CONMED Corporation
Q3 2010 Earnings Call Transcript

Published: 29 Oct 2010

[Operator:]

Good day, ladies and gentlemen, and welcome to the third quarter 2010 CONMED earnings conference call. My name is Lisa and I’ll be your operator for today. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. (Operator instructions) As a reminder, this conference is being recorded for replay purposes. I’d now like to turn the conference over to your host for today Mr. Joseph Corasanti, President and CEO of CONMED. Please proceed.

[Joseph Corasanti:]

Thank you, Lisa. Good morning, everyone. Welcome to CONMED Corporation’s third quarter 2010 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 the 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 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 in the press release issued this morning. With these required announcements completed, I can now turn to my comments. 2010 continues to be a strong year for us as we consistently fulfill our stated goal for improved profitability. Cost-cutting activities and factory consolidations completed this year and last year continue to drive profitability. For the just-completed third quarter, earnings again exceeded our expectations. GAAP diluted earnings per share were over seven times greater in this third quarter than in the third quarter of 2009. Adjusting for unusual items in both quarters, non-GAAP diluted EPS increased 21% to $0.34 per share. Year-over-year, the GAAP gross margin improved 51.7% compared to 49.9% and the non-GAAP gross margin improved to 51.8% compared to 51.2%. Our non-GAAP operating margin also improved from 8.3% in the third quarter last year to 9.1% in the third quarter this year. Because currency had only a negligible effect on the third quarter results and pricing was flat, these increases in margins were primarily a result of the manufacturing or restructuring activities we have been focused on over the last two years. As a reminder, we have completed the consolidation of the former three upstate New York manufacturing sites into one site and moved a number of product lines to a new manufacturing plant in Chihuahua, Mexico. Consequently, the benefit of searching out these efficiencies help grow the gross margin in third quarter compared to the same period a year ago. Although the most visible and difficult restructuring activities are complete, we will continue to optimize our manufacturing footprint. On our last conference call, we discussed the consolidation of 40 administrative positions at our Florida, Santa Barbara and Portland locations, resulting in approximately $5 million in annual savings. Based on this initiative, in the just completed third quarter, SG&A as a percentage of sales, excluding restructuring costs, declined to 38.4% of sales compared to 39.5% of sales in the previous second quarter. Turning to the top line, as we anticipated and communicated on the July conference call, the quarterly sequential trend related to CONMED sales returned to a normal historical pattern. This was in sharp contrast to the unusual sales results generated in 2009 as a result of the unprecedented effects of the global economic crisis. Specifically, this year’s third quarter sales declined quarter-over-quarter as a result of the normal summer slowness. Last year, the third quarter sales uncharacteristically grew $11 million over the 2009 second quarter, as we fulfilled significant capital equipment orders that had been delayed from the first half of ’09, and we saw a material number of surgeries that had been previously delayed actually take place. Consequently, the year-over-year comparison of sales growth in the third quarter is a reflection of the very difficult comparisons created by the unusually strong results in last year’s third quarter. So, while the 1.7% year-over-year constant currency decline in sales is certainly not the kind of growth percentage that we strive for, we believe CONMED is