sidoti & Company

Operator

Hello and welcome to the Orthofix Third Quarter 2016 Earnings Conference Call. Today’s call is being recorded.

I would now like to turn the call over to Mr. Mark Quick, Director of Business Development and Investor Relations. Please go ahead, sir.

Mark Quick

Thanks, operator, and good afternoon, everyone. Welcome to the Orthofix third quarter 2016 earnings call. Joining me on the call today are President and Chief Executive Officer, Brad Mason; Chief Financial Officer, Doug Rice; and Chief Strategy Officer Mike Finegan.

I’ll start with our Safe Harbor Statements and then pass over to Brad.

During this call, we’ll be making forward-looking statements that involve risks and uncertainties. All statements other than those of historical fact are forward-looking statements, including any earnings guidance we provide or any statements about our plans, beliefs, strategies, expectations, goals or objectives. Investors are cautioned not to place undue reliance on such forward-looking statements as there is no assurance that the matters contained in such statements will occur.

The forward-looking statements we make on today’s call are based on our beliefs and expectations as of today, October 31, 2016. We do not undertake any obligation to revise or update such forward-looking statements. Some factors that could cause actual results to be materially different from the forward-looking statements we make on the call include the risks disclosed under the heading Risk Factors and our Form 10-K for the fiscal year 2015, as well as additional SEC filings we make in the future. If you need copies of these documents, please contact my office at Orthofix in Lewisville, Texas.

In addition, on today’s call we will refer to various non-GAAP financial measures. We believe that in order to properly understand our short-term and long-term financial trends, investors may wish to review these matters as a supplement to financial measures determined in accordance with U.S. GAAP. Please refer to today’s press release announcing our third quarter 2016 results for reconciliations of these non-GAAP financial measures to our U.S. GAAP financial results.

At this point, I’ll turn the call over to Brad.

Bradley Mason

Thanks, Mark, and good afternoon, everyone. I will start by giving you a summary of our third quarter 2016 performance after which Doug will walk you through the financial results that we reported today. I will then follow-up with a few questions about our expectations for the rest of the year before opening it up for Q&A.

Our third quarter results were mixed. While we fell short of our expectations for net sales, we significantly exceeded our adjusted EBITDA EPS targets. A number of factors affected both our top and bottom lines in the quarter, which I will now discuss at a high-level starting with the top line.

Our third quarter consolidated net sales of $98.5 million decreased over prior year by 2.3% at constant currency. This shortfall to our expectations was led by a decrease in sales in our Spine Fixation strategic business unit or SBU over prior year.

Now, looking at each business. Our BioStim SBU grew net sales 3.4% over the prior year. As I mentioned on the Q2 call, we expected the BioStim business to return to this more sustainable growth rate in the last-half of this year. This business is the mainstay of our consolidated Orthofix business for both the top and bottom line perspective. It continues to grow faster than its markets and is producing nearly 45% of our net sales and approximately 53% of our net margin dollars. The growth in this SBU continues to be driven by strong commercial execution.

While net sales in our Biologics SBU declined 2.1% for the period. Both net sales and volumes for our Trinity allograft tissue were up year-over-year in the U.S. despite pricing pressures. Our Structural Allografts and other biologics business, which makes up approximately 5% of our total biologic sales decreased significantly in the period.

The results in the quarter were negatively impacted by the reorganization of our management team in the second quarter in the largest of our three sales regions in the U.S. and the loss of a large hospital group contractor earlier in the year. We are pleased to report that effective next month, we will once again be marketing our biologics tissues to that hospital system. Additionally, both our new regional sales leadership team and the strategic national distribution partner that I mentioned last quarter are gaining traction.

Our Extremity Fixation net sales were flat for the period. They grew 5.4% on a constant currency trailing 12-month basis, which when calculated over this extended time period minimizes the impact of cash collections. This SBU continues to capitalize on the outstanding market acceptance of our TrueLok Hex product line and our Galaxy pin-to-bar external fixator.

