CONMED Corporation
Q3 2008 Earnings Call Transcript

Published: 23 Oct 2008

[Operator:]

Good day, ladies and gentlemen, and welcome to the Third Quarter 2008 CONMED Earnings Conference Call. My name is Sean Fillet and I will be your facilitator for today’s call. At this time, all participants are in a listen-only mode. We will conduct a question-and-answer session towards the end of this conference. (Operator Instructions). I would now like to turn the call over to your host for today, Mr. Joseph Corasanti, President and CEO. Please proceed, sir.

[Joseph J. Corasanti:]

Thank you, Sean Fillet. Good morning. Welcome to CONMED Corporation’s third 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 may 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 may 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 credits or charges that are considered by management to be unusual or outside of the normal ongoing operations of the company. These unusual items are specified in the reconciliation stated in the press release issued this morning. With these required announcements completed, I can now turn to our results. CONMED once again had excellent quarterly financial results. Here are the highlights for the third quarter of 2008

[Robert Shallish:]

Thanks very much, Joe, and good morning everyone. As Joe mentioned, the company’s third quarter was a further continuation of the consistent earnings growth experienced over the last several quarters. Sales for the September 2008 quarter were 179.4 million, an increase of 9.1% over the third quarter of 2007. In constant currency, the rate of growth was 8.3%. By geography, sales outside the United States outpaced domestic revenue growth by increasing 17% in the third quarter and amounted to 42.9% of our total sales. On a constant currency basis, the weakening of the US dollar relative to a year ago produced a third quarter sales number, $1.3 million higher than if foreign currency exchange rates had remained consistent with the third quarter of 2007. However, FX changes compared to a year ago also produced higher expenses that more than offset the benefit at the top line. Approximately $700,000 of additional expense was incurred due to the translation of our normal overseas sallied and marketing activities. Additionally, approximately $2 million in additional expense was incurred due to the rapid strengthening of the dollar in the last few weeks of the September quarter and the effect of this currency change on the company’s intercompany balances with our subsidiaries. Accounting for foreign currency translation requires that we record the effect of these changes immediately. So in total, the net effect of the third quarter’s currency changes produced an additional expense of $1.4 million, which is equivalent to $0.03 per share. As of the end of September, we have entered into several currency hedges with a goal to minimize the future impact of currency changes on the intercompany balances. Before turning to a discussion of profits and margins, I would like to discuss comparisons to GAAP and non-GAAP financial amounts. It has been our practice to call out adjustments to the GAAP numbers, which we and 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 third quarter of 2008, such adjustments totaled $709,000 and relate to the additional cost we have incurred as part of the manufacturing restructuring plan Joe mentioned a few moments ago. In the third quarter of last year, there were no such non-GAAP adjustments. For the first nine months of 2008, the non-GAAP adjustments are the third quarter’s manufacturing restructuring and the first quarter’s pre-tax charge of $1 million related to the purchase of our Italian distributor earlier this year. For comparative purposes, the first nine 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 nine months of 2007 net of the other non-GAAP adjustments led our GAAP earnings to outpace our non-GAAP earnings by $0.10 in that prior period. So, on a GAAP basis, the company’s diluted earnings per share for the third quarter of 2008 were $0.36 compared to GAAP EPS of $0.29 in the third quarter of 2007. While the non-GAAP EPS for the third quarter of 2008 was $0.01 more at $0.37 compared to $0.29 in the comparable period last year. Now I would like to turn to a discussion of our margins. Our gross margin percent of sales was 52.8% in the third quarter of 2008 compared to 50.1% in the third quarter of 2007. This 270 basis point improvement is principally a result of the lean manufacturing initiatives that Joe highlighted, the higher gross margin on our Italian sales due to the fact that we are now selling direct to hospitals in that country and foreign currency exchange rates. SG&A as a percentage of sales was 37.8% in the third quarter. Without the additional $2 million charge resulting from the FX accounting on intercompany accounts, the percentage would have been 112 basis points lower, in line with the SG&A percentage to sales we demonstrated in the first and second quarters of this year. For the nine months of 2008, SG&A as a percentage of sales was 36.6% compared to 34.8% in the nine months period of 2007. 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 4.8% of sales in the third quarter of 2008, consistent with the 4.8 of sales in the third quarter of 2007. But none of these changes results in a GAAP operating margin for the 2008 third quarter of 9.8% compared to the GAAP operating margin of 10.3% in the 2007 third quarter. However, on an operating basis, backing up the cost of the manufacturing restructuring and the $2 million FX charge, the adjusted operating margin for the third quarter is equivalent to 11.3%, similar to the margin percentages in the first and second quarters of 2008. Interest expense was $2.4 million, a 37% reduction when compared to interest of $3.9 million in the third 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 8.4% of sales compared to 7.9% of sales in the third quarter of 2007. Adjusted for the restructuring and FX charges, our pre-tax margin was equal to 9.9%, 200 basis points higher than last year. The company’s income tax rate in the third quarter was 30.3% compared to 36% in the third quarter of 2007. The rate is lower due to positive adjustments resulting from the completion of IRS audits and state tax matters. In the fourth quarter of 2008, we expect that the effective tax rate will approximate 36%. 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. Staying with cash flow, CONMED’s cash flow provided by operations continues to be very positive amounting to $55.8 million for the first nine months of 2008. I would especially like to highlight the fact that this operating cash amount is 1.6 times 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 perhaps most importantly, deferred taxes. Much of the deferred taxes will become payable only as a result of unusual event outside of the normal operations of the business, such as the sale of a major part of our 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 had grown by approximately $20 million since December 2007, and 26.5 million since last September. The company’s debt balance is $21.4 million less than last September. As a result of the company’s earnings and debt reductions, debt-to-total book capitalization declined to 28.9% at September 30, 2008 compared to 33.2% at the end of September 2007. Now turning to specific balance sheet accounts with regard to inventory, our days investment and inventory at September 2008 was equal to 170 days, about where we have been running in the last few quarters. In absolute dollar terms, the company’s inventory balance declined approximately 3.5 million from December 2007. Accounts receivable days in September 2008 adding back the effect of the $40 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. So with that operator, I would now like to open the lines for questions.

