Exactech's CEO Discusses Q4 2011 Results - Earnings Call Transcript

| About: Exactech, Inc. (EXAC)
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Exactech, Inc. (NASDAQ:EXAC) Q4 2011 Earnings Call February 29, 2012 10:00 AM ET

Executives

William Petty – Chairman and Chief Executive Officer

Joel C. Phillips – Chief Financial Officer

David W. Petty – President

Analysts

James Sidoti – Sidoti & Company, LLC

Christopher Sassouni – Eagle Asset Management, Inc.

William J. Plovanic – Canaccord Genuity, Inc.

Jason M. Bednar – Robert W. Baird & Company

James Terwilliger – Duncan-Williams, Inc.

Mark Landy – Summer Street Research Partners

Operator

Good day, ladies and gentlemen. Thank you for standing by and welcome to the Exactech fourth quarter and 2011 full year results conference call. During today's presentation, all parties will be in a listen-only mode. Following the presentation, the conference will be open for questions. (Operator Instructions) This conference is being recorded today, Wednesday, February 29, 2012.

I would now like to turn the conference over to Mr. Bill Petty, Chief Executive Officer. Please go ahead.

William Petty

Thank you and welcome to our conference call. I will begin with the SEC statement. 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 may represent the company's expectations or beliefs concerning future events of the company's financial performance. These forward-looking statements are further qualified by important factors that could cause actual results to differ 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 for the company, market acceptance of the company's products, and the effects of government regulation. Results actually achieved may differ substantially from the expected results included in these statements. I will first talk about Q4 2011.

For the fourth quarter of 2011, revenue was $53.1 million, which is an increase of 2% over $51.8 million for the fourth quarter last year. Net income for the fourth quarter was $1.8 million, compared to $2.7 million for Q4 of 2010. Diluted earnings per share was $0.14 for the fourth quarter in 2011 and $0.21 in the same quarter of 2010. If we exclude the DoJ cost of $0.9 million in Q4 2011, the resulting EPS is $0.18, and this compares to a cost of $0.5 million for DoJ in 2010 and the resultant $0.23 earnings per share for the fourth quarter of 2010.

I now want to summarize the entire year 2011. For the full year, our revenue increased 8% to $205.4 million from $190.5 million in 2010. Net income was $8.8 million with an earnings per share of $0.67 in 2011, compared with a net income of $10.5 million and $0.80 per share a year ago. Again, if we exclude the DoJ expenses in 2011 of $4.5 million, compared to $1.3 million in 2010, the 2011 net income was $11.7 million, or $0.89 earnings per share, compared with $11.3 million, or $0.86 per share, in 2010.

I now want to summarize the segment performance for the fourth quarter. Our knee implant revenue in Q4 was down 2% to $20.1 million. Extremity implant revenue increased 29% to $11 million, hip implant revenue was up 13% to $9.3 million, biologic and spine revenue decreased 21% to $5.9 million, and other revenues were down 4% to $6.7 million.

Now, for the segment performance for the entire year. Knee implant revenue was up 5% to $80.1 million, extremity implant revenue increased 33% to $39.9 million, hip implant revenue was up 17% to $33.7 million, and biologic and spine segment revenue was down 13% to $24.3 million, while other revenues increased less than 1% to $27.4 million. Obviously, our results in biologics and spine both for the quarter and the year hurt our overall performance.

We are looking for stronger results from these segments in 2012 from new product introductions, which include the first pedicle screw system developed in-house and our Gibralt Spinal System for posterior cervical fusion. We have experienced excellent surgeon acceptance in the early launch of these product lines. From the biologic side, we are positive about our autologous stem cell technology, which we think has some advantages over other stem cell technologies which we know are an important topic, especially in the area of spinal surgery.

Also on the biologic side, in the fourth quarter of 2011, we began a multicenter clinical trial on our cartilage regeneration technology that we have been working on in development for the past three years. On the major joint side, we are pleased with the strong surgeon acceptance in the early release of the Optetrak Logic knee system. We had a strong year in hip sales, primarily due to significant contributions from our direct operations in Spain and Japan, and we expect to continue the momentum there as well is in other parts of the world.

In the U.S. we launched a new Novation Crown Cup system featuring InteGrip porous metal technology and an advanced surgical technique for acetabular reconstruction. Our extremity segment continued to shine by substantially outpacing market growth, and we have strong momentum there moving into 2012. Overall, for 2011 Exactech outperformed the industry in revenue growth. From this solid base we are excited about our prospects to outperform the industry in 2012.