Net sales for TrueLok Hex, which was released just 18 months ago have already ramped up to over $4.5 million annual run rate in the U.S. and our Galaxy product sales outside of the U.S. are growing over 25% year-over-year.

Net sales for our Spine Fixation SBU decreased 16.7% year-over-year for the third quarter. Approximately half of this increase was due to our reduction in international cash collections versus the prior year. Our international collections from cash-based customers can vary significantly from quarter-to-quarter and year-to-year, as we saw in Q3.

The U.S. business is still dealing with the loss of several key customers, a national hospital group and continuing price compression. Following Doug’s comments, I will speak more about our expected top line recovery in this business and give more color on our expectations for each of our SBU’s.

Moving on to our bottom line performance, we are pleased to report that adjusted EBITDA as a percent of net sales for the quarter was 23.9% compared to 15.7% in Q3 of 2015, and adjusted earnings per share was $0.36 compared to $0.28 for the prior year. Doug will discuss this performance in more detail in a few minutes.

As of the end of the third quarter, we had a trailing 12-month adjusted ROIC of 10.9% versus the prior year of 6.5%. Free cash flow year-to-date was $24.1 million compared to $5.3 million in 2015. Our team has done an outstanding job of focusing on the key operational changes that are driving these improvements. As of October 28, 2016, we have purchased a cumulative total of approximately 1.8 million shares of Orthofix common stock for $75 million, as a part of our stock repurchase plan, which was completed last week.

I’ll now review few of our key operating highlights for the third quarter. This month, the North American Spine Society or NASS issued first of its kind coverage recommendations for electrical bone growth stimulators. NASS develops credible and reasonable coverage recommendations to assist payers, providers, and patients in defining appropriate and fair coverage decisions.

NASS evidenced-based coverage recommendations are developed to advocate for NASS’s positions on various clinical and practice issues to ensure continued provision of quality spine care. The recent issued evidence-based coverage policy recommendations support the use of pulsed electromagnetic field stimulation devices as an adjunct to spinal fusion surgery. The coverage policy recommends the use of electrical stimulation for spinal fusion healing in all regions of the spine, including cervical.

Orthofix is the only company with a bone growth stimulator approved by the FDA as a noninvasive adjunctive treatment option for cervical fusion. I expect that the validation of PEMF electrical stimulation from this leading surgical society may give us a competitive advantage and further support our efforts to expand the availability and use of the therapy to many patients who can benefit from it.

In September, we announced the enrollment of the first patient in a study evaluating the use of our pulsed electromagnetic field technology for osteoarthritis or OA of the knee. This study will assess the efficacy and safety of the company’s Physio-Stim system in reducing inflammation and restoring homeostasis of the extracellular matrix, potentially providing symptomatic relief of OA pain, reducing cartilage breakdown and stimulating new cartilage formation. If successful, this would be the first disease-modifying treatment for osteoarthritis, the most common type of arthritis of the knee, which according to CDC statistics will affect nearly one in two people by the age of 85.

Regarding our option to purchase eNeura, the option exercise period has expired. We still feel that that technology has great potential, because the ramp up of eNeura’s commercial activities was behind schedule, we chose not to exercise our options. As a reminder, we have $15 million in convertible note plus interest due from eNeura, which is secured by the intellectual property of eNeura. The note and accrued interest come due in March of 2019.

Lastly, this will be the final time I speak about our Bluecore infrastructure improvement project, as we wrap it up before year-end. We expensed approximately $800,000 in the third quarter and have now essentially completed all elements of the project and expect only modest spending for the remainder of the year.

I want to remind you that the primary objective of this two-year project was to upgrade our controls, systems, and processes worldwide, including our Oracle ERP system in the U.S. and Italy, as well as numerous other systems supporting finance, operations, and human resources. The project was completed ahead of schedule that all of our key objectives came in under budget.