[Operator:]

(Operator Instructions). Your first question comes from the line of Mr. Raj Denhoy of Thomas Weisel Partners. Please proceed, sir.

[Raj Denhoy:]

Good morning, guys.

[Joseph J. Corasanti:]

Good morning, Raj.

[Raj Denhoy:]

Couple of questions actually on the margins and then a product question as well. Obviously the gross margin improvement was nice (Ph) in the quarter and it sounds like it’s going to continue to play out. Can you give us a sense of what trajectory of that might look like as you are moving manufacturing to Mexico over the next several months?

[Joseph J. Corasanti:]

Well, Raj we see a gradual improvement in our gross margin. We really haven’t -- I guess we are not in a position at present to highlight what those changes may be. We do think that on an annual basis, the changes that we’ve announced relative to changes in our manufacturing plans would give us approximately 3 to $5 million of additional benefit by the end of the year. At this time next year we should see a run rate benefit of 3 to $5 million.

[Raj Denhoy:]

Out of the cost of goods line?

[Joseph J. Corasanti:]

Out of the cost to goods line, yes.

[Raj Denhoy:]

Okay. And then, the other source of margin which I don’t think materialized much in the quarter might have been masked a little bit by this FX effect of your intercompany transfers, but I think there has been a -- you guys have spent a lot and you guys invested a lot I should say in SG&A over the last several years. When can we start expecting to see some significant margin or leverage to flow out of that line?

[Joseph J. Corasanti:]

Well, I think the reason for the increase this year in SG&A as a percentage of sales has totally been related to foreign currency, which makes it more expensive to do business in the international location. So, that’s one piece of it. And then the second piece being the acquisition of the Italian distributor, so obviously when we are selling to them as a distributor, we did have selling and administrative cost in Italy, now we do it because we are direct. So those two factors only have been the cause of SG&A increasing this particular year. As we go forward, we do think that we should see leverage on that particular percentage. So a combination of sales growth at the top line and minimizing the growth in our overhead expenses in SG&A should allow us to see some benefit in the SG&A percent to sales.