I'm now going to ask Jody Phillips to give you some more of the financial details, operational data.

Joel C. Phillips

Good morning everyone, and thanks for joining us for the fourth quarter and full year conference call.

The fourth quarter sales results were within the range of our expectation of $53.1 million. However, the fourth quarter net income of $1.8 million and diluted EPS of $0.14 was below our expectations, primarily due to sales mix, currency losses, and a higher-than-expected tax rate. As we reviewed each of these issues in relation to our first quarter and 2012 guidance, we feel that each of these were factored into our thinking for 2012 and therefore we are reconfirming our guidance for the first quarter as well as the full year.

In order to review our full year 2011 operating performance and outline our expectations for 2012, I will review each of the operating line items from a percent of sales perspectives. Our gross margin percent expansion during the full year of 2011 from 66.4% to 68.4% was consistent with our expectation. And as we look to 2012, we expect flat to only modest -- basically a 50 basis point increase. As the large mix and OUF direct business has now annualized, plus we expect to continue to see moderate pricing pressure in the U.S. somewhat offset by our continued internal manufacturing cost reduction effort.

From our sales and marketing expense perspective, the full year 2011 increase in the direct business outside the U.S. was the largest driver behind our 17% increase to 37.6% of sale, as we experienced the full year of infrastructure cost in our Spanish and Japanese subsidiaries. During 2012, we expect sales and marketing costs to increase between 3% to 8% primarily due to variable selling expenses and buildup of direct sales forces outside the U.S.

This will result in sales and marketing expenditures for 2012 of approximately 37% of sales. 2011 general and administrative expenses increased 25% to 10.7% of sales, primarily due to the $4.5 million in compliance spending related to our ongoing monitorship. And this represented a $3.2 million increase in these compliance costs versus 2010. During 2012, we anticipate that G&A expenses will be flat to potentially down 5%.

Assuming we conclude the monitorship and there is a $1.5 million reduction in compliance spending, which would result in G&A costs of approximately 10% of sales for 2012. 2011 research and development expenditures decreased 4% to 6.4% of sales, although we expect these cost increase in 2012 by 15% to 20% to roughly 7% of total sales. During 2011, we experienced a 35% increase in depreciation and amortization, to 7% percent of sales, due to our large investment in instrumentation during 2010 and 2011.

During 2012, we are projecting depreciation and amortization expenses to increase roughly from 6% to 10% and remain at the 7% of total sales level. Our 2011 total operating expenses, as a result of the above, increased 17% to a total of 62% of sale. And for 2012 we project a 4% to 7% increase in total operating expenses, which would equate to roughly 60% of sales if you look at the midrange of our revenue guidance.

As a result of these targets for 2012, the midrange of our 2012 earnings guidance roughly equates to a 34% increase in operating profit, to $18.5 million, and this would represent 8% of total sales. Our 2011 full year effective tax rate was 34%, versus 43% in 2010, and our current expectations are for a rate of 31% to 32% for 2012. The rate spiked in the fourth quarter, compared to the previous year-to-date rate, primarily due to increased valuation allowances related to certain market specific tax losses in 2011 that we currently project are not deductible.

The primary reason for the projected decrease in 2012 of the overall effective tax rate is that we do not expect these non-deductible losses in 2012 to be as material as they were in 2011. From a balance sheet perspective, we reached an inflection point in inventory increase and credit line increases during the middle of 2011, as we projected. And, actually, both of these numbers decreased during the second half of the year.

We currently project for inventory and credit line usage to be stable during the first half of the year and increase modestly in the second half of the year due to product and market expansion. Our full year accounts receivable days sale outstanding increased to 75 during 2011 from 70 days in 2010, primarily due to extended receivables in Europe, and we expect this to expand further in 2012 to a range of 78 to 81 days.

Total capital expenditures during 2011 were $24.9 million and we are projecting approximately $20 million in capital expenditures for 2012. We announced on Monday the increase of our credit facilities to $100 million in total capacity and an extension until 2017. While we do not have any immediate needs for the expanded borrowing, we feel that taking advantage of the attractive terms, extending the expiration date by four years and providing capacity for future growth opportunities was in the best interest of the company at this time.