I’ll now spend a few minutes discussing recent product launches in our new product pipeline. In our BioStim business, we are preparing for the early 2017 launch of our next-generation of lumbar and cervical bone growth stimulation products. These products will be phased in during the year and ultimately replace our existing products. We will be getting more details about them as we get closer to launch dates.

For our Biologics SBU, in the first quarter of next year, we will introduce a novel disposable delivery system for our Trinity tissues. One of the challenges the surgeons have is introducing biologics by hand into confined spaces. We expect this system will be particularly beneficial to physicians for minimally invasive surgeries, but also provide more precise delivery in all open and small bone procedures.

Moving on to our Extremity Fixation business, in the third quarter, we continue to release additional components to augment our TrueLok and TrueLok Hex products, as well as completed our Galaxy Unyco damage control limb fixation portfolio. We also began the limited market release of our new hip fracture system in Europe. This system competes with the market leading systems with a number of advantages in procedure simplification.

By year-end, we expect to have completed over 200 cases, and to-date, the feedback from surgeons has been very positive. This product will further bolster our trauma portfolio products, which also includes the Galaxy system. Additionally, in the first-half of 2017, we expect to not only launch line of foot-and-ankle plates and screws that we recently acquired, but also several new products specifically focused on pediatric orthopedics.

Lastly, our Spine Fixation SBU just launched PTC color essay anterior lumbar standalone interbody implant. This product utilizes our proprietary porous titanium endplates and PEEK Composite technology that was introduced last year in our FORZA interbody line.

While our surgical implant product portfolio is very comprehensive, we have two notable gaps that have limited our sales efforts. These are state-of-the-art Anterior Cervical Plate and an expandable interbody product line. Late this year, we plan to launch our Cetra Anterior Cervical Plate, which we believe meets the demanding needs of today’s market. And towards the middle of 2017, we expect to release our expandable interbody line of products.

In summary, the third quarter results while short of our top line expectations did demonstrate the company’s potential to generate significant profitability and cash largely as a result of our operational improvements over the last few years. We also had a number of positive highlights in the quarter and in combination with our robust pipeline of new products should give us good momentum heading into the New Year.

After Doug’s more detailed comments on our Q3 financial results, I’ll discuss what we see ahead for the rest of the year. Doug?

Doug Rice

Thanks, Brad, and good afternoon, everyone. Our revenue was down slightly this quarter. We were able to realize certain operating efficiencies, which increased our bottom line and adjusted EBITDA above our expectations.

I’ll start with providing details into our net sales and earnings results and then discuss some of our other financial measures. Total net sales in the quarter were $98.5 million, down 2.6% on a reported basis and down 2.3% on a constant currency basis from the third quarter 2015.

As Brad mentioned, the decrease during the quarter was primarily driven by challenges in our Spine Fixation SBU. Going through each of SBU’s briefly, BioStim third quarter 2016 net sales were $43 million, up 3.4% versus the same period in the prior year. Biologics third quarter 2016 net sales were $14.3 million, a decrease of 2.1% versus the same period in the prior year.

Extremity Fixation third quarter 2016 net sales were $24.3 million, a decrease of 1.5% on a reported basis and flat on a constant currency basis in comparison to the same period in the prior year. On a constant currency basis, this SBU increased net sales 5.4% for the trailing 12 months. And lastly, Spine Fixation third quarter 2016 net sales were $16.9 million, a decrease of 16.6% in comparison to the same period in the prior year.

Now, I’ll move on to the rest of the P&L. Gross margin in the third quarter 2016 was 79.8%, an increase of 340 basis points when compared with the prior-year period, primarily due to an increase in the mix of net sales from our BioStim products, which have higher margins than our Fixation products and also due to lower fixed manufacturing costs. We continue to expect that our gross margin for the full-year will be approximately 78% to 79%.

