CONMED Corporation (CNMD) Q2 2012 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Q2 2012 CONMED Corp. Earnings Conference Call. My name is Chenne and I’ll be your coordinator for today. [Operator instructions] As a reminder, this conference is being recorded for replay purposes. I would now like to turn the presentation over to your host for today, Mr. Joseph Corasanti, President and Chief Executive Officer. Please proceed, sir.

Thank you, Chenne. Good morning, everyone. Welcome to CONMED Corporation’s Second Quarter 2012 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 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 also hear Rob and me refer to certain non-GAAP adjusted 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. Adjusted net income and adjusted 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. I'm pleased to report that we completed the second quarter 2012 with solid operating results. The quarter’s highlights included sales of $189.7 million, while near the lower end of our forecasted range increased 3.5% over sales in the second quarter of 2011. Adjusted earnings for the quarter were $0.43, in line with our expectations and growing 22.9% over Q2 of 2011. On a GAAP basis, diluted EPS was $0.36, an increase of 20%. Adjusted operating margin expanded to 10.6% of sales, an increase of 90 basis points over the second quarter of 2011. Adjusted EBITDA margin expanded to 16.4% of sales, an increase of 160 basis points. Cash provided from operating activities was also strong in the quarter, amounting to $25.6 million with free cash flow of $20.5 million, 10.8% of sales. Our board of directors continued the recently adopted cash dividend policy and declared a quarterly cash dividend of $0.15 per share. Operationally, the second quarter performance was largely in line with our expectations. Margins increased, cash flow was strong and the company delivered earnings in the anticipated range. One headwind was the continuing softness in the global economy, which caused capital equipment sales to be less than we had anticipated a few months ago. We will discuss this further in a moment. First, however, I would like to discuss a few recent initiatives. Last month, we held an analyst and investor day at CONMED’s Linvatec campus in Largo, Florida. The event provided investors and analysts an opportunity to gain valuable insight into our business through presentations on sports medicine, powered instruments, our agreement with MTF and related allograft sports tissue market, our new Altrus product, surgical video and a review of our global sales organization. In addition, there was a tour of our new state of the art surgeon training facility as well as surgical demos. We strongly believe that surgeon education is important for advancing the art of surgery and for instructing surgeons on new techniques and products. Along these lines, I will now briefly touch on the announcement last week that we are partnering with Exactech on surgeon education programs in North America that will emphasize the continuing care for knee and shoulder repair. We will leverage our combined knowledge and expertise to offer comprehensive education programs that address advancements in patient care from early arthroscopic intervention to total joint replacement technologies and techniques. These educational programs will take place at our state-of-the-art surgeon training center on our Largo, Florida campus. Likewise, as I discussed in our last conference call, our association with MTF continues to enhance the relationship with our physician customers. MTF, a non-profit organization, is the largest tissue bank in the country. With our recent agreement, we are now the exclusive worldwide marketing representative for MTF’s sports medicine allograft tissue. We are excited about this arrangement with MTF and the promise it has shown thus far. Beyond the financial impact, it will have our association with the industry leader for allograft sports medicine tissue will enhance our product offering and sports medicine and augment our leadership position in the industry. Turning to our quarterly financial results, CONMED’s total sales for the second quarter grew 3.5% over the second quarter of 2011. Excluding the $7.2 million related to the MTF agreement, overall sales were 0.4% less than that of the second quarter of 2011. Single use product continue to significantly outperform capital products. As was the case last quarter, our sports medicine, our arthroscopy single-use products continue to performance well with reported growth of 18.4% for the second quarter and 18.8% year-to-date. The organic sales increase in the June quarter was 5.8%, excluding the MTF revenues. Powered instrument single-use products also grew with powered instrument burrs and blades advancing 5.6%. General surgery products declined 1.2%. Single-use surgical devices are the core of CONMED’s product offerings. Accordingly, they now comprise over 80% of the company’s sales with margins on average higher than those of capital products. As we have said previously, we are attempting to reduce our near-term reliance on capital equipment sales, which have long sales cycles and are greatly impacted by global economic conditions. As a result, much of our recent R&D activities have been focused on the single-use categories. To this end, we have introduced several new devices so far this year. Of note are the Y-knot shoulder anchor made entirely of suture material, our expanding product offering for hip arthroscopy and the M-Class cutting blades for powered instruments. The remaining 20% of our products offerings consist of equipment which generally falls under the capital equipment budgets of our hospital customers. Sales of these capital products declined 10.7% compared to the second quarter of 2011, reflecting