In summary, and back to our 2012 guidance, we continue to target full year revenue of $215 million to $223 million, which represents a 5% to 9% top line growth number, and diluted EPS of $0.88 to $0.96. Our first quarter revenue guidance of $54 million to $57 million represents a 1% to 7% increase versus the first quarter of 2011, and that is expected to result in first quarter diluted GAAP EPS ranging from between $0.22 to $0.24.

Those are all the comments that I have at this time. And again, thank you for joining us.

William Petty

Thank you, Jody. We can open up for questions now.

Question-and-Answer Session

Operator

Thank you. We will now begin the question-and-answer session. (Operator Instructions) And our first question comes from the line of Jim Sidoti with Sidoti & Company. Please go ahead.

James Sidoti – Sidoti & Company, LLC

Good morning. Can you hear me?

William Petty

Yes, Jim.

James Sidoti – Sidoti & Company, LLC

Can you just remind me, is there a specific hurdle you have to across to complete this compliance phase, or is this at the discretion of the DoJ?

William Petty

I don't believe there is a specific hurdle. The completion of the DPA will come at the recommendation of the monitor and the acceptance of that recommendation by the U.S. Attorney's Office. We have had what we believe are positive communications from our monitor related to that. But I will also say that we felt comfortable at this stage last quarter that our DPA was going to end. As you will recall, though the monitor stated that we had a strong compliance program in place, they felt that they needed additional time to test that system. We believe that they have done that. But to use a sports analogy, the way I look at it, it's not over till it's over.

James Sidoti – Sidoti & Company, LLC

Understood, understood. And then can you just talk a little bit about the new products for 2012?

David W. Petty

Sure, Jim. It's David. So, on the knee we're going to continue the launch of our Logic PS Optetrak knee and complement that with the meaningful release of the Logic Cruciate Retaining knee. Both of those will benefit from the use of what we call the Logic FIT tibial tray, which we will continue to launch, and there are two new tibial inserts at will be available this year. One we call a PSC, posterior stabilized constrained, and also a CRC, or cruciate retaining constrained dial insert.

And we will be launching the Logic version of the rotating bearing knee in Europe. For the hip, we will be launching shorter neck element hip stems. This is the stem that we've been using with our direct anterior approach, as well as large heads and liners for the Novation Crown Cup and then we will continue -- we have a pilot launch underway with the Novation InteGrip Acetabular augments, that's a revision system.

And we will be launching more fully in other markets, some of the German hips that we acquired in 2010. And we are in -- still in the regulatory process with the Novation Prime, that's the short stem that's been in development and before the FDA. With the Equinoxe System, we've figured that our fracture -- platform fracture stem that's fully launched, we have an ongoing limited release of the proximal humeral fracture plate as well as the CTA humeral head.

And the posterior augment glenoid will be launched in the first quarter along with the augmented reverse base plate. And we will have a pilot release of the cage glenoid that's really ongoing and throughout this year. It will be fully launched in the third quarter and with the spine, we've launched a number of systems at the second half of last year, and we'll continue with the Gibralt posterior cervical Phase 2 launch in the first quarter of this year, and also an expandable antibody system in the fourth quarter of 2012.

James Sidoti – Sidoti & Company, LLC

All right, and are all these products approved or do you still require FDA for a portion of these?

David W. Petty

Everything is cleared with the exception of what I call the Novation Prime, the shorter stem, which is we're going to resubmit in the second half of this year. So it's probably optimistic to even think about that for the 2012.

James Sidoti – Sidoti & Company, LLC

All right. And then just finally, listening to some of the larger implant makers, it sounded like they were cautiously optimistic that procedure rates have bottomed out, for lack of a better term; is that you are seeing?

David W. Petty

Yes, we're optimistic as well. The way we think about that though is whether that is the case or not. We should be less affected by slightly negative procedure rates. And, certainly, if we do the basic blocking and tackling in our sales management processes that we should be able to have positive growth no matter what the market is doing. And I think we've demonstrated that even through these last few years that have been, I think, challenging for all of us.

James Sidoti – Sidoti & Company, LLC

All right. And then, I guess reading between the lines a little bit, it seems like some of the cost you had, particularly in the fourth quarter of 2011 were more of a one-time nature? Is that correct?

Joel C. Phillips

I think it's best for us to characterize that we feel that any of those cost that continue in 2012, we feel like we've got factored into our guidance.

James Sidoti – Sidoti & Company, LLC

Okay, all right. Thank you.