[Raj Denhoy:]

Okay and just a point of clarification too, it sounds like you are going to start hedging those intercompany transfers. There is obviously some cost associated with that, but do you expect that to be a net benefit to you in SG&A going forward?

[Joseph J. Corasanti:]

Yes, absolutely. It takes away the risk, we have recorded -- over the last year we recorded some benefit on these intercompany accounts because of the weakening of the dollar. This particular quarter with everything happening so rapidly with exchange rates, it ends up being $2 billion number. So by hedging those intercompany transactions effectively, we are eliminating the risk.

[Raj Denhoy:]

Okay. And then just on the product line, I mean your arthroscopy number was strong again here in the quarter, comps there again start getting somewhat difficult in the fourth into next year, what's your level of confidence you can sort of maintain this kind of teens growth in that business going forward?

[Joseph J. Corasanti:]

We are pretty confident. We have got some very strong momentum going into 2009, with that the entire line we are seeing improvement on the US sales line and seeing improved traction really on a lot of the new products. As far as video goes, I am pretty confident that we will be maintaining the strong growth in video for the high definition video system.

[Raj Denhoy:]

So it’s -- I mean -- so you are not expecting even while the comps are getting tough, you will see that sort of fall off, we should maintain it pretty strong level of growth here for at least the fourth quarter and into next year?

[Joseph J. Corasanti:]

Yeah.

[Raj Denhoy:]

Okay, very good. Thanks a lot.

[Operator:]

Your next question comes from the line of Dalton Chandler of Needham & Company. Please proceed sir.

[Dalton Chandler:]

Hi, good morning.

[Joseph J. Corasanti:]

Hi Dalton.

[Dalton Chandler:]

Hi, let me just ask first a product question on the ECOM. First of all, I just want to make sure I heard you right, you think you can generate about 30,000 per year per system in disposables revenue. And did I hear that correct?

[Joseph J. Corasanti:]

That’s correct yes.

[Dalton Chandler:]

Okay. And then, how do you anticipate pricing the capital equipment and the disposables?

[Joseph J. Corasanti:]

For the pricing on the disposable trach tube is $150 per tube. And the system, the monitoring box, the current plan is to place the box as long as customers are willing to buy at least between 10 to -- I guess a minimum of 10 trache tubes per month. But, the box does have a sales price and so right now we haven’t sold one and I don’t anticipate selling one for several months. What if a customer does elect to purchase a monitoring box, they certainly can and the price will be probably around $15,000.

[Dalton Chandler:]

Okay. And then, Rob I am sorry, did you give us the impact of the Italian acquisition for year-over-year comparable?

[Robert Shallish:]

Well, in the third quarter, the top line benefit so the addition to sales as a result of selling direct to hospitals rather than through distributor was approximately 3.4, $3.5 million.

[Dalton Chandler:]

Okay.

[Robert Shallish:]

And the additional expenses that we had in selling and administration were equivalent to about $3 million. So, net benefit in the third quarter was about $500,000.

[Dalton Chandler:]

Okay, great. And in the past with the increase in commodity prices, you’ve talked about how that impacts your margins and your efforts to try to contain that now in a very short period of time we have had a complete reversal of that. Do that figure into your guidance for next year or is that something that might still be some upside out there?

[Joseph J. Corasanti:]

That’s an interesting question, because obviously base petroleum and base plastics should come down. We really have expected that into any great extent. But, some of the ancillary chemicals we’re still seeing price increases in it and we do have some concern about increased cost as a result of these ancillary chemicals that go into the manufacturing process. Whether they -- whether that pricing continues to remain higher, will be interesting to see, but in general we have assumed pretty flat cost at present in this estimate.

[Dalton Chandler:]

Okay. Thanks a lot.

[Operator:]

Your next question comes from the line of Mr. James Sidoti of Sidoti & Company. Please proceed, sir.

[James Sidoti:]

Good morning, can you hear me?

[Joseph J. Corasanti:]

Yes. Hi Jim, how are you?