performing as we had anticipated and is well positioned for future success. I would however be remiss if didn’t acknowledge that the third quarter sales of $172.2 million was slightly short of the low end of our previously provided quarterly revenue guidance of $174 million. I’d now like to take a moment to discuss the significant impact some of our newer products are having, as we continue to enhance our portfolio of arthroscopic procedure specific devices. For the nine months ended September 30th, single use arthroscopy sales have increased 9.2% in constant currency. This is due in part to the strong market acceptance we’ve have seen for our shoulder restoration system and the recently launched PopLok device for shoulder instability. Moreover, we continue to see significant potential for our ECOM device for monitoring cardiac output on a minimally invasive basis during surgery. At a major anesthesiology conference last week, clinicians displayed significant interest in the possibility to provide hemodynamic measurements that improve patient outcomes by lowering hospital costs. We will continue to keep you advised of our progress in leveraging this potentially large market opportunity. As we mentioned on our last conference call in July, we have submitted the 510(k) to the FDA for our tissue-sealing device developed by our electrosurgery group. We’ve responded to all the questions they have raised and submitted additional data for their evaluation. We continue to think it possible that we will receive the FDA’s clearance to market the product before the end of this year. Nevertheless, please note that our fourth quarter 2010 total company sales and earnings forecasts do not include any benefit from this product launch. Further, we believe it’s premature to expect meaningful benefit in 2011, and therefore have not included material contributions for the tissue sealing device into next year’s forecast. As I mentioned earlier, and discussed on the conference call for our second quarter, we expect that the sales and earnings progression by quarter for 2010 will continue to evolve as we have seen historically. Specifically, the first and second quarters of the year typically have solid sales and earnings. The third quarter has the softest sales and earnings due to the summer slowness in surgeries, while the fourth quarter produces the strongest results of the year. In 2009, this pattern was substantially altered by the global economic crisis that significantly reduced business in the first half of ’09, while the second half of that year grew dramatically due to previously delayed surgeries and spending for capital products. So while the 2009 numbers for the third and fourth quarters make for difficult comparisons to the expected 2010 results, we anticipate our business will perform relative to sequential historical trends. Specifically, we estimate that fourth quarter 2010 sales should increase from the third quarter and approximately $185 million to $190 million. For the full year of 2010, this fourth quarter estimate would result in 2010 annual revenues of $715 million to $720 million. This minimally revised revenue guidance takes into account the third quarter sales that were slightly below our expectations. Conversely, our fourth quarter non-GAAP diluted earnings per share estimate of $0.33 to $0.38 leads to a full-year estimate of $1.27 to $1.32, which compares to our previous full-year guidance of $1.20 to $1.30. As we look forward to 2011, we anticipate continued measured improvement in the economy and in our revenues. Further, the cost efficiency actions we have taken during 2010 should have a positive effect on the results of 2011. Accordingly, we estimate next year sales will be in the range of $745 million to $755 million, and the non-GAAP diluted earnings per share will approximate $1.40 to $1.50. So, with that, I’d like to turn the call over to Rob Shallish for a further review of our financials. Rob?