William Petty

Thank you, Jim.

Operator

And our next question comes from the line of Chris Sassouni with Eagle Asset Management. Please go ahead.

Christopher Sassouni – Eagle Asset Management, Inc.

Yes, good morning. I was wondering if you could give us the number, because I haven't seen the 10K, what the estimated free cash flow was for 2011?

Joel C. Phillips

It was probably in the $4 million to $5 million neighborhood, Chris. As we do not have the case filed as of yet, it will be a while before that.

Christopher Sassouni – Eagle Asset Management, Inc.

Okay. And what you think it will be or will you projecting a will be? You give us CapEx summers, what you expect free cash flow to be for 2012?

Joel C. Phillips

It was probably in the $4 million to $5 million neighborhood, Chris.

Christopher Sassouni – Eagle Asset Management, Inc.

Okay.

Joel C. Phillips

And we do not have the 10K filed as of yet, it will be a little long before that.

Christopher Sassouni – Eagle Asset Management, Inc.

Okay. And then, what do you think it will be or what are you projecting it will be? You gave us the CapEx numbers, what do you expect free cash flow to be for 2012?

Joel C. Phillips

We're hoping it will be somewhere in the neighborhood of $5 million to $10 million.

Christopher Sassouni – Eagle Asset Management, Inc.

$5 million to $10 million, okay. Could you also provide us with some understanding of the competitive dynamics of extremities? You've been enjoying supernormal growth in that business with your products, and at the same time I am seeing other entrants come into the marketplace that are also showing pretty strong growth in that market segment. Do you expect that the product lines that you have and/or that the end customers that you are targeting will allow you to maintain that kind of growth trajectory? Or is it going to start slowing down pretty soon just on the basis of your coming off of a small base?

David W. Petty

This is David. We don't anticipate that it will slow down substantially anytime soon. And bear in mind that I don't think there is another company that's growing at the rate that we are. When you say extremities, remember the world of extremities to us is basically total shoulder replacement and fracture fixation. So we don't have -- we don't include the foot and ankle piece in our extremities business unit and by our estimation, the extremities -- the shoulder market itself is growing, let's say 8% to 10%, and so we are doing almost 3.5 times that.

And the reason for that is we believe that surgeons believe that we have a better product, a product that does a better job treating patients in difficult problems, especially with the reverse shoulder. And so our strategy is quite simply to stay ahead of the technology curve. You heard me recite the product launches that we are in the process and anticipating going forward. And so, with those product launches, we expect to stay ahead of the competition and continue to have strong performance with our shoulder product line. We will add to that in the second half of 2013 with a total ankle arthroplasty product. But, of course that won't have any effect during the current year.

Christopher Sassouni – Eagle Asset Management, Inc.

Okay. And then, just also wanted to understand in this world of GPO's, you have been operating in this environment for a long time. But with what we hear going on in terms of the leverage that they have to influence physician preference items and to push more of the purchases towards bundled contracts, if you will, how you have been able to navigate in that environment and are you seeing any incremental pressure or it's always been there?

David W. Petty

In terms of GPO's, I think Exactech is the only company with a hip and knee contract with HPG. So I think we certainly know how to navigate those waters. We have just been included on the Kaiser California group agreement with our shoulder. Now, generally what we're seeing is a lot of discussion about pricing at the hospital level and at the group level. And certainly we're responsive to that. We understand that the economic customer piece of the equation and we're very focused on meeting those needs.

In terms of consolidation to suppliers, I know that's fewer suppliers, I know that's a popular theory to talk about, but I can tell you at least one experience recently is we're in discussions with a university hospital that's on a sole supplier, not Exactech, very dissatisfied with the notion that the surgeons don't have enough freedom to select what they need to taking good care of their patients and we're in discussions with them about expanding that to several suppliers. So that's one test case.

Christopher Sassouni – Eagle Asset Management, Inc.

Okay. And final question is, maybe I missed it along the way, but could you -- have you ever disclosed details about your cartilage regeneration technology and how that works?

William Petty

There is some public information. We have shown it in some meetings, and it's not that it's a major secret. As I mentioned earlier, it's now in a multicenter clinical trial outside the U.S. So, we haven't divulged everything about it but it's not a secret.

Christopher Sassouni – Eagle Asset Management, Inc.

Okay. I'm just trying to understand, is it -- if it's regeneration, is that based on infusion of stem cells onto articular surfaces or have you even gone that far?

