CONMED Corporation
Q2 2008 Earnings Call Transcript

Published: 28 Jul 2008

[Operator:]

Good day, ladies and gentlemen, and welcome to the second quarter 2008 CONMED Corporation's Earnings Call. (Operator Instructions). I will now like to turn the presentation over to your host for today's call, Mr. Joseph Corasanti, President and Chief Executive Officer of CONMED. You may proceed, sir.

[Joseph Corasanti:]

Thank you, Jasmine. Good morning, everyone. Welcome to CONMED Corporation's second quarter 2008 earnings conference call. With me today is Rob Shallish, our Chief Financial Officer. After formal remarks, the call will be open 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. You will also hear Rob and me refer to certain non-GAAP measurements during this discussion. While these figures are not a substitute for GAAP measurements, company management uses them to aid us in monitoring the company's ongoing financial performance from quarter-to-quarter and year-to-year on a regular basis and for benchmarking against other medical technology companies. Non-GAAP net income and non-GAAP earnings per share measure the income of the company, excluding unusual credits and charges that are considered by management to be outside of the normal ongoing operations of the company. These unusual items are specified in the reconciliation in the press release issued this morning. With these required announcements completed, I now turn to our results. CONMED, again, had excellent financial results in the second quarter of 2008. Here are the quarter's highlights. Sales increased 13.9% over the 2007 second quarter with a majority of our product lines delivering double-digit sales growth. GAAP diluted earnings per share grew to $0.43 per share, a 23% increase compared to the non-GAAP EPS of $0.35 per share in the second quarter of 2007 and 34% when compared to the GAAP EPS of $0.32 for the quarter. Cash from operations continued to be strong. For the first six months of the year, cash from operating activities was $35.1 million, a 36% increase compared to the first six months of 2007. Importantly, our sales growth in the second quarter was broad-based across our product lines. We often mention that 75% of our product portfolio consists of single-use medical devices, with the 25% remainder being items of capital equipment, such as video systems. While this ratio will vary slightly quarter-to-quarter, it is a good rule of thumb. In this just completed quarter, our single-use devices grew 12%, while our capital products grew 19%, indicating to us that surgical procedure rates remain strong and that the demand for the types of capital products we provide also remains robust. Furthermore, I think it underscores our ability to understand the need of our customers. Now, I would like to review each of our product lines in more detail. CONMED's Arthroscopy product line consist 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 repair are caused by sports-related activities. In the second quarter of 2008, this product line grew 18% overall and 14% in constant currency compared to the same period last year. This was clearly another very strong quarter for our Arthroscopy products and was driven by 17% growth in our core Arthroscopy products and 20% growth in the imaging portion of this line. Now, moving on to the Powered Surgical Instruments line, which consists of electric, battery or pneumatic-powered surgical instruments used to perform orthopedic and other surgical procedures, we experienced revenue growth of 10.8% in the second quarter within this business. Especially strong were our large bone systems in international markets. The Electrosurgery line exceeded the growth rate of the last quarter by achieving a sales increase of 16.7% compared to the second quarter of 2007. We had very strong generator growth of 35%, while the single-use products saw revenue increase a healthy 10%. As a reminder, Electrosurgery is used in 80% to 90% of all surgical procedures, and we hold the number two market share position in this market. Following last year's sales decline, we are confident that meaningful sales growth has now returned to this product line. Switching to our Endosurgery line, which consists of products enabling minimally invasive surgery of the abdominal region without making a major incision, this business grew 11.6% in the second quarter. This product portfolio has been consistently achieving sales increases of 11% for the last several quarters and we expect this type of solid performance to continue over at least the next several quarters. Our Patient Care line of products consists of heart monitoring electrodes, pulse oximetry monitoring, surgical suction tubing and various other devices used in clinical settings. These products achieved a growth rate of 13.8% in the second quarter. On