[Rob Shallish:]

Thanks very much, Joe, and good morning everyone. As Joe mentioned, the profitability we delivered in the third quarter of 2010 was much better than we had anticipated. Earnings per share grew over seven times on a GAAP basis and 21% on a non-GAAP basis compared to a year ago. For the nine months, GAAP EPS was higher by over three times and non-GAAP EPS grew 49%. This is particularly impressive, considering sales for the third quarter were slightly less than the sales in the third quarter a year ago. Thus, this significant profit improvement is largely due to the manufacturing cost efficiency measures we initiated over the last couple of years, resulting in a meaningful improvement to the company’s gross margin from a year ago. Foreign exchange had no effect in the third quarter. So, the full amount of the increase in third quarter margins is due to improved efficiencies. Specifically, the third quarter non-GAAP gross margin percentage, excluding restructuring matters, was 51.8% compared to 51.2% in the September 2009 quarter. Our Mexican manufacturing plant is fully operational, and as we’ve discussed in the past, we continue to transfer additional lines to the new facility. Selling, general and administrative expense for the third quarter this year was 38.4% of sales, the same as the third quarter last year. I know, however, that for the nine months this year, the SG&A percentage of sales was 39.2%. So, the third quarter’s reduction to 38.4% reflects the benefit of various cost improvement actions we have taken during 2010. None of these actions affected our worldwide sales forces, I should point out. Research and development costs of $7.4 million declined $300,000 compared to the September 2009 quarter as a result of certain R&D activities nearing completion. For the fourth quarter, we expect R&D cost to range between $7 million and $7.5 million. With respect to the company’s overall non-GAAP operating margin derived by adding back the reconciling items between GAAP and non-GAAP amounts described in the press announcement this morning, the third quarter’s margin grew to 9.1% compared to 8.3% in the third quarter of 2009. This is in line with our goal for expanding CONMED’s operating margin. The company’s income tax rate in the third quarter on a non-GAAP basis was approximately 30%. During the third quarter, upon filing the 2009 federal income tax return and resolving some matters with the IRS, we were able to reduce the tax provision by $1.1 million. Please note that we have yet to record a benefit this year for the research and development tax credit, which Congress may approve before the end of this year. While we expect that Congress will extend the credit later this year, we will not be able to benefit from it until the enactment occurs. Should the credit be approved for this year, the resulting fourth quarter estimated tax rate would approximate 33%. Should it not be approved, we estimate the fourth quarter tax rate to be in excess of 38%. I’ll remind you that the company’s income tax expense has little effect on our cash flow. 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 position. With regard to the reconciling items between GAAP and non-GAAP amounts that are described in this morning’s press announcement, we now anticipate that the remaining restructuring costs associated with the movement of additional product lines to the Chihuahua manufacturing site will approximate $1.5 million for the rest of the year. Now, turning to the balance sheet, the most significant change results from the company’s receivable financing facility with a bank, and a required change in accounting for such facilities. Previously, receivables sold to a bank through the facility were eliminated from our balance sheet, as we have disclosed in all of our SEC filings. As we’ve discussed on previous calls, beginning in 2010, the Financial Accounting Standards Board required such off-balance-sheet receivable financing to be placed on the company’s balance sheet. As of September 2010, we used $24 million of this facility to finance receivables. So, on this quarter’s balance sheet, receivables are higher by $24 million than they would have been in December without this change in accounting. Further, the company’s debt is $24 million higher than would have been the case using the previous methodology. Let me emphasize that all of the company’s financing sources are exactly the same as they were in December 2009. The changes in receivables and in the current portion of long-term debt on the September 2010 balance sheet are simply the result of the required change in accounting for the receivables facility. Further, this change in accounting only affects the balance sheet and the cash flow statement. There is no effect on our P&L. Including the securitization financing in the debt-to-book capitalization calculation, the September 2010 ratio was 27% compared to the December 2009 ratio of 27.1%. Cash flow of the business continues to be quite strong in 2010. I draw your attention to the cash flow statement and the additional reconciliation of cash flow from operations included in this morning’s press release. Excluding the effect of the change in accounting, which we view as a non-cash matter, cash flow from operating activities for the nine months was $44.3 million in 2010 compared to $25.8 million in 2009. During the third quarter of this year, we used this cash flow and repurchased 690,000 shares of the company’s stock in the amount of $13.5 million. For the nine months, we have repurchased a total of slightly over 1.1 million shares at a cost of $23 million. This leaves another $23.8 million of unused authority under the Board of Directors’ authorization for future repurchases. Now, I’ll spend a few moments updating the foreign currency hedging program we started some months ago. Our plan involves entering into foreign currency exchange contracts, whereby we agree to deliver foreign currency at a set time at an agreed upon exchange rate. As of now, approximately 80% of the estimated FX exposure in the fourth quarter is hedged and 15% of the next year’s exposure is hedged. Using currency rates from last week as an estimate of the future, and knowing the hedges we have in place, we estimate that currency fluctuations in this upcoming fourth quarter will have an unfavorable effect on sales of approximately 1%. Using the same assumptions for all of 2011, we anticipate a negligible effect on sales from foreign currency changes, although our quarterly results may exhibit some slight effect. With that, Lisa, I’d now like to open up the call to questions.

[Operator:]

(Operator instructions) Your first question comes from the line of Matt Miksic with Piper Jaffray. Please proceed.

[Matt Miksic:]

Hi, it’s Matt Miksic. Thanks for taking our questions, guys.

[Joseph Corasanti:]

Good morning.

