CONMED Corporation
Q1 2008 Earnings Call Transcript

Published: 28 Apr 2008

[Operator:]

Good day, ladies and gentlemen, and welcome to the first quarter 2008 CONMED earnings conference call. At this time all participants are in a listen-only mode. We will be facilitating a question-and-answer session towards the end of the conference. (Operator instructions) At this time, I would like to turn the presentation over to your host for today's call, Mr. Joseph Corasanti. You may proceed.

[Joseph Corasanti:]

Good morning, everyone. Welcome to CONMED Corporation's first quarter 2008 earnings conference call. With me today is Rob Shallish, our Chief Financial Officer. After formal remarks, the call will be opened for questions. Before we begin, let me remind you that during this call we will be making comments and statements regarding our financial outlook which represent forward-looking statements that involve risks and uncertainties as those terms are defined under federal securities laws. Our actual results could differ materially from our current expectations. Please refer to the risk factors and other cautionary factors in today's press release as well as our SEC filings for more details on factors that could cause actual results to differ materially. Continuing the trend of strong results from 2007, CONMED enjoyed a robust start to 2008, exceeding our previously provided sales and EPS guidance for the first quarter. Here are the quarter's highlights. Sales increased 11.6% over the 2007 first quarter. The non-GAAP operating margin percentage grew 120 basis points to 11.6% in the first quarter of 2008 compared to the non-GAAP operating margin of 10.4% in the first quarter last year. Non-GAAP diluted earnings per share grew 33% to $0.40 per share from the $0.30 per share non-GAAP comparative figure in the 2007 first quarter. After tax income increased 38% year over year. Cash from operations for the quarter was $19.9 million, or $0.67 per share. Now I would like to review each of our product lines in more detail. CONMED's Arthroscopy product line consists of minimally invasive medical devices designed to repair soft tissue injuries in the joints, such as ACL repair in the knee or rotator cuff repair in the shoulder. This business is also referred to as Sports Medicine because many of the injuries giving rise to the surgical procedure are caused by sports activity. In the first quarter of 2008 this product line grew 22% overall and 18% in constant currency compared to the same period last year. This was another very strong quarter for Arthroscopy products and was driven by 14% growth in our core Arthroscopy products and 36% growth in the Imaging portion of this line. We believe this line's core business, consisting of numerous surgical devices, screws, and anchors for the repair of soft tissue injuries, grew at a greater pace than the overall market for those items. Our Surgical Video Systems, led by our High Definition cameras and related equipment, continued the superb growth that we have seen for the last several quarters. We believe our autoclavable HD camera system provides the highest resolution and clarity available on the market today. As a reminder, this system operates at 1080p, the highest resolution possible, and provides an increased horizontal field of view with a 16

[Rob Shallish:]