the new product front, we remain excited about the prospects for our ECOM cardiac output monitoring device. As anticipated in our last conference call, in this June quarter we began selling the ECOM product on a limited market release basis to a handful of customers. You may recall that our ECOM product is a vital sign monitoring device designed to measure cardiac output in a noninvasive manner. Present technology for this kind of monitoring involves placing a catheter into the patient's jugular vein and threading the catheter into the patient's heart. Because of the invasiveness of the catheter, anesthesiologists refrain from using the catheter even though the cardiac output measurement would be useful to them in maintaining the health of the patient during surgery. The initial feedback we have received from customers has been very positive and we remain excited about the future of this product. In addition to the seven hospitals that are purchasing the ECOM product, we are continuing our studies at five other institutions for the purpose of completing data in support of clinical white papers. Our next milestone will be the receipt of an additional 100 monitors from our supplier, anticipated in the third quarter, which will allow us to expand the limited market release. We continue to see demand for this product remain high and have already received reorders for single-use ECOM tools from our customers. Lastly, although the Endoscopic Technologies line had flat sales in the second quarter, it recovered from a sales decline in the first quarter of this year. We continue to anticipate that for the full year of 2008, we will achieve positive growth, not only from our current product offering, but also as a result of the introduction of new products. As mentioned in this morning's press release, over the last year we have been focused on achieving manufacturing efficiencies. To accomplish this, we have adopted lean manufacturing methodologies in a number of our manufacturing locations. These lean initiatives are based on the philosophy of continuous improvement. While no one efficiency improvement to a manufacturing cell is significant in itself, the accumulation of each small improvement adds up overtime. We are now beginning to see the positive effect of this type of accumulating activity as demonstrated by the expansion of our gross margin percentage to 52.3% of sales, up from 50.7% of sales in the second quarter of 2007. The next step in our efficiency plan involves plant consolidation. We have leased a manufacturing plant in Chihuahua, Mexico that is in the final stages of construction. When completed in the fall, we will implement a plan to move certain of the product lines manufactured in our upstate New York locations to this lower cost facility. As space is freed up, we will consolidate the remaining Utica, New York area manufacturing into our headquarters location and close the other two plants located in New York. This consolidation plan will result in the loss of approximately 100 to 150 manufacturing positions in the Central New York area. In the future, as we follow-through on the plan, we may incur restructuring charges, which could include severance costs and product line relocation costs. We take these actions to enable the company to produce our products as cost effectively as possible and to remain competitive in today's global markets. As we look out to the rest of 2008, we see the favorable trends of the first six months, including positive sales growth, rates of current products, the expected benefits to be derived from the new product introductions, a favorable foreign currency environment and the impact of the newly purchased direct sales organization in Italy extending for the full year. In our April Conference Call, we increased the full year EPS guidance to $1.50 to $1.58 per share. We now expect that with the momentum built in the first two quarters, we can achieve full year EPS of $1.56 to $1.64, excluding any unusual charges such as restructuring costs. For the full year 2008, we forecast sales growing to $755 million to $760 million. In the 2008 third quarter, generally the seasonally softest quarter of our business each year, we anticipate that sales will approximate $175 million to $180 million with diluted earnings per share of $0.32 to $0.36, excluding any unusual charges such as restructuring costs. In summary, the second quarter of 2008 was a continuation of the excellent performance of the company over the last several quarters, with increasing sales and profitability. During the remainder of 2008 we intend to further build on these achievements, yielding excellence in service to our customers and improved profitability for our shareholders. I will now turn the call over to Rob Shallish for a further review of the financials. Rob?