[Matt Miksic:]

Good morning. Just wanted to follow-up on some of your comments, Rob, about – and Joe about the hospital spending environment. Is – so, there was a period of catching up in some of your business lines, pent-up demand. And I thought you also are starting to see hospitals move beyond that and into sort of buying more broadly. Yet, the numbers show something weaker obviously in the quarter. What – help me reconcile, I guess, if I heard you correctly in the past and how those two things are happening?

[Joseph Corasanti:]

Well, we still think that is happening with hospitals buying more broadly. We’ve had a lot of deals in the pipeline. Video for example, if you look at the actual numbers Q1, Q2, Q3, video sales were 17.3 million in Q1 and we did have the spike that we have talked about in Q2 growing video to $20.5 million. That really was an exceptional quarter for video, and then Q3 is 18.4 million. So, we look at these numbers in terms of actual sales. I think they are fairly consistent in tracking in a way that tells us that capital spending is back on track at hospitals. So, when we look at our numbers for capital in terms of just the percentages, it does get you a little excited, but it’s really just because the comps were way out of whack, I think, from what happened – because of the economic crisis in 2009.

[Matt Miksic:]

Okay. So the punch line is that hospital spending is still on track, we’re not seeing sort of a pause or a double dip in terms of hospital behavior. Is that fair?

[Joseph Corasanti:]

Yes, correct. I mean, and I think that basis really bears itself out with – when you look at the actual sales numbers. I think power shows a similar trend 14.8 million in Q1, growing to 16.7 in Q2, then Q3, 16 million. So, and we would expect that in Q3. We are really not doing a lot of selling in Europe in Q3 because of the vacations in August. So, and that’s what we’ve seen historically for many, many years. And generators, I think, says the same thing, very consistent, sales of $6 million in Q1, 5.8 in Q2 and 5.7 in Q3.

[Matt Miksic:]

Okay. That’s helpful. I have one follow-up and then I’ll let some other folks jump in. But, on the share dynamics or competitive dynamics in the quarter, I guess we saw what were some pretty healthy numbers in some of these business lines coming out of Stryker, was it – do you think it’s – is there a changing competitive dynamic there, is that just maybe a difference in comps to your point about last year everyone seems to have a different comp heading into Q3, which has made a difference. Or if you could characterize how you are competing, how you competed historically, how you are competing today and sort of the integrated larger purchasing pattern in some of those hospitals? Is there – if they are going after buying three or four or five different sets of equipment from a given supplier, how do you play well there? Is that an area where you have a disadvantage? Is that a difference in the way you and Stryker might be performing? Any color on those issues will be helpful.

[Joseph Corasanti:]

Sure. So, we’re going specifically reference Stryker, we compete with Stryker, primarily with power surgical instruments. Most of our business is outside the U.S., and when we look at the capital number down 12% for power, a lot of that has to do with Europe. I think Stryker clearly has more business in the U.S. especially with their battery instrumentation. So, I think the story there really is tough comp for us and down in Europe with capital. The single use being down 1%, 1.5%, I think that’s reflective of disposable drill bits and saw blades, those are used in the total reconstruction procedures, and I think those are simply down when compared to prior periods. On the larger deals, we are very competitive, and because as you know, we have got full product lines in the six businesses that we have. So, we have got a lot of ability to mix and match our offerings between capital and disposables of our merchandising programs. And it’d be very competitive as a value player when a hospital is looking to buy 20 video towers, 30 generators and even the large integration systems, because we don’t talk about it very much, but of course, we still offer the full integration systems. So, I think our package of products lines up very nicely with Stryker’s and other companies that have sales volumes that are much larger than ours.

[Rob Shallish:]

And let me also just add that, it’s very difficult to break out from Stryker’s information the product lines that we specifically compete in. I know that they’ve got this instrument division and presumably the powered instruments that we sell compete against certain products within that particular line of business that they have. But, they’ve got much more in that line than we sell. So, it’s difficult for me to know exactly how our particular product line competes with theirs, since we just don’t get that information. So, I tend to think that we are not at a disadvantage relative to our powered instrument line that we compete very favorably. How that particular other company is doing with the same line that we sell is just unknown to me.