continued softness in the markets for these types of products. Specifically, surgical video systems are the capital component of the arthroscopy product offering. For the second quarter of 2012 as well as for the first 6 months, sales of these systems were slightly less than the comparable period in 2011. This is consistent with our expectations for this line this year. We did not expect growth for 2 reasons. First, economic factors in the United States and the rest of the world are causing hospital administrators to make capital investments judiciously only in areas of specific need such as healthcare information technology. Since our surgical video systems are capable of extended service life, replacement of existing systems can often be delayed. Secondly, new products in our surgical video line are anticipated in the first half of 2013. Though, these expected technology upgrades provide further reason for hospitals to delay purchase decisions. As for powered surgical handpieces, the surgical drills and saws which make up the capital components of the powered instrument line, we experienced a decline of 11.9% for the quarter and 7.7% for the first 6 months. To some extent, we are handicapped by our success last year when we had growth of 11.4% for the second quarter of 2011 and 15.3% for the first 6 month of 2011. But besides the difficult comparison to 2011, one of our important new product offerings in this line, lithium-ion batteries, has taken longer to rollout than previously anticipated. We now believe that we will launch these enhanced batteries in the second half of this year and that this will help us return to more normal growth pattern. However, as with video systems, we believe there will be little growth this year in the capital line due to continued constrained hospital spending globally. Finally, the last component of ConMed’s capital equipment offering is our line of electrosurgical generators within the electrosurgery division. As with powered instrument capital equipment, we experienced extraordinary growth in last year’s second quarter of 37.9%. So this year’s second quarter decline of 25% is largely attributable to the very difficult comparison to last year. Electrosurgical generators are found in every operating room around the world and provide the radiofrequency energy that facilitates open and minimally invasive surgery in 90% of all surgical procedures. These pieces of equipment range in price between $10,000 and $20,000. While not expensive in relation to other hospital capital items such as radiology machines or surgical robots, electrosurgical generators can have extended life, so we believe that hospitals have delayed replacement in favor of other more pressing needs. On the topic of electrosurgery, one of our newest single-use devices is the Altrus vessel-sealing instrument for open and minimally invasive surgery. As a reminder, we believe the current market for vessel-sealing devices is approximately $2 billion based upon the current sales of 2 principal market participants. As the newest participant in this large market segment, we believe that Altrus can gain market share based upon its advantageous features and benefits. Although our device was launched last year, we are only now gaining traction in the market because of a series of manufacturing delays. As recently as April of this year, we stopped shipping for a number of weeks in order to increase the product’s performance. With this work now fully completed, we can concentrate on building market share without being hampered by product supply or performance issues. The second quarter sales of Altrus were in excess of $500,000. This was the highest quarterly sales amount generated since last year’s launch of the product. We believe that sales should accelerate as we progress through 2012 and expect total sales to reach $4 to $6 million for the year. With 1/2 of the year completed, we remain optimistic about CONMED’s ability to deliver continued improving earnings and margin expansion with greater cash flow. As evidence of this, as I noted earlier, our Board of Directors recently declared the second cash dividend in the company’s history. This dividend was equal to $0.15 per share with the expectation that similar quarterly dividends would be paid for the remainder of this year, making the annualized dividend equal to $0.60 per share for a yield on the current stock price of over 2%. The board concluded that this dividend policy was justified based on the company’s cash flow and that the payment of dividends is appropriate in order to ensure shareholders are benefiting appropriately from CONMED’s operational strength. As a reminder, in 2011 the company had a record year in free cash flow of $85.4 million. As we look forward to the remainder of 2012, we are adjusting slightly the year’s sales forecast and are reiterating the earnings forecast. Specifically, we now expect sales will approximate $765 million to $775 million compared to our previously issued guidance of $775 to $785. The adjustment is due to the second quarter’s results for capital equipment sales and the outlook for the remainder of the year. As for earnings, we are reiterating our previously provided expected adjusted EPS range of $1.75 to $1.85 per share. The third quarter of 2012, historically the seasonally weakest of each year, we forecast sales of $180 to $185 million and adjusted earnings per share of $0.38 to $0.42. As I have mentioned before, we remain extremely positive about the direction of the company and look forward to making continued progress in 2012. We will continue to focus on devices that improve patient outcomes on controlling costs to improve profitability and create long-term shareholder value. I would now like to turn the call over to Rob Shallish for further review of our financials.