[Rob Shallish:]

Thanks very much, Joe, and good morning everyone. As Joe mentioned, the company's second quarter was an excellent continuation of the earnings growth experienced over the last several quarters. Sales for the June 2008 quarter were $192.8 million, an increase of 13.9% over the second quarter of 2007. In constant currency, the rate of growth was 10.9%. By geography, sales outside the United States outpaced domestic revenue growth by increasing 26% in the second quarter and amounted to 45.9% of our total sales. On a constant currency basis, the weakening of the US dollar relative to a year ago produced a second quarter sales number $5.1 million higher than if foreign currency exchanges rates had remained consistent with the second quarter of 2007. 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 in management consider critical when analyzing our ongoing business operations and believe that investors may also find this information useful in evaluating our performance. In the second quarter of 2008, there are no such adjustments, although for comparative purposes, the second quarter of 2007 had non-GAAP pre-tax adjustments of $1.3 million related to the closure of a small facility in Montreal. For the first six months of 2008, the only non-GAAP adjustment relates to a pre-tax charge of $1 million recorded in the first quarter of 2008 related to the purchase of our Italian distributor early this year. For comparative purposes, the first six months of 2007 had several non-GAAP adjustments, by far the largest being the gain on a legal settlement of $6.1 million recorded in the first quarter of 2007. This settlement in the first six months of 2007, net of the other non-GAAP adjustments, led our GAAP earnings to outpace our non-GAAP earnings by $0.08 in that prior period. So on a GAAP basis, the company's diluted earnings per share for the second quarter of 2008 was $0.43 compared to the GAAP earnings per share of $0.32 in the second quarter of 2007. The non-GAAP EPS amount for the second quarter of 2007 for comparative purposes representing the ongoing business was $0.35 per share. Please refer to today's press announcement and the reconciliations between GAAP and non-GAAP amounts for further information. Now, I'd like to turn to a discussion of our margins. Our gross margin percent to sales was 52.3% in the second quarter of 2008, compared to 50.7% in the second quarter of 2007. This 160 basis point improvement is principally a result of the lean manufacturing initiatives that Joe highlighted, the higher gross margin on our Italian sales where we are now selling direct to hospitals in that country and the favorable foreign currency exchange rates. Selling, general and administrative as a percentage of sales was 36% in the second quarter. This is the same percentage as the first quarter of 2008 but an increase from the 34.4% of sales in the second quarter last year. The increase is due to the effects of foreign currency translation on the costs of our international operations and the SG&A costs related to our newly acquired Italian direct operation. Research expenditures were 4.5% of sales in the second quarter of 2008, consistent with the 4.4% of sales in the second quarter 2007. The net of these changes results in a GAAP operating margin for the 2008 second quarter of 11.8% compared to the GAAP margin of 11.2% in the 2007 second quarter and the non-GAAP operating margin of 11.9%. Interest expense was $2.4 million, a 44% reduction when compared to interest of $4.3 million in the second quarter of 2007. The reduced interest cost resulted from lower debt levels, as well as a decrease in rates compared to a year ago. Our GAAP pre-tax margin for the quarter grew to 10.5% of sales compared to 8.6% in the 2007 second quarter and 9.4% on a non-GAAP basis. The company's income tax rate in the second quarter was 38.4%, slightly higher than our original projection for 2008 of 37.5% because Congress has not yet extended the R&D tax credit for 2008. 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. Speaking of the cash flow, CONMED's cash flow from operations continues to be positive, amounting to $35.1 million for the first six months of 2008. I draw your attention to the fact that this operating cash amount is 50% greater than the company's net income. The superior amount of cash compared to net income is a result of the non-cash charges associated with equity compensation, amortization, depreciation and deferred taxes. Much of the deferred taxes would become payable only as a result of an unusual event outside of the normal operations of the business. So as a practical matter, the deferred taxes would not reverse and become payable in the foreseeable future. Now turning to the balance sheet, the company's cash balances grew by approximately $6 million since December 2007 and the balance sheet debt grew by a like amount. Debt to total book capitalization declined to 30% at June 30, 2008 compared to 33.6% at the end of June 2007. Now turning to specific balance sheet accounts, with regard to inventory, our days investment in inventory at June 2008 was equal to 160 days, about where we have been running for the last few quarters. In absolute dollar terms, the company's inventory balance declined approximately $4 million from December 2007. Accounts receivable days in June 2008, adding back the affect of the $42 million utilization of the securitization facility, were 70 days, in line with our historical average. In absolute dollar terms, receivables have increased since December as a result of the acquisition of the Italian distributor. Sequentially, since March 2008, the receivable balance grew $6 million because of the reduction in usage of the securitization receivable sale facility, meaning that we sold $6 million fewer of our receivables in June than in the March quarter. Jasmine, that concludes my remarks and we would now like to open the line for questions.

[Operator:]

(Operator Instructions). And your first question comes from James Sidoti. You may proceed.

[James Sidoti:]

Good morning, Rob. Good morning, Joe. Can you hear me?

[Joseph Corasanti:]

Yes, good morning.

[James Sidoti:]

Okay. On the manufacturing expansion plan, can you give us a little color on what do you think that's going to cost?

[Rob Shallish:]

Well, in terms of cost, we haven't really come up with a hard number to be honest with you, Jim. And that's why we haven't disclosed it. There are some positions that we're eliminating here in Utica, as we mentioned this morning. There will be some costs associated with that. There'll also be costs related to just moving equipment and so forth. But in the scheme of things, I don't think these charges are going to be very large.

[James Sidoti:]

Okay. I'm just trying to figure out free cash flow including the effects of the transition. Can you just give us a ballpark on what you think to build the factory and move the equipment?

[Rob Shallish:]

Well, building the factory is not a cost. We're leasing the factory.

[James Sidoti:]

Okay.