Sales and marketing expenses were $41.7 million, or 42.4% of net sales in the third quarter of 2016, compared to $46.1 million, or 45.6% of net sales in the third quarter of 2015. This year-over-year decrease was primarily due to $2 million of bad debt expense in Puerto Rico during the third quarter of 2015, and a reduction of $2.4 million in certain indirect tax liabilities in the quarter. As a percentage of sales, we expect sales and marketing expense to be in the 44% to 45% range for the year.

Net margin, which we define as gross profit minus sales and marketing expenses was $36.9 million, or 37.5% of net sales in the third quarter 2016, an increase from $31.2 million, or 30.8% of net sales in the third quarter of 2015. This increase as a percent of sales was primarily due to the sales and marketing expense decrease and a modest increase in gross profit.

General and administrative expenses were $18.6 million, or 18.9% of net sales in the third quarter of 2016, which was down from $19.3 million or 19.1% compared to the prior-year period. A number of factors affected our G&A expenses this quarter, including a favorable legal settlement of $3 million and a decrease in professional fees and consulting costs. These favorable items were offset by an increase in share-based compensation of $5.8 million, largely due to our 2014 and 2015 performance-based equity grants becoming probable to vest in future periods.

When excluding costs related to strategic investments, Bluecore infrastructure investments, succession charges and a legal settlement, G&A expenses were 20.1% of sales versus 17.7% in the prior year, driven by the increase in stock compensation expense. Going forward, we expect adjusted G&A to be approximately 17% of net sales for the year.

Research and development expenses were $6.9 million, or 7% of net sales in the third quarter, which was from $6.5 million, or 6.4% of net sales in the prior year. For the year, we expect R&D to increase nominally.

In the quarter, we recorded an additional $1.5 million in charges related to our ongoing discussions with the Division of Enforcement of the SEC. Please see our 10-Q for additional details.

Adjusted EBITDA during the third quarter increased to $23.5 million, or 23.9% of net sales from $15.9 million, or 15.7% of net sales in the prior year. This represented a 48.4% increase in year-over-year adjusted EBITDA despite a decrease of 2.6% in net sales. The year-over-year increase in adjusted EBITDA is primarily due to the reductions in sales and marketing expense, as well as increased gross profit. For the year, we expect adjusted EBITDA to normalize near 18% to 19% of net sales.

Now, turning to tax. We had income tax benefit for the quarter of $1.3 million, or 14% of income before income taxes, as compared to income tax expense of $3.1 million, or 134.6% of income before income taxes in the same period of 2015. The primary factors affecting our effective tax rate this quarter were beneficial change in the deductibility of certain compensation expenses offset by the additional charges related to the U.S. government resolutions, which have little tax benefit.

For the third quarter 2016, we reported net income from continuing operations of $10.4 million, or $0.56 per share, as compared to a net loss of $800,000, or $0.04 per share for the third quarter 2015.

After adjusting for certain expenses and when normalizing for using a tax rate of 38% adjusted net income from continuing operations was $6.6 million, or $0.36 per share, compared to $5.3 million, or $0.28 per share in the third quarter of 2015. This 28.6% growth in adjusted earnings per share was driven primarily by the reduced sales and marketing expenses and the lower share count as a result of our previously announced share repurchase program, which is now complete.

Moving on to the balance sheet highlights. Days sales outstanding or DSOs were 49 days at the end of the third quarter 2016, down from 51 days at the end of the third quarter 2015. Our inventory turns at the end of the third quarter 2016 were 1.3 times, which while slightly slower than the prior year at 1.5 times, reflect the acceleration of our new product introductions and resulting increases in inventories, including the purchase of the line of foot-and-ankle internal fixation products that Brad mentioned. These factors were somewhat offset by the gains we’ve made in lowering inventory levels for legacy products.

Cash and cash equivalents at the end of the third quarter decreased to $46.8 million, compared to $63.7 million at the end of 2015, primarily as a result of our share repurchase activity offset by cash flow from operations. We continue to have no long-term debt on our books.

Cash flow from operations for the nine months ended September 30, 2016 was $38.4 million compared to $26.5 million during the same prior period. The increase is primarily due to the year-over-year increase in net income of $12.5 million.