Thanks very much, Joe. And as you mentioned, the company's first quarter was an excellent start to 2008. Sales for the quarter were $190.8 million, an increase of 11.6% over the first quarter of 2007. In constant currency, the rate of growth was 8.6%. By geography, sales outside the United States outpaced domestic revenue by increasing 21% in the first quarter and amounted to 45.3% of the sales total. On a constant currency basis, the weakening of the US dollar relative to a year ago produced a first-quarter sales number that was $5.1 million higher than if foreign currency exchanges rates had remained consistent with the first quarter of 2007. As Joe mentioned, in the first quarter, the company purchased the Italian distributor of our products. We have had a longstanding relationship with the organization in Italy, and they have been selling the full line of our products since 1998. The purchase has affected a few of our financial statement line items, most notably the $1 million charge to cost of sales resulting from the purchase accounting stepped up basis value assigned to inventory as a result of purchase accounting. As the purchased inventory turned to sales all in the first quarter, the entire stepped-up basis was expensed in the first quarter. We have highlighted this charge as an unusual item and show it as the only reconciling item in our reconciliation from GAAP to non-GAAP income in this morning's press release. From an operating standpoint, the acquisition added approximately $3.5 million to sales and approximately $0.02 to non-GAAP earnings per share. On a non-GAAP basis, including the inventory charge, the acquisition was breakeven for the quarter. Before turning to a discussion of profits and margins, I would like to discuss comparisons to GAAP and non-GAAP financial amounts. Over the last several quarters we have called out a number of adjustments to the GAAP numbers, which we felt were important for gaining an understanding of CONMED's ongoing business. In the first quarter of 2008, there is one adjustment, the effect of the purchase accounting on the acquired inventory that I just mentioned. In the first quarter of 2007, there were three items, by far the largest being the gain on a legal settlement of $6.1 million. This settlement caused our GAAP earnings to be greater than our non-GAAP earnings by $0.14 in 2007. On a GAAP basis, the company's diluted earnings per share for the first quarter of 2008 were $0.38 compared to the GAAP earnings per share of $0.42 in the first quarter of 2007, which demonstrates why, for purposes of clarifying our financial results, we believe certain non-GAAP measurements aid in an understanding of our business. Now I'd like to turn to a discussion of our margins. Our gross margin percent of sales was 51.8% in the first quarter of 2008 on, a non-GAAP basis, compared to 49.8% in the first quarter of 2007. This 200 basis point improvement is principally a result of favorable foreign currency exchange rates and the higher gross margin on our Italian sales, now that we are selling direct to hospitals in that country. SG&A as a percentage of sales was 35.5% in the first quarter, an increase from the 34.5% of sales in the first quarter last year. The entire 100 basis point increase was due to the SG&A costs associated with the Italian direct operation. Research expenditures were 4.2% of sales in the first quarter of 2008, a slight decline compared to 4.4% of sales in the first quarter 2007. This decline should not be construed as a reduction in our research and development efforts, but rather the result of standard timing related to work on various projects. The net of these changes results in a non-GAAP operating margin for the 2008 first quarter of 11.6% compared to the non-GAAP margin of 10.4% in the 2007 first quarter. Interest expense was $3.2 million, a 29% reduction when compared to interest of $4.5 million in the first quarter of 2007. The reduced interest cost results from lower debt levels as well as a decrease in rates effective during the quarter. Our non-GAAP pretax margin for the quarter has grown to 9.9% of sales compared to 7.8% of sales in 2007. These margins demonstrate that CONMED's profits continue to improve substantially. We believe further progress will be made during 2008 with our current expectation of achieving an operating margin closing in on 12% for the full year 2008. The company's income tax rate in the first quarter was 38.2%, slightly higher than our original projection for 2008 of 37.5% because congress has not yet extended the research and development tax credit for this year. As mentioned in past conference calls, payment of nearly all of this tax provision is deferred to future periods because of differences in reporting expense for financial accounting compared to tax accounting, thus increasing the company's current cash flow. Cash flow from operations continues to be a strong positive for the company, amounting to $19.9 million, or $0.69 per share for the first quarter of 2008. While this per-share calculation is a non-GAAP measurement, we believe it is useful for a more complete understanding of the company's business. The company's balance sheet debt remained consistent with amounts at the end of December 2007 as cash flow was used for the purchase of the distributor in Italy. Debt to total book capitalization declined to 30% at March 31, 2008, compared to 36.3% at the end of March 2007. Now, turning to specific balance sheet accounts, with regard to inventory, our days investment in inventory at March 2008 was equal to approximately 163 days. This is approximately the same amount as March 2007. Although we experienced a slight increase in inventory due to the Italian acquisition compared to December of 2007 balances, there were offsetting declines in other inventory netting to approximately the same consolidated inventory balance. Accounts receivable days in March 2008, adding back the effect of the $48 million utilization of the securitization facility, or 77 days, higher than our recent past performance due to the addition of receivables associated with our new Italian subsidiary. Receivable collection times from hospitals in Italy associated with government-financed health care are well known to be relatively lengthy. Therefore, although our receivable balance had increased as a result of the acquisition, our due diligence gave us confidence that the receivables are collectible. It should be noted, though, that going forward we expect higher receivable days outstanding. With that, I would now like to open the lines for questions.