[Matt Miksic:]

Actually, the geographic, the comps, the color around what’s in that bucket, all very helpful. Thanks again for taking our questions.

[Joseph Corasanti:]

Sure, Matt.

[Operator:]

Your next question comes from the line of Robert Goldman with CL King. Please proceed.

[Robert Goldman:]

Hi, thank you and good morning.

[Joseph Corasanti:]

Good morning.

[Robert Goldman:]

I have a couple of questions. First, on the tissue-sealing device, I thought you mentioned, Joe, that we should – that you don’t expect meaningful benefit in 2011. I was hoping maybe you could explain that a bit. I imagine that is the result of whatever your launch plans are and perhaps you could detail those plans a little bit? And then, the second question is, so we’re not overly fixated on one product, could you just sort of suggest what you would cite as the one or two next most promising pipeline products after the tissue sealing device?

[Joseph Corasanti:]

Sure. With the comments about tissue sealing, we’re looking at – assuming the 510(k) is cleared at the end of this year, we think we could have sales of $5 million to $10 million for tissue sealing next year. However, due to the manufacturing cost of the line at these low volumes and the early start-up costs, we will not have any significant profit from – and in fact, very little gross profit, gross profit percentage from the line until we actually increase the volumes as well as bring in some components for you that is a part of the product line and bring that from outside vendors in-house. So, fairly – not insignificant on the top line, but yes, not a contributor on the bottom line for that product line. But, of course, we’re still extremely bullish on that line. It’s – the market is over $1.5 billion for tissue sealing. There are currently three players in that business. And we still believe that we will be launching a product that offers superior performance to what is currently available for surgeons on the market today. So, we do think we’ll make a significant impact in penetrating that market, which is also continuing to grow. The latest report we have says that that market is growing at 11%. So, we’re still very excited about tissue sealing. Other new products include a new product launch for our arthroscopy at the end of the year. That product will be a surgical device for the repair of the knee. I’m going to wait a little longer to describe what that product is. Perhaps we’ll probably wait for the launch of it before we talk about the product in any detail. We’re still very excited about what’s been launched in arthroscopy and that’s the shoulder restoration system. That launch has really been in two stages. We came out with the rotator cuff product first. We’ve been out with the instability device for about two months. It’s doing extremely well. We have augmented the line with a suture passer and a biomaterial device. Our biometrics is a fully threaded screw. So that launch, we would expect for 2011 for the full system to have sales of 15 million to 20 million, and over time, we think it can get up to $45 million to $50 million. So we’re very excited about that. And I’d say that those are the two most important launches along with tissue sealing.

[Robert Goldman:]

Okay. Thank you very much.

[Joseph Corasanti:]

Sure.

[Operator:]

(Operator instructions) Your next question comes from the line of James Sidoti with Sidoti & Co. Please proceed.

[James Sidoti:]

Good morning, Joe. Good morning, Rob.

[Rob Shallish:]

Good morning, Jim.

[Joseph Corasanti:]

Good morning, Jim.

[James Sidoti:]

You guys have been pretty clear over the past call or two about the slowdown on the hip and knee side of the business. But, your arthroscopic numbers seem to be holding up fairly well. Are you seeing any signs about a slowing going forward, or are you still feel pretty good about that business?

[Joseph Corasanti:]

Well, arthroscopy is, we are feeling very good about it. And mostly, the number one reason for feeling good about is because of the new product launches. We are still very bullish on the SRS System, especially now that we’re really in, I would say, Phase II of that with the launch of the instability device, the tissue – the suture passer, et cetera. The knee product will provide a very significant boost, we think, in arthroscopy, and we still think that procedure rates will continue to grow. And we think the market growth of 6% to 8% in any quarter that may be a little more or a little less. But on average, it’s about 6% to 8%. So we think it’s a very healthy market to be participating in and we continue to launch new products to basically be technology leaders in that space.