William Petty

No, we're much beyond that. It's actually a device which is provided to fit a prepared stage where the cartilage damage is. And then it is -- that device is stopped with autologous cartilage cells that are prepared at the time of surgery. So, it's a single-stage procedure, as compared to some of the other autologous procedures that are two-stage, meaning that it has to be treated outside the operating room for a period of time.

Christopher Sassouni – Eagle Asset Management, Inc.

Got it, okay. Thank you very much.

Operator

Thank you. And our next question comes from the line of Bill Plovanic with Canaccord Genuity. Please go ahead.

William J. Plovanic – Canaccord Genuity, Inc.

Great, thanks. Good morning. I might have missed this, sorry. I'm just curious, so the DPA, the monitor gets to decide whether he is done or not monitoring you, so he keeps collecting a check as long as he wants. Bar that, thoughts on -- in the guidance that you've given for earnings, do you assume that the monitor goes away in the next quarter? Or is that an ongoing cost in your assumptions for guidance?

Joel C. Phillips

The assumption there basically there's an implied $1.5 million reduction in compliance costs in total and the assumption is that the monitorship is completed at the end of the first quarter.

William J. Plovanic – Canaccord Genuity, Inc.

Okay, okay, so if that gets extended, then that earnings will change?

William Petty

Yes. If it continues with the external costs at the rate that they have been and it gets extended, yes I would suspect that would change.

William J. Plovanic – Canaccord Genuity, Inc.

Okay. In -- sorry, but how much room do you expect out of that component specifically in Q1, the monitorship?

Joel C. Phillips

Here's the way to look at it, $900,000 in the fourth quarter, there likely will be somewhat increased costs in the first if the wrap up is going on because there will be some increased activities. But think of it in the neighborhood of that $1 million to $1.3 million that we've ran in some prior quarters.

William J. Plovanic – Canaccord Genuity, Inc.

Okay, that's helpful. And then the cartilage product, it's a multi-center trial, can you just give us some color on how many patients, how long will that take to enroll and when we could see some data from that?

William Petty

Bill, first of all, let me say that we did a trial in 10 patients. We might call it a Phase 1 but we don't usually use those terms in devices. We do have data, even including some histology from those which do show regeneration of higher than our articulated cartilage. The multi-center clinical trial is just underway, and actually Bruce Thompson who is head of our biologics division and I will be going to Taiwan in April for the first meeting of the clinical site.

And I am a little reluctant to give an estimate of when we will have that completed at this point. But I think we can have more information about that on the next call after we have this meeting in April.

William J. Plovanic – Canaccord Genuity, Inc.

Okay, so it sounds like you will probably start enrollment somewhere around midyear. And then how many patients do you expect in this trial?

William Petty

We have already -- we have begun enrollment. We began at the end of 2011 and I believe the number is 96, about 100 but maybe just slightly below 100.

William J. Plovanic – Canaccord Genuity, Inc.

Okay. And then would this get you approval in the U.S. or you would have to do a separate U.S. trial for this?

William Petty

No, no, it will be a separate U.S. trial. Our goal, Bill, is to get approvals in Asia and Europe in the relatively near term. I say relatively. It will be longer in the U.S.

William J. Plovanic – Canaccord Genuity, Inc.

Okay. And then you talked about a stem cell technology. I was wondering if you could give us some color on that?

William Petty

Sure. We have an autologous stem cell technology which is somewhat similar to our PRP technology. It's autologous, cellular-based, it's collected from the person's bone marrow, and those stem cells are concentrated and then they can be used in whatever methodology that the surgeon chooses. But the major advantage is that they are autologous, rather than some other technologies such as allograft or other.

William J. Plovanic – Canaccord Genuity, Inc.

Okay. And then when -- in that technology, given the fact that that is autologous and it goes under the tissue, when would you expect that -- we see the data on that or that gets commercialized?

William Petty

Well, it is being commercialized now. We expect the major use to be in our spinal area, though those numbers will be reported at least currently through the biologics. That means biologics and spine for us. So we anticipate that as part of our growth in spine and biologics for this year.

William J. Plovanic – Canaccord Genuity, Inc.

Fantastic, thank you.

William Petty

You are welcome.

Operator

(Operator Instructions) And our next question comes from the line of Jason Bednar with Robert W. Baird. Please go ahead.

Jason M. Bednar – Robert W. Baird & Company

Good morning guys. Can you hear me okay?