Capital expenditures for the nine months ended September 30, 2016 were $14.3 million versus $21.2 million in the prior year, due to the company nearing completion of project Bluecore. Year-to-date, we have incurred $3.3 million of project Bluecore-related capital expenditures and expect this spending to tail off going forward, as we complete project Bluecore in the fourth quarter.

Free cash flow defined as cash flow from operations minus capital expenditures was $24.1 million for the nine months ended September 30, 2016 compared to $5.3 million in the prior year period.

The year-over-year improvement in free cash flow is primarily driven by our significant operating cash flow increase, as well as a $6.9 million year-over-year decrease in capital expenditures. We expect to see our year-over-year free cash flow generation continue to improve with the completion of project Bluecore and our improved operating cash flow.

I will now turn it back to Brad.

Bradley Mason

Thanks, Doug. Before we turn to our outlook for our business, I’d like to comment on why I believe Orthofix is well-positioned to succeed in the market. We have four focused bone healing businesses serving over 75 countries. We’re the market leader in bone growth stimulation and growing faster than the market. We offer a highly differentiated stem cell allograft in our Trinity franchise to our long-term partnership with a Musculoskeletal Transplant Foundation.

Our Extremity Fixation SBU is highly regarded worldwide for its best-in-class products, and as with our Spine Fixation business has an impressive pipeline of new products. In the last few years, we have successfully transformed our culture, management, processes, systems, controls, and strategies. From all of these perspectives, we are now a better company with a stronger foundation, and we have a very strong balance sheet, moderate growth, excellent gross margins, double-digit ROIC, and generate exceptional free cash flow.

Now looking at the remainder of the year. In our BioStim SBU, we expect net sales growth to remain generally consistent with our Q3 growth rate. The introduction of our next-generation lumbar and cervical spine products early next year and the recent North American Spine Society policy coverage and usage recommendation for stimulation should give us good momentum heading into 2017.

Considering our result over the last few quarters in our Biologics business, we’re now anticipating a low to mid single-digit decrease in year-over-year net sales for the fourth quarter and full-year 2016. We also expect that the progress we’re making in our underperforming region, the launch of our MIF delivery system in Q1, and the acceleration of net sales from our strategic distribution partner will overcome the market headwinds and enable us to resume revenue growth within the next several quarters.

On our Extremity Fixation business, we expect that for the remainder of the year, we will maintain a trailing 12-month growth rate in the mid single-digit range with our TrueLok Hex and Galaxy product lines continuing to drive our growth.

Also as I alluded to a few minutes ago, this SBU has a tremendous pipeline of new products that will be released in the first-half of 2017, which we expect will augment our success in our TrueLok Hex and Galaxy product lines. Our updated expectations for the fourth quarter and full-year 2016 for Spine Fixation are for net sales to decrease mid single digits.

Despite the challenges in this business, we are optimistic about returning to growth next year to our new product pipeline and a number of commercial initiatives that we have underway, particularly focused on our sales channel. Based on our performance over the last two quarters and our current forecast, we are updating our full-year guidance as follows.

Net sales for the full-year 2016 and today’s FX rates is expected to be in the range of $404 million to $408 million, down from our previous guidance range of $412 million to $416 million. This represents a year-over-year net sales growth rate of 1.9% to 2.9%. We expect adjusted EBITDA for the full-year to be $76 million to $79 million, an increase from our previous guidance of $69 million to $72 million.

This would be an increase in adjusted EBITDA of 25% to 30% over 2015. We expect full-year 2016 adjusted earnings per share to be in the range of $1.35 to a $1.45 using weighted average shares of $18.5 million and a tax rate of 38%, this is consistent with our previous guidance.