[James Sidoti:]

Good, good. Nice to hear couple other people on the call. I wanted to ask a couple of questions. First, on the Endoscopic Technologies line, it’s been a few quarters -- it’s been more than a few quarters since you’ve shown steady growth in that line. Do you think you are over the hump now, do you think that from this point on we can start to see growth?

[Joseph J. Corasanti:]

Yes. I think that’s what we will be expecting. That growth is going to be driven by new products that came out with four fairly significant new products this year. So, I think we are in well position to grow that business from this quarter forward.

[James Sidoti:]

Okay. And then on the Electrosurgery line, I think you said there was a new tissue-sealing product in the fourth quarter this year, is that still the status or can you update us on that?

[Joseph J. Corasanti:]

Yeah, our tissue-sealing device, that’s true. We have been talking about that for six to nine months. We – well, probably – well, six to nine months or a year ago I think we spoke about the tissue-sealing product being released in late Q4 of this year, that won’t be the case. It looks like we are now looking at probably April or May to launch that new product. So, that’s our vessel sealing device also know as tissue-sealing and it operates on a very unique energy source, something that’s different than the products that are currently on the market.

[James Sidoti:]

Is that something you will need a 510(k) for?

[Joseph J. Corasanti:]

Yeah, that’s just a 510(k).

[James Sidoti:]

Do you have that yet?

[Joseph J. Corasanti:]

No.

[James Sidoti:]

Okay. Is that what’s holding up the launch or there are other issues?

[Joseph J. Corasanti:]

Well, yes, you could say that’s holding it up, but actually I am not even sure if we’ve even applied for the 510 (k) yet, it should only be about a 30 -- 60 day – 30 to 60 days process. But we were late in freezing the design of the device as we went through our validation testing on the device. So, we ended up making some design changes to meet basically the product inputs that were required.

[James Sidoti:]

Okay. And are there any sales for that product factored into your ’09 guidance?

[Joseph J. Corasanti:]

Yes, there are some sales for that product in our guidance, yes.

[James Sidoti:]

More heavily towards the fourth quarter though?

[Joseph J. Corasanti:]

Correct, that will be right.

[James Sidoti:]

Okay. And then on the balance sheet Rob, do you plan on paying down anymore debt in the fourth quarter?

[Robert Shallish:]

Given the current state of the world at present, the economic world, I think we feel pretty comfortable with liquidity, so we don’t have any demands on us to repay debt. The cash balance has increased and our present thought is to build the cash balance.

[James Sidoti:]

Okay. And then just with regards to the non-cash charge on the convert. I assume there is something that affects 2008 numbers as well. So, will the effecting be about that $0.06?

[Robert Shallish:]

Yeah, that’s correct. It’s a very complicated calculation. We are going to – we’ve done our own internal estimates of what the number is, but we are going to hire some evaluation assistants to help us come up with an exact calculation. But in rough terms, the number should be the same for 2009 and retroactively the 2008.

[James Sidoti:]

Okay. So after the restatement, I guess, you are still looking from growth in the low-teens area for next year on the bottom-line?

[Robert Shallish:]

On the bottom-line, yeah that would be right because basically the $3 million will affect both ‘08 and ‘09.

[James Sidoti:]

Okay. All right, thank you.

[Operator:]

Your next question comes from the line of Mr. Matt Miksic of Piper Jaffray. Please proceed.

[Matt Miksic:]

Hi, thanks for taking the question. Follow-up on the arthroscopy business, you commented earlier about your strong growth continuing likely to continue there particularly on surgical video. Can you talk at all about how much of that I guess is what’s driven by surgical video, how much is driven more by the products or procedural type revenues?

[Robert Shallish:]

Yeah, I think in the past we had most of the growth coming from video sales, ’07 was about 36% growth, so far this year -- we’re around the 20% for the year-to-date. Video sales growth will probably come down slightly, but what we are going to see is what we had been hoping for is that the core arthroscopy product line will start to grow faster both in the US and outside the US. We’ve spoken in the past about one of our immediate goals when they improve the performance of core arthroscopy products both procedure-specific, as well as resection and fluid improve the performance of those product lines in the United States. And so, we expect, we’ve seen a little bit of that already this year and we expect to see even further improvement going forward.