[James Sidoti:]

All right. And then on the large joint side, do you see it leveling off any time soon, and do you think you’re going to – we’re going to stay in this mode for a couple of quarters?

[Joseph Corasanti:]

That is a tough one for us to talk about. I mean, we are on the periphery there with selling drills and saws – on the disposable bits and blades that are used in those procedures. So we track it a little bit, but I don’t think we can comment as well as the larger companies that are selling the actual implants. I mean, we are following their lead there. We’ve been reading their reports and they are talking about it being a little bit slow growth at 1% or 2%. But beyond that, I don’t think we got any more information than you doing on that topic.

[James Sidoti:]

Okay. And then, just real quick on the tax rate, Rob, why did you get the one-time tax benefit in the quarter and what should we think about for the tax rate in 2011?

[Rob Shallish:]

Well, in 2011, we’re thinking that the tax rate is going to be between 36% and 37%. So, a little bit better than the tax rate that we had forecasted for this year at around 38%. The adjustment relates, in this quarter, relates to a net operating loss of an acquired business that we were able to take, and so that’s what that is.

[James Sidoti:]

Okay. So, we should see that in any ongoing quarters?

[Rob Shallish:]

Correct. I mean, the next unknown I guess is this research and development tax credit, if Congress enacts that before the end of the year. And that would be a plus for us. If they don’t, which I find unlikely, if they don’t, then our tax rate in the fourth quarter, it’d be a little bit higher.

[James Sidoti:]

Okay. All right. Thank you.

[Operator:]

Your next question comes from the line of Dalton Chandler with Needham & Co. Please proceed.

[Dalton Chandler:]

Good morning. You mentioned the new knee repair device in your product pipeline. I was wondering is that a new product category for you? And when you look at your R&D pipeline, what’s the mix of new products versus refreshed products?

[Joseph Corasanti:]

Well, this is a new – the knee product is a new product for us in that it allows us to participate in a procedure that we’re not participating in right now, although, we could say that we do have products for the procedures, just done in different way. So, I do look...

[Rob Shallish:]

It’s an arthroscopy product.

[Joseph Corasanti:]

It’s an arthroscopy product. I just look at it as – it allows us to get into a new procedure area. The mix of new products versus refreshed products – I can’t give you a percentage, I don’t think, but we offer both. But in general, I think our product lines are improved and refreshed certainly more often than they’re completely new products that offer a completely new procedure. And I think that’s about the best I can answer on that one.

[Dalton Chandler:]

Okay. Thanks a lot.

[Operator:]

Your next question comes from the line of John Sullivan with Olstein Capital Management. Please proceed.

[John Sullivan:]

Hi, guys. I apologize, this is (inaudible). I had to jump on a bit late. Just with respect to inventories, year-on-year were up, by my calculation, 11% versus – I know sales in the quarter were a little bit lumpy relative to unseasonably high revenue last year. But, even on a gross year-to-date, say, just revenues were up about 5%, inventories were up pacing that a bit, is that just – is that new product oriented thing, or is there anything else I should be looking for there?

[Rob Shallish:]

Well, there are a couple of things going on. Some of it is new product. I agree the tissue-sealing device is building inventory. We don’t have anything else for that as yet. Second is the moving of product lines from our Utica manufacturing to Chihuahua manufacturing. So, we built up a safety stock to assist in the transfer. And then, the third thing is that we generally build inventories during the summer for the anticipated increased sales in the fourth quarter. So, all those things come into play in the inventory number that we have here in the third quarter. I do anticipate that on an absolute dollar amount that that would decline as we issue the December numbers.

[John Sullivan:]

Okay. Thank you very much.

[Operator:]

There are no additional questions at this time.

[Joseph Corasanti:]

Well, with that, I’d like to thank everyone for joining us today. CONMED continues to work hard to improve the company’s operations, and we look forward to discussing our further progress with you on our next conference call. Thank you very much. Have a good day.

[Operator:]

Ladies and gentlemen, that concludes today’s conference. Thank you for your participation. You may now disconnect. Have a great day.