William Petty

Yes, Jason. Good morning.

Jason M. Bednar – Robert W. Baird & Company

Great, so some of my questions have already been answered here. But Jody, just hoping you can walk me through how you're thinking about margins for 2012. Looking back at the past several quarters, margin trend line has been improving and we have gone from seeing margin down a couple hundred basis points earlier in the year to now being down less than 100 as we exit the year.

So we're trying to get our arms around how we get to the 100 basis points or so margin expansion that's implied in your guidance. Is that correct to think of this margin guidance coming more in the back half of the year, where your margin comps are a bit more favorable, rather than the year being more level loaded?

Joel C. Phillips

I think level loaded is a fair assumption and probably 50 basis points is the number I think I mentioned that we were -- the way we're looking at things. And the primary reason for the change is the large gross up that we have through the increase in sales in a couple of our direct subsidiaries, a lot of that sales increase is now annualized. And so that's the primary reason that the expansion of the margin is going to be much less than 2012 than what we experienced in 2011.

And I will add that all of that, we're continuing to anticipate some pricing pressure in the neighborhood of 1% to 2%. That's kind of factored into that and then as well as we continue to bring more and more products in house so that somewhat offset the impact there. But I'd think about it more on a level loaded basis than any specific quarter having a larger change.

Jason M. Bednar – Robert W. Baird & Company

Okay, that's helpful. And sorry I wasn't clear. I was actually more referring the operating margin line, is that would you -- our math gets us to 100 bps but is it 50 bps there as well or I thought I heard you reference around --

Joel C. Phillips

I'm sorry, I did totally misunderstand you. I was thinking about gross margin level. Looking at operating margin level, yes you are exactly right. The expansion is going to be much more in the second half of the year, because our operating margin performance in 2011 was lower in both the third and the fourth quarter than it was in the first half of the year. So a lot of that expansion will be in the third and fourth quarter of 2012.

Jason M. Bednar – Robert W. Baird & Company

Okay. So then maybe as a bit of a follow up there, could you talk about what you are assuming from a high level with regards to volumes in the U.S.? Is embedded in that margin assumption, is that -- is there an assumption that there is a rebound in U.S. volumes or U.S. recon volumes? Just given how tied you are -- you tend to be, your margins tend to be to that part of your business.

Joel C. Phillips

Sure. I think that's kind of factored or assumed into our assumptions is that the U.S. market is probably in the flat to 2% type neighborhood. Certainly, we expect our U.S. specific performance to be higher than that. But we still kind of expect that U.S. growth rate to be slightly lower than our outside the U.S. growth rate. So baked into that is continuing to assume that we outperform the market slightly in the U.S. and more significantly outside the U.S.

Jason M. Bednar – Robert W. Baird & Company

Okay, that's helpful. So, and just final one housekeeping item from me, just tell us what the currency impact to the top line was for the quarter?

Joel C. Phillips

Sure. It was much lower in the fourth quarter than it was earlier in the year. I think if you look at things on a constant-currency basis it was 6%. I am sorry, that's full year, the full year number was 6% constant-currency growth versus 8%, and actually there was no impact in the fourth quarter to the 2% rate on a constant-currency basis, it was still 2%.

Jason M. Bednar – Robert W. Baird & Company

Okay, thanks very much guys.

William Petty

Thank you.

Operator

And our next question comes from the line of James Terwilliger with the Benchmark Company. Please go ahead.

James Terwilliger – Duncan-Williams, Inc.

Hey guys, can you hear me?

Joel C. Phillips

Yes.

William Petty

Good morning.

James Terwilliger – Duncan-Williams, Inc.

Good morning. When I look at the industry and I see what you guys have done with your extremity growth and the hip growth I think it looks very impressive. I have two quick questions. On the first side of this release on this call you alluded to you guys were very bullish with what is going to happen and what you believe is going to happen in 2012 in both Japan and Spain. And could you just remind us of some of the different initiatives you have in both of those countries?

I know you have tried to make a move of going direct. I know Japan has had some issues that in no way are related to you guys and I know you have built Spain throughout the year. Can you just expand a little bit on some of the positive trends that you have going on in Japan and Spain in 2012?