[Matt Miksic:]

And is that -- are there any new products that you are rolling there or is it just sort of improved pull through behind the camera?

[Joseph J. Corasanti:]

It’s improved pull through behind the camera. One of our, of course, short-term goals we knew that would happen as we started to have more of an installed base of cameras, but also we’ve got some new products that were launched last year at the Academy and some new products that will be coming out in Q4 and then of course there is probably five or six new products focused on procedure-specific and they will come out at the February Academy in Las Vegas.

[Matt Miksic:]

And then just one more on that. Just to clarify your, I guess, how things are going competitively, I am assuming this is opening up new accounts for you, sort of building out your sort of base of hospitals that you work with. Any sense of sort of share or do you talk at all about number of placements or the size of the market or your ability to sort of build out your footprint?

[Joseph J. Corasanti:]

I don’t know if we talked about that in the past but what I know today is that the video market for both arthroscopy and general surgery is about $500 million and we are getting close to – well, we certainly have over 10% of that market today and I think that with the way things are going we should have 20% of that market very shortly.

[Matt Miksic:]

Great. And then, just generally, I know that some of you talked earlier about some of these procedures, if there are deferrals, these things, surgical procedures need to be done sooner or later and will come back. I am sure you get this question a lot, but if you look at the kinds of surgical procedures that your instruments are used in do you have a sense of how many of those are sort of acute versus chronic or deferrable?

[Joseph J. Corasanti:]

Yeah, you know, when we talk about deferrable elective procedures nothing we are talking about is cosmetic surgery which is deferrable forever.

[Matt Miksic:]

Of course.

[Joseph J. Corasanti:]

When we are talking about -- really what could be deferrable is your ACL repair or your rotator cuff repair in the shoulder. We think -- our experience has been that, you know, you can get along for few months, maybe even a year without having -- going without your knee repaired. But you go longer, I think, it’s something that the customer, the patient just does not going to want to do. I think it’s a burden to walk with a limp, it’s a burden to walk with a cane, it’s also not healthy. It’s not healthy to go to have your ACL be torn and so that you can’t exercise. Your health will deteriorate over time if you don’t get that fixed.

[Matt Miksic:]

Yeah. No, we’ve seen some great data about that recently. It doesn’t seem to be affecting your business at the moment but in the market and as we look into Q4 may be it’s a flip of a coin or a toss-up or hard to predict, but any sense that we might see sort of an uptick of people looking to capitalize on their deductibles or year-end flush of deductibles as we get into Q4?

[Joseph J. Corasanti:]

You know that’s a coin flip, I think Matt. It’s very possible. There is two theories here that people are going to accelerate these kind of procedures because they are concerned about the health insurance. They have it now, so let’s get the procedure done while I still have a health insurance, so that’s on the one side. On the other hand, there is the other theory that gee, I am concerned about the economy. I don’t want to spend the money on the deductible. Maybe I will hold off for a couple of months. I think that’s a coin flip. I can’t tell you which theory might be appropriate. So we are going right down the middle. We are saying we are going to stay with our expectations. I believe the growth rate will continue and we should have a good fourth quarter.

[Matt Miksic:]

And then the other dimension of this is sort of term of rehab right? I mean if you look at your procedures versus some of the other procedures in sort of musculoskeletal, is it fair to say that you have sort of I don’t want to put words in your mouth but more sort of weekend rehab procedures, shorter a week or two kind of rehab rather than three and four month rehab.

[Joseph J. Corasanti:]

You know, I think that’s true. I don’t think the rehab is as long especially if you do a hamstring ACL repair versus a patellar tendon repair and of course the patellar tendon option is usually reserved for your professional athletes or someone who is vigorously engaged in sports activity, you may choose a patella.

[Matt Miksic:]

Okay. That’s helpful. Thanks for taking the questions.

[Operator:]

At this time, there are no further audio questions.

[Joseph J. Corasanti:]

Well, I want to thank 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. We look forward to discussing our further progress with you at our next conference call. So thank you very much. Have a good day.

[Operator:]

Thank you for your participation in today’s conference. This concludes the presentation. You may now disconnect. Good day.