Thanks very much, Joe, and good morning everyone. As Joe mentioned, the second quarter continued the strong earnings and cash flow trends seen in the first quarter. In the June 2012 quarter, sales grew 3.5% while adjusted earnings per share increased a robust 23%. For the first half of 2012, adjusted earnings per share grew 18.1% on sales growth of $4.7%. So with fairly moderate sales growth, we are able to deliver earnings increases in the mid-teens or higher due to our various ongoing operational improvement activities as well as the benefits from the MTF association. The second quarter sales totaled $189.7 million compared to sales of $183.2 million in the second quarter of last year. Excluding the $7.2 million of revenues from MTF, the organic sales decline was 0.4% due to lower capital equipment sales as discussed by Joe a few minutes ago. By geography, sales in the United States grew 3.8% on a reported basis, but excluding MTF U.S. sales declined 4.2% organically due to the lower capital equipment sales. As a reminder, almost all of the MTF revenue at this point is generated in the United States. CONMED’s international sales grew 3.2% and continued to make up slightly more than 50% of our business. As we anticipated, the gross margin percentage, excluding ongoing restructuring costs, increased sequentially from the first quarter and increased substantially over the second quarter of 2011. In this second quarter, the adjusted gross margin was 53.2%, a 280 basis point improvement over the 50.4% in the second quarter last year. While the gross margin percentage last year was abnormally low as we discussed at that time because of unfavorable manufacturing variances generated in late 2010, the recently completed quarter’s margin improvement is also due to the favorable effect of operational improvements as well as the MTF revenues. We expect that the gross margin in the second half of 2012 will continue to improve as a result of the operational efficiency programs our team has implemented. I previously mentioned that our operations team has been dedicated to improving inventory turns and reducing our investment in inventory. Compared to the June 2011 balance, inventory has declined 6% and the days investment in inventory has also declined. Selling, general, and administrative expense increased $5.8 million to $73.7 million compared to $67.9 million in the second quarter last year. The majority of this increase was due to additional sales and marketing personnel and activities associated with the MTF partnership. As a percentage of sales, SG&A was 38.9% of sales this quarter compared to 37% last year. Research and development increased approximately $400,000 but as a percentage of sales remained more or less consistent with the prior year period at 3.8 % of sales. Overall, as a result of the changes in gross margin, SG&A and R&D as a percentage of sales, the adjusted operating margin in the second quarter of this year grew 90 basis points to 10.6% compared to 9.7% in last year’s second quarter. We continue to forecast a 100 basis point improvement in operating margin for the full-year 2012. By comparison, the adjusted operating margin in 2011 was 10.1%. The second quarter’s growth demonstrates continued progress on that front. Perhaps even more impressive is the increase in the adjusted EBITDA margin. In the second quarter, adjusted EBITDA margin increased 160 basis points to 16.4% of sales compared to 14.8% in the second quarter last year. [indiscernible] EBITDA grew 60 basis