Thinking broadly about our goals for 2017, we anticipate having low to mid single-digit growth in each of our SBUs, as we continue to invest in clinical research, new product launches, and our distribution network. Most importantly, we are also accelerating our efforts to identify inorganic opportunities that can leverage our distribution channels, operational competencies, and management expertise. We’re focusing on transactions of all sizes that we believe can have a significant strategic impact on the company at reasonable levels of risk. In the absence of such opportunities, we will consider other means to return our available cash to our shareholders.

With that, operator, we can open up the line for questions.

Question-and-Answer Session

Operator

Thank you. [Operator Instructions] And we’ll take our first question from Anthony Petrone with Jefferies.

Anthony Petrone

Hi, gentlemen, thanks and good afternoon. Thanks for taking our call today. Maybe just to start a bit with some of the moving parts on revenue, specifically within Biologics first, and then we’ll move on to BioStim. Within Biologics, you did call out the, I guess, return to a hospital formulary that is effective this month. I’m just wondering, what impact you’re expecting to that business unit into the fourth quarter? And it certainly seems that it’s helping that unit get back to low single-digit growth. So maybe more specifically on that hospital system bringing Biologic spec into formulary?

Bradley Mason

Sure, Anthony this is Brad. Thanks for calling in today and being with us on Halloween, we appreciate it.

Anthony Petrone

No problem.

Bradley Mason

Yes, from the – in terms of the hospital, it’s just coming back online in November, so we’re not anticipating a huge uptick in the fourth quarter. But over time, it will make a difference. It was one of the factors this year that negatively impacted our top line. But as it comes back on, that will be one of the factors that then subsequently helps it. So not a huge impact, but in Q4, as we just have a couple of months left, but it will help us particularly going into next year.

Anthony Petrone

Yes. And then maybe the shift over to BioStim, the performance has – there was a guide for an improvement into the second-half and we were trending exiting last year in a high single-digit range. It looks like for all of the units return to low single digits across the board as expected. I guess a little bit more on ultimately where should we – we should be normalizing for BioStim growth? And in particular, what expectation are you expecting from the NASS coverage recommendation for electro bone growth stimulator? I mean, how much of that do you see in 2017, as that settles into coverage?

Doug Rice

Yes, Anthony, today actually we have Brad Niemann’s with us. He is the President of BioStim, and I’ll flip it over to him, he can answer the question directly.

Bradley Niemann

Hi, Anthony, it’s Brad Niemann.

Anthony Petrone

Hey, Brad.

Bradley Niemann

First to talk a little about the NASS coverage recommendations, it’s probably best summed up, it’s too early to tell. Obviously, we’re excited that, there’s another reference point in the market that further supports the use of cervicaly in lumbar and specifically for pulsed electromagnetic fields. But again, it’s probably little bit too early to tell and what impact that will have in the market and the use of our products.

And really from your – the first part of your question on the comparables of high single-digit to mid single-digit growth rates, I think that’s just more reflective of really where the market is at and how we continue to take incremental share up against difficult comparables over the last couple of years.

Anthony Petrone

Okay. Maybe shift to margins overall and zoning on gross margin, and then I’ll wrap it up with a question on use of cash. So on the gross margin, the guide, I guess, for the full-year actually factors in a sequential deceleration. And you did reference some cost savings, as well as some manufacturing efficiency gains, I know mix is part of this as well.

So I’m just wondering why the step down sequentially in the margin guidance, given where it exited in 3Q? And then in uses of cash, if we could just get an update, it sounds like if I’m hearing you correctly, Brad, that there’s a little bit of a shift here and priorities away from the buyback toward strategic initiatives. But if you can just give us an update on capital deployment that would be helpful? Thanks again.

Doug Rice

Sure.

Bradley Mason

Doug you want to.

Doug Rice

Yes, Anthony, this is Doug Rice. With regards to the gross margin guidance of 78% to 79%, we had 79.8%, I’m sorry, we had a higher number this quarter largely because of the mix of our BioStim top line and also the manufacturing efficiencies that I mentioned earlier, which included some pickups in E&O and just as better managing our inventory. So those are the items that we expect to taper off some in the fourth quarter is why you saw the lowered range.