[Operator:]

(Operator instructions) And gentlemen, your first question comes from the line of Dalton Chandler with Needham & Company. You may proceed.

[Dalton Chandler:]

Good morning and congratulations on a nice quarter. I just wanted to clarify, with regard to the acquisition of the Italian distributor, and the $86.4 million in international sales, the $3.5 million, Rob, that you mentioned you picked up from that acquisition; is that part of the $86.4 million?

[Rob Shallish:]

Yes, it is.

[Dalton Chandler:]

So, even if I back that out, it looks like international still grew better than 16% year over year, which is quite a bit faster than you are growing domestically. Do you think that's just because you are taking more control over the international distributors, or international sales, I should say, or is there some other factor driving that?

[Joseph Corasanti:]

Well, let me add this. We have seen in the past that our international sales have been growing faster than our United States sales. I'm somewhat pleased frankly, that our United States sales grew approximately 5% this past quarter. Last year, United States sales grew approximately 2%, so we saw improvement in our US sales growth this quarter compared to last year. Internationally, I think one of the reasons that we have been growing more rapidly is the sales force. We have a very mature sales force outside the United States. There tends to be less – there's more longevity among that group and less changing of jobs in those cultures. So I think that the relationships that our sales force have developed over time have allowed us to grow our business much more rapidly in those locations.

[Dalton Chandler:]

Do you have any goals that you could share with us for further expanding the direct international sales?

[Joseph Corasanti:]

Well, there are opportunities for growing direct as opposed to using distributors. We have not identified any specific opportunities at this point, but I would expect that as time passes and the structure and sales in certain countries increase, that it would make sense for us to be direct in more countries.

[Dalton Chandler:]

On the Endoscopic Technologies business, you mentioned that you have some new products coming out around midyear that you think can help that segment out. Could you just talk about what products you are expecting? It sounds like maybe there's going to be a rollout over the course of this summer; if you could talk about the timing you expect.

[Joseph Corasanti:]

Sure, Dalton. The products are going to be released at the DDW in San Diego this year. That's May 16 and – or 17 through 20, I believe. Probably the major product is going to be a new access device for the biliary procedures, and we're expecting significant sales from that product. We also think we will come out with some other products related to hemostasis for polypectomy procedures.

[Dalton Chandler:]

Okay. All right, thanks a lot. Congratulations again.

[Operator:]

And gentlemen, your next question is from the line of James Sidoti of Sidoti & Company. You may proceed.

[James Sidoti:]

Good morning. Can you give us an update on the new generator that you are working on for the Electrosurgery line?

[Joseph Corasanti:]

Well, actually, we're not working on a new generator for Electrosurgery. For general surgery, we've talked about a new tissue sealing device.

[James Sidoti:]

Oh, right, that's the one.

[Joseph Corasanti:]

And that's still on track for a Q4 release. So this is new technology, uses an energy that's not being currently used on the market right now and we believe that it is a product that will be able to steal tissue faster than products on the market today and create a stronger seal.

[James Sidoti:]

Which distribution channel will that growth through?

[Joseph Corasanti:]

That's the Electrosurgery sales force of about 60 sales reps, direct employee sales reps in the U.S.

[James Sidoti:]

Okay, great. Thank you.

[Operator:]

And your next question is from the line of Brad Evans with Heartland. Go ahead.

[Brad Evans:]

Good morning guys, thanks for taking the question. Joe, I am just curious, roughly in the first quarter, what percentage of sales were single use?

[Rob Shallish:]

Brad, it was slightly – typically, our historical percentage has been 75% of sales. We have been seeing greater growth in our capital sales because of the nice growth that we've seen in our HD video systems. So I think that the number for this quarter is slightly less than the 75% single use. It's more in the range of 72% to 73% single use, and the remainder capital. But not a significant change by any means from our overall goal to have about 75% of our business come from single-use products.

[Brad Evans:]

Is that what you have assumed in your full-year guidance of 740 to 750?

[Rob Shallish:]

Well, this year it's probably going to be a little bit less than the 75%. I would say between 72% and 73% single-use products.