David W. Petty

Sure. In both cases, I think the most important thing we have done over time is to develop very effective sales organization. So, start with that and note then that in both markets, under previous distributor arrangements, we effectively were a one-product company. In both cases they predominately relied upon the Acutrak knee from Exactech and the distributor arrangements. And when we have established these direct operations, we have now taken control of putting more of the [bag] [ph] in the markets.

So we got important approvals related to our hip product line in Japan last year and the year before. And so it's helpful to drive revenue from both knees and hips in Japan. And we do feel very good about the momentum we have there. Formerly in Spain, we were selling mostly knees and some biologics. Now we are selling a tiny little bit of shoulder. Now we are selling knees and hips in a meaningful way, spine, biologics, and shoulders as well.

And so, with the effective sales organization and now leveraging the entire range of products, it makes it easier for us to defy the market dynamic and show real strong growth in a market that is still a little bit challenged.

James Terwilliger – Duncan-Williams, Inc.

And can you remind me how big your organizations are in Japan and Spain in terms of number of employees?

David W. Petty

We have about 70 to 75 people in Spain. And more like 15 in Japan.

James Terwilliger – Duncan-Williams, Inc.

Okay, great. And then I am going to switch maybe to more of a -- I don't want to call it a negative question but also in the release you indicate there are some difficulties or headwinds in France. Could you expand on what you view the French market going into 2012?

David W. Petty

That for 2011 was a challenge for us. Our people tell us that the market itself was actually negative by double digits in hips and knees. The bright spot for us was we have managed to make some good progress with our shoulder in France. And really we've done -- I don't want to overstate it, but we are doing a little bit of restructuring, making some changes with respect to focusing the investments into the sales organization and out of some administrative functions.

But we do have fixed cost there that when we are challenged at the top line it kind of ripples through and puts pressure on it. And so we understand where we are there. We have made some changes. Our VP of international sales and marketing has been there for the last week and a half, working directly with the team to get things moving in the right direction. And so we feel like we've got it under control. And despite the market conditions, we expect to have a stable business and eventually a strong, growing business in France.

James Terwilliger – Duncan-Williams, Inc.

So for the French market, did I misinterpret 2011 was down double digits per se and you think it could stabilize for 2012? Is that...

David W. Petty

That's correct. And the double-digit was a market reference but it also applied to our own experience, unfortunately.

James Terwilliger – Duncan-Williams, Inc.

And then lastly, in the U.S., is it just multiple headwinds coming in with lower procedures, maybe some price pressure, some competitive market share pressure? And is there any change in your -- let's call it your U.S. distribution network? What is driving the flat to slightly down U.S. performance? Not just for you, for a lot of other companies as well?

David W. Petty

So I am going to -- I want to put you in sales management now because you hit the nail on the head. I think the most important for us is the channel. We've been making investments into the domestic channel. And when we think about 2010 and 2011 where Exactech invested substantially in our channel outside the U.S., and I won't say we took our eye off the ball drastically, but we really are focused on creating a more effective sales organization domestically and there are a lot of opportunities out there now for us to do that.

And I don't want to be dismissive of your comments about competitive pressure and market conditions, because those are real. But, on the other hand, the same sales channel that I'm talking about is outperforming the market by a factor of 3.5 with our shoulder and certainly we are capable of doing what we've done for 15 consecutive years by outperforming the market with knee growth and we expect to do that.

So the way we think about it is, with our relative size, the market conditions in general should be less relevant to us. It's about execution, it's about having an effective sales organization and, yes, I don't mind saying, we have made and are continuing to make changes in the sales organization where we don't have the performance that we require.

James Terwilliger – Duncan-Williams, Inc.

Excellent. Thank you for taking my questions. And again, your extremity and hip businesses look great. Take care, guys. Thanks.

William Petty

Thank you.

Operator

Thank you. (Operator Instructions) And our next question comes from the line of Mark Landy with Summer Street Research. Please go ahead.

Mark Landy – Summer Street Research Partners

Good morning, folks.

William Petty

Good morning.

Mark Landy – Summer Street Research Partners

And again, great quarter on extremities. Just a couple questions I had some housekeeping. In the first quarter in 2012 relative to 2011 what's the compare on day sales selling days?

Joel C. Phillips

Was the comparative selling days? I think it's same or minus one. We think it's the same. I know there is one obviously one extra in February and one less in March, but we believe it's the same.

Mark Landy – Summer Street Research Partners

Okay. So if I have a look at the guidance for 1% to 7%, that's suppose on an absolute basis it's not that large, but on a percentage basis it's quite a range. What would have to happen to get you closer to the upper end of the range? And if you don't get to that upper range, does that roll into the second quarter?