Anthony Petrone

Okay.

Doug Rice

And then in terms of the capital deployment and use of cash, Anthony, yes, it is a bit of a shift. We – we’ve been focused on our bottom line for quite some time now and getting our foundation rebuilt, so that we could put more weight on it. And going forward, it is a priority of us to grow our top line and we will look at opportunities that – to do that. And we’re going to look at all different sizes.

We continue to, we have been looking, and we will continue to look at opportunities that that will have a good shareholder return and at a reasonable risk is where we are. And if – in the absence of that, we’ll figure out it another way, whether it’s a start buyback or some other way to get our cash back to our shareholders. But our top priority is really to grow our top line and that’s what we’re going to look to do.

Anthony Petrone

And maybe just to sneak one in there. Just been looking at the business units, is there anyone in particular that jumps at you as being a preference for acquisition? And should we be thinking more on the Stim side and Biologics, as opposed to the ortho side?

Doug Rice

I think, they all have opportunities and I don’t want to sound like a political answer here. But it’s really about what’s available in the market as much as anything else. Certainly, if we have the opportunity in our highest margin businesses, that’s where we would look first. But if – in the absence of that, we have really good opportunities to grow all of our businesses and there’s not going to be a lot of things out there that fit our criteria. So as they come along, they could be in any one of our businesses and we’ll still be actively looking for it.

Anthony Petrone

Thank you.

Operator

We’ll take our next question from Jim Sidoti with Sidoti & Company.

Jim Sidoti

Good afternoon. Can you hear me?

Bradley Mason

Hey, Jim.

Doug Rice

Yes, Jim, how are you?

Jim Sidoti

Good, good. Can you just repeat what you said about gross margin in the quarter and why it was so strong?

Doug Rice

We saw a couple of things happened in the quarter, Jim, this is Doug. And the first one is, with regards to mix, as you know, our BioStim business generally carries higher margins for us. And so as that picked up for us, we saw an increase in our gross margin. And then we also had some favorable variances in some of our manufacturing costs specifically around E&O reserves and why manage inventory and some other manufacturing efficiencies.

Jim Sidoti

Okay. How about geographic mix? Is that an issue in the quarter?

Doug Rice

Geographically in what way, Jim?

Jim Sidoti

Low growth, or do you have more sales in the U.S. than normal, do that help you?

Doug Rice

No. Yes, I got you now. Sorry, the international U.S. business was basically the same – the same percentage.

Jim Sidoti

Okay.

Doug Rice

No big shift.

Jim Sidoti

All right. And…

Doug Rice

And just to be clear some – that’s roughly 23% of our top line is outside the United States and that’s pretty consistent with past quarters.

Jim Sidoti

Okay. The charge – the SEC charge you took in the quarter, I assume that I just went over the queue real quickly, you were speaking that’s related to the issue in Brazil, it’s not a new issue, it’s something you think you are almost passed at this point, is that correct?

Bradley Mason

Yes, that’s basically right, Jim. I mean, we’re continuing to work with the SEC and we’re proceeding on track and looking forward to a final resolution most likely in Q1 of 2017. But they have their process. They have to go through as well and we’re just waiting to finish it up and hopeful to finish it up.

Jim Sidoti

All right. And then can you just repeat why the tax credit in the quarter was that, because some of the options compensation or the obsolete charges was deductible or…?

Doug Rice

The – you’re referring to the indirect tax favorable variance that we had in sales and marketing. We discussed before that we’ve invested a lot in managing our overall tax past year for the company, including any – potential liabilities for indirect taxes like sales and use tax, like property taxes, and other business taxes, and in large part due to some of the visibility provided by some of the systems that we’ve implemented under our Bluecore project. During the year, we were able to favorably reduce a portion of our indirect tax liability during the third quarter.

So going forward, we’re going to continue to evaluate the remaining balances and expect that we could see some further reduction in these tax liabilities, but probably not to the extent that we saw in the third quarter.