[Rob Shallish:]

There is no upfront cost on the build out of the factory. There'll be some internal purchases of machinery and cubicles and telephone systems and so forth. Those kinds of purchases will probably be in the neighborhood of $1.5 million to $2 million. Movement of the machines and so forth, I don't think that's going to be a very big cost at all. So if you're trying to add up cash, I would say the biggest cash component would be the purchases of some machines and so forth for the plant itself.

[James Sidoti:]

So it sounds like in spite of the move your free cash flow is going to still be significantly higher than your GAAP EPS?

[Rob Shallish:]

I would expect that, yes. And it's all not going to happen at once. It will be coming through in stages. So we won't see the full impact on cash this year.

[James Sidoti:]

Okay. I just wanted to verify that was the case. And then, on the sales line, you had real strong growth again on Arthroscopy and the Electrosurgery lines. Are there any particular products driving that or was that pretty broad based?

[Rob Shallish:]

Well, it's pretty broad-based frankly. The single-use products did very well this quarter. The capital products did well. It's really hard to point to any one product that was the cause of the entire increase.

[James Sidoti:]

The high definition camera sales, are those still going pretty well?

[Rob Shallish:]

That did well, particularly in the United States. Sales here in the United States showed a very nice improvement compared to the same quarter a year ago.

[James Sidoti:]

Okay. And then my last question is on raw materials. Some of the other names in the industry have been noting that commodity pricing going up is starting to hurt them a little. I'm sure it's going up for you as well, but how easy is it for you to pass along those costs to your customers? Is that something you can do in one or two quarters or will it take a little longer to do that or can you do it?

[Rob Shallish:]

Well, we've had this program of trying to cover those cost increases for the last two to three years. So we've had an ongoing process of increasing price. Probably most recognizable in the patient care business where we have been trying to offset raw material cost increases, primarily dealing with plastics and the related petroleum. So in and of itself, there's no way to pass on an immediate price increase for freight or petroleum or whatnot, but because of the implementation of the pricing schemes that we have over the last several years, I think we're managing to keep up with the cost increases. That together with the manufacturing improvements that we've made as a result of lean manufacturing have enabled us to, at least up till this point, offset those cost increases.

[James Sidoti:]

Okay. All right. Well, it seems like it's worked in the last several quarters at least. Thank you.

[Operator:]

Your next question comes from Dalton Chandler. You may proceed.

[Dalton Chandler:]

Good morning. First, a little housekeeping item. The international growth that you're reporting, is that all organic growth or is there a component of that that's due to the Italian acquisition? And if so, could you break that out?

[Rob Shallish:]

Yes, there is. When we look at the Italian business, this particular quarter, sales are higher by approximately $3.7 million compared to what the sales would have been had the Italian business been through a distributor relationship.

[Dalton Chandler:]

Okay. And then on the restructuring plan, do you have a sense of what sort of margin impact this could have once all of the transitions are completed?

[Rob Shallish:]

Well, I don't have a number to share at this point, Dalton, because part of the process is because it's a continuous improvement. So part of the plan is just day-to-day looking at the efficiency of all of our lines, and once you go through everything you start again and try to become more efficient. The plan that we announced relative to closing a couple of our plants here in New York, outfitting the distribution center in Atlanta, using the Chihuahua, Mexican operation, and it's not immediate, but overtime we would see approximately $3 million to $5 million benefit as a result of those changes.

[Dalton Chandler:]

$3 million to $5 million a year?

[Rob Shallish:]

Correct.

[Dalton Chandler:]

Okay.

[Rob Shallish:]

But as I say, that doesn't come all at once. That would be as we look out two years down the road.

[Dalton Chandler:]

Okay.

[Joseph Corasanti:]

Yeah. All of this happens in stages, very deliberate stages. And of course, the first stage for us is moving some product lines into the Chihuahua facility. That will free up space here in our corporate headquarters, and then that will allow us to move some product lines from the two other buildings located in the Utica area into this building and closing down those other buildings. And then, of course, moving distribution from corporate headquarters to Atlanta frees up a significant amount of space and that further allows for the consolidation of the other buildings into this one building.

[Dalton Chandler:]

Okay. Is there also a cost savings associated with being able to ship out of Atlanta versus Utica?

[Joseph Corasanti:]

Yes, absolutely. We have favorable rates because of the zone that Atlanta is in compared to the zone that Upstate New York is in.