Joel C. Phillips

I think primarily what has to happen in the first quarter to get to the upper end of that range is we've got to get a little more traction in our U.S. knee revenues. That's probably the key item. If we don't get to the upper end of that range does it just roll into the next quarter? I don't think necessarily so, because I think that would be a little bit of statement on the market and how we're performing. So I think we'll just have to kind of see how it plays out.

Mark Landy – Summer Street Research Partners

Okay. And suppose if there's one month left in the quarter, I don't want to push you too hard, but it is quite a good range with just one month left in the quarter.

Joel C. Phillips

All I can say is we reconfirmed our guidance, so that's kind of where we are.

Mark Landy – Summer Street Research Partners

All righty, thanks for that. And if I look at, obviously, you've annualized the benefits from going direct with the business as it relates to gross margin in Europe and Japan and then -- now you basically have to carry some of the variable cost and the fixed cost [as you have been full-time] [ph] versus distributor. On a dollar-for-dollar basis, how is that coming up relative to expectations? Now, obviously we can look at it on a margin basis. But as you look at that, are you getting a net benefit yet, or is that still going to come in 2013 on a dollar basis?

Joel C. Phillips

I think it's a little bit of tale of different markets there. Certain of those markets, where we made the election to go direct where we're well ahead of where we formally were with the independent model. There are those that we are really in the fourth quarter just got back to where we were with the independent model before. And then there is some of those that we're still not there yet. But I think the key point is that the two bigger ones, Spain and Japan, we're steadily making progress, which is encouraging.

Mark Landy – Summer Street Research Partners

So then looking ahead to 2013, would it be fair to assume that 2012 is almost a foundation-building year from the expense side, and that there could be some leverage in 2013? Or would you still see 2013 as being a building year?

Joel C. Phillips

Yeah. It's going to be a function of the revenue growth that we produce in those markets, but I do think it's safe to assume that we will not be enduring the shocks that we incurred at the sales and marketing expense line in 2010 and 2011 in the years 2012 and 2013. Those should be kind of baseline growth years.

Mark Landy – Summer Street Research Partners

And then lastly, as you look at the cartilage repair program, have you had any indications from the FDA whether you could get this through under a 510(k) with clinical data or would that be a full [PMO] [ph]?

William Petty

We feel reasonably confident we could not do it through the 510(k) process.

Mark Landy – Summer Street Research Partners

Okay. So when would that -- then start hitting R&D and would we need to raise R&D from a historical basis or should we put that into your historical R&D run rate as a percentage of sales?

William Petty

Well as I mentioned earlier, our near-term strategy is to get approvals in some of the countries in Asia and Europe, and frankly we have not made a final decision about the regulatory development pathway in the U.S.

Mark Landy – Summer Street Research Partners

But [Dr. Petty] [ph] has decided to leave that cost out of our models for 2012 then?

William Petty

Absolutely.

Mark Landy – Summer Street Research Partners

Okay, great.

William Petty

The costs for the clinical trials that we are doing are in our guidance.

Mark Landy – Summer Street Research Partners

Correct. I was referring to the U.S.

William Petty

And the answer to your question is, yes. You have no reason to put that into your model for 2012.

Mark Landy – Summer Street Research Partners

Thank you. And then lastly, as we look at 2013 and the likelihood of the medical device excise tax, do you think that you could share that with some of your customers, or given the strength of the market definitely direct it to the P&L and you'd have to come up with some other ways of negotiating that increased cost?

William Petty

We are a member of AdvaMed, which is our major industry organization, and we are working diligently with them to work on the best potential strategies for dealing with the medical device tax and we've not made any final decisions on that. But we are paying close attention to their work, their advice, and we'll of course make those decisions as we get closer to that date.

Mark Landy – Summer Street Research Partners

Thank you very much for your time this morning.

William Petty

Thank you. I appreciate it.

Operator

Thank you. (Operator Instructions) And I am showing no further questions. I'd like to turn it over to management for any closing remarks.

William Petty

Thank you, [Amarillas] [ph] and thanks to all of you for your interest in Exactech, and we look forward to rewarding your interest in our company. Have a great day and a great rest of the week. Bye-bye.

Operator

Ladies and gentlemen, this concludes the conference call for today. Thank you for your participation. You may now disconnect.

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