Jim Sidoti

So basically over-reserved in the first-half of the year and now you’re just chewing that up?

Doug Rice

I wouldn’t say it like that, Jim. I would say that we thought our reserves were certainly adequate and that due to the management of those liabilities in the visibility that we were able to get that we’ve been able to manage them down.

Jim Sidoti

Okay. And what do you think in normalized tax rate should be for the fourth quarter and for 2017 and beyond?

Doug Rice

Yes, that’s a good question. So from an income tax perspective, so these are all just indirect tax liabilities that hit above the line. But just from an overall effective tax rate position, we expect our long-term tax rate to be in the upper 30s specifically at 38%. And so we’ve got variability from quarter-to-quarter on income taxes just because of the way our our taxes are complex, or in many jurisdictions, we don’t always get full tax credit in some of those jurisdictions. So it’s volatile for quarter-to-quarter, but we feel like 38% is the appropriate adjusted rate to use. The gap tax rate for the quarter was 44%.

Jim Sidoti

Okay. But what you’re saying, is that may change going forward just because some of the issues you had in this quarter, or if some of those issues change – it might change your reported tax rate?

Doug Rice

The other things might impact our sales and marketing line, the sales and use tax…

Jim Sidoti

Oh, okay.

Doug Rice

And other indirect tax items that I mentioned.

Jim Sidoti

Okay. But in this quarter and the September 2016 quarter, those indirect items affected your income tax expense, is that correct?

Doug Rice

No, maybe I’m not being clear. But that $2.4 million impacted sales and marketing and that was….

Jim Sidoti

Okay.

Doug Rice

because it was an indirect kind of a business tax, if you will, with sales and use property, all the different types of taxes that don’t get counted as income taxes.

Jim Sidoti

Okay. So and is that why you reported the $1.2 million credit on the income tax expense line, or was that in your SG&A line?

Doug Rice

That was a different time. So the income tax line was largely driven – so we had a – we’re in a good position this quarter for the first time and a long time to be able to do record a favorable variance on tax. So we had pre-tax book income when you would normally expect a tax provision, we actually booked a tax benefit.

So it was primarily driven by a favorable change in our allocation estimates, certain compensation expenses across subsidiaries in different jurisdictions that was offset by the additional $1.5 million of SEC estimated penalty for which we get limited deductibility. So that the large favorable variance was driven by the compensation allocation.

Jim Sidoti

Okay. So – all right. That’s the question I was going to do. So because you change some of your compensation assumptions that income tax expense assumption now changes, and so that’s why you reserve the – you had the credit in the quarter?

Doug Rice

You got it.

Jim Sidoti

All right, good. All right. And then as far as – as getting the top line back on track, you think you had a sales – you had reorganized your sales force in the second quarter and that impacted sales in the third quarter, so should we assume that it probably impact sales in the fourth quarter in the first-half of 2017, as well?

Doug Rice

Definitely in Q4, as I said Jim, I think, we’re looking for Biologic. We’re looking mid single-digit decrease in Q4 in 2016 for both our Biologics and Spine Fix business – Spine Fixation businesses. So – but we do expect them to be both into the low to mid single digits growth next year.

So the ramp up time of that is still not determined. We’ll give you a lot more color around that on our Q4 call when – as we get into next year. But we do expect a good recovery in those businesses next year.

Jim Sidoti

All right. All right, thank you.

Doug Rice

Thanks, Jim.

Bradley Mason

Thank you, Jim.

Operator

That does conclude today’s question-and-answer session. At this time, I’ll turn the conference back to Mr. Brad Mason for any concluding remarks.

Bradley Mason

Thank you, operator. I appreciate the help today, and thanks, everyone, for joining us on the call. Look forward again to – look forward to speaking you again after the close of the year and have a happy Halloween.

Operator

This does conclude today’s conference. Thank you for your participation. You may now disconnect.

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