[Dalton Chandler:]

Okay. And then just a last question on your guidance. You are talking about the $0.32 to $0.36 excluding unusual charges. Are those unusual charges related to the restructuring plan? And if there were no restructuring plan the $0.32 to$0.36 would be GAAP, in my understanding.

[Rob Shallish:]

That would be correct, Dalton, yes.

[Dalton Chandler:]

Okay. All right, great. Thanks a lot.

[Rob Shallish:]

And we may not have any of these restructuring costs in the third quarter. It may be more toward the tail end of the year, but that's our present thinking.

[Dalton Chandler:]

Okay. Thanks again.

[Operator:]

(Operator Instructions). Your next question comes from Matt Miksic.

[Matt Miksic:]

Hi. It's Matt Miksic calling from Piper Jaffray. A couple of follow-up questions here. You talked a little bit about the impact of the distributor on the international business. How should we think about the impact to gross margins of that acquisition, if we should think about it at all?

[Rob Shallish:]

Well, the $3.7 million increase in sales has a direct impact on the gross margins. So that would be at the gross margin level. The operating costs, however, are approximately $2.4 million. So we increased our SG&A by $2.4 million because of the selling costs, if you will, picking up that distribution portion of the business. So that's one of the major reasons for the increase in SG&A as a percentage of sales this particular quarter compared to the second quarter last year. And thinking about it, we've got $2.4 million of SG&A costs on increase of $3.7 million of sales. So that's about a 60%, 70% SG&A number relative to those sales, and that causes the whole SG&A percentage to go upward a little bit. But obviously, it's profitable for us, as a result of having that direct business to the tune of $0.02 or so per share.

[Matt Miksic:]

Okay. And with you running that, is there going to be operating leverage you're expecting to get over the next year or so? What kinds of things and when, I guess, should we expect that part of the business to improve?

[Rob Shallish:]

Well, the Italian business has been a good growing business for our company whether through distribution or direct, and we would expect improving sales there just as we would in any of our locations. But specifically, we haven't called out what we think the growth rate would be in Italy compared to any of our other geographic locations.

[Matt Miksic:]

Got you. A bit of a higher level, it looks like your equipment and capital revenues are coming through pretty strong and continued to in the quarter. Can you talk a little bit about what's been going on with the flow of deals or evaluations? Are those decision cycles getting longer or are we sort of hitting a stable, you know, we may be starting to annualize that process?

[Rob Shallish:]

No. The evaluations always take some time. It's usually done by a committee that evaluates. I'm speaking of video now, which would be one of our major capital items. So it's a committee process and that always takes some time. I don't know if we are seeing any lengthening of that process now as compared to a year ago, but I guess I'll just say that because of the committee process these things do take some time once in awhile.

[Matt Miksic:]

Okay. And then last question on just the nature of the competitive landscape. As we look into next quarter and the quarter after, any dynamics you can highlight in terms of either competitive product launches that you expect to put pressure on or maybe launches that you're starting to annualize that would help us think about the rest of the year?

[Joseph Corasanti:]

We evaluate the competition all the time, as you might expect. We have not seen anything in terms of new product releases come out from our competition that we think will change the playing field for us. And as far as our new product launches, we're certainly expecting to start gaining some traction with some of the products we've already launched, especially in the Endoscopic Technologies area with our Axcess device, which is a Multi-Directional Papillotome for gaining access to the biliary tree, our Argon Beam generators used in GI endoscopy primarily for polyp removal and our multiband ligator. Last year, in '07 we launched a Feeding line, Enteral Feeding line and a Spider-Net product for polyp retrieval that are gaining some traction. But most importantly for CONMED is the anticipation of launching a full market launch of the ECOM product, which I discussed in the prepared remarks. And then, at the end of the year, the tissue sealing device for electrosurgery, we would expect a fairly significant ramp of tissue sealing in 2009. I haven't talked about another product that should launch very soon and that's in Endosurgery, and that's our OnePort product line. That is our new and improved trocar line, and it covers all versions of trocars both the reusable, the disposable as well as an area called reposable. And so that, I think, would certainly help the Endosurgery line both in the US and outside the US. So this has been a good year for CONMED in terms of product development. So we look forward to seeing those products gain traction as the year progresses.

[Matt Miksic:]

Great. Thanks for taking the questions.

[Joseph Corasanti:]

Sure.

[Operator:]

At this time, we show we have no further questions. I'd like to turn it back to management.

[Joseph Corasanti:]

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

[Operator:]

Thank you for attending today's conference. This concludes your presentation. You may now disconnect. Good day.