[Brad Evans:]

There has been some concern, I think, in the marketplace with respect to hospitals making large capital commitments for certain technologies and products. Could you just give us a sense of how you see that playing out and how that could affect CONMED as you move forward?

[Joseph Corasanti:]

Yes, sure. It's interesting; in the first quarter we certainly haven't seen that. Our largest capital sale is our High Definition video systems. So sometimes those capital deals are even larger when we add in our integrated system product that are typically about $120,000 per operating room for the fully integrated system of ceiling-mounted pendant supports and integration software. But, in any event, we certainly haven't seen hesitation on the part of our hospital customers to cut back on those large capital items. The generator sales in the quarter was very strong as well, and perhaps that represents part of a backlog from last year. The bottom line is we just haven't seen any kind of hesitation in terms of capital purchases so far.

[Brad Evans:]

Could you just speak to what you are seeing on the raw materials side in terms of any major issues from a cost of goods sold perspective?

[Rob Shallish:]

Well, we're continuing to see price increases on the plastic that we use in the manufacturing process, most notably for our Patient Care and our EndoSurgery lines. I think we've been quite diligent about increasing price, however, in both of those lines. So I think our price increases that we've been able to achieve have offset those cost increases. I guess the second point besides price increases is that we've been working very diligently for the last year on efficiencies in our manufacturing processes, using lean manufacturing techniques to be even more efficient in our manufacturing process. So, while there have been raw material cost increases, I think we've offset those by both price increases and efficiencies in manufacturing.

[Brad Evans:]

As an adjunct to my earlier question, can you give us a sense as to whether you've seen any moderation in the capital equipment sales in April, at this point?

[Joseph Corasanti:]

I don't think I have – in April, I don't have that information. I don't know if, Rob, you've looked at that?

[Rob Shallish:]

Well, Brad, it's very difficult to give guidance based on three weeks of information relative to the full quarter. So I guess I'd rather not comment on April sales at this point.

[Brad Evans:]

Your CapEx was a little bit higher than I was thinking, at least for the quarter. Can you remind us of what you think you will spend for the full year, CapEx-wise?

[Rob Shallish:]

I think CapEx is going to be a little bit higher than what we originally projected, probably in the neighborhood of $23 million to $24 million. We were talking about $21 million last conference call. We do have additional tooling that we're purchasing related to these new products, so there's about $1 million to $1.5 million of additional tooling expense in the first quarter, tooling cost, I should say, relative to the capital additions associated with some of these new products. We are also remodeling one of our offices, one of our office locations. So that's an additional cost this year. So we are looking at in the neighborhood of $23 million to $24 million at this point.

[Brad Evans:]

So you are still on pace, it looks like, to generate something on the order of approximately $80 million in free cash flow for the year? Is that probably pretty close?

[Rob Shallish:]

I think on a free cash flow basis that could be a little bit higher than what we are currently expecting. I think the last time we talked about this it may have been $65 million to $70 million of free cash flow. I think a lot depends on the working capital. We did a very nice job of controlling inventory in this quarter. Inventory was flat compared to the December numbers. We did see an increase in receivables, but that was because of the acquisition and not because of anything else. So if we can keep working capital increases to a minimum, we could potentially do better than the $65 million to $70 million of free cash flow.

[Brad Evans:]

That's a good point. I kind of assumed a neutral working capital position. So your – good efforts there. Rob, you generated a 51.8% gross margin in the quarter. That's your highest gross margin since the second quarter of 2005. Could you maybe help us build a mosaic to understand where you think gross margins could move to over the next year or so or next several quarters?

[Rob Shallish:]

Obviously, we are very happy with this gross margin approaching 52%. A good deal of the increase this quarter came from foreign currency, which – I don't have a crystal ball on that, but it sure seems as though foreign currency will be in our favor for at least the next few months. So that's a positive for us. The Italy direct sales situation is positive, so that increases the gross margin, although we do have additional operating costs because of Italy. So I would expect that for the full year we would be in the same ballpark, somewhere near 52%. I think we've talked in the past that our focus on manufacturing efficiencies should help us improve our gross margin over time. Plus, new product introductions, particularly things like ECOM and tissue sealing, which come out later this year, should help us from a gross margin perspective. So I guess I want to refrain from giving any goals beyond the 52% that I just mentioned for this year, but I do foresee in the future growing the gross margin beyond that.

[Brad Evans:]

I realize the foreign currency had a 3% effect on the top line in the quarter. Local currency cost below the operating line – I mean to the operating line – was it a fairly neutral effect of foreign currency, or did that have a favorable effect on the operating line?

[Rob Shallish:]

Well, we had roughly $5 million of sales benefit from foreign currency. Roughly half of that is absorbed by increased operating expenses because we do have these 11 locations around the world all spending money in the local currency. So that's an increased cost as a result of foreign currency being more valuable than the US dollar. So about roughly half of the $5 million would be used in additional operating expenses.

[Brad Evans:]

So there was a modest positive effect on the operating line then, just to be clear?

[Rob Shallish:]

Yes.

[Brad Evans:]

The only thing that would have made the report even more stellar would have been if you would have been able to leverage the selling, general, and administrative line on a percent of sales basis. It looks like you were up about 100 basis points year over year. Do you think that you might have an opportunity to start to leverage the SG&A line as we move into the remaining quarters of fiscal 2008?

[Rob Shallish:]

Well, yes. I think we can. I think the increase this quarter was a result, compared to the first quarter last year, was a result of the additional operating cost that we have in Italy, which we did not have last year; and then, secondly, the increased cost associated with foreign currency in all the local countries. So if we back both of those things out, the Italian change as well as the FX effect, from increased cost associated with the weaker dollar, I think we probably would have – I know we would have shown an improvement in the SG&A margin.

[Operator:]

(Operator instructions) And Brad, you are back.

[Brad Evans:]

All right, thank you. I should have taken my other question on free cash flow one step further. I mean, as we move through the remainder of the year, how do you think you will prioritize the use of free cash flow?

[Rob Shallish:]

Well, Brad, we like paying debt down. We still have some debt on the books, so that's a possibility. Acquisitions – we always look at things that would be strategically beneficial to the company, so acquisitions are a possibility. So I would rank those one and two. We have repurchased stock in the past. I don't think that's necessarily high on our priority list, so it would be a combination of debt repayment and acquisitions, if the right opportunity exists.

[Brad Evans:]

This is a big if, I guess, if you are able to hit your guidance for the full year. I guess the market is valuing CONMED at about 7, 7.5 times enterprise value to EBITDA. Can you find acquisitions that are cheaper than your own company in the marketplace today? In terms of how you weigh the buyback versus making acquisitions at this point with this somewhat depressed multiple the market seems to want to afford the company?

[Rob Shallish:]

Now, I understand. I guess it's a situation, a matter of cash conservation, too. We look at the credit markets, and the credit markets are not very favorable. If we had to borrow to any great extent for an acquisition, that is probably going to be much more costly if we ever had to redo our credit agreement currently. So perhaps we are being a little bit conservative, but I think the point of thinking about stock buybacks is certainly one for us to consider. But I think we are trying to be a little bit conservative with cash at this point too.

[Brad Evans:]

Is it fair to say that most acquisitions, seller's expectations are higher than that number I cited for the company's current valuation, again assuming you've hit the guidance you've given us?

[Rob Shallish:]

Well, with things that I've seen in the marketplace, I would agree that sellers are expecting greater returns than the multiples CONMED is receiving today.

[Brad Evans:]

Okay. Great quarter. Thank you very much for answering the questions.

[Rob Shallish:]

Thanks, Brad.

[Operator:]

And gentlemen, at this time, there are no further questions on the line.

[Joseph Corasanti:]

Thanks everyone for joining us today. CONMED continues to work hard to improve the company's operations. We are pleased with our results to date, and we look forward to discussing our further progress with you on our next conference call. Thanks very much. Have a good day.

[Operator:]

Thank you very much for your participation in today's conference, ladies and gentlemen. This does conclude the presentation, and you may now disconnect. Have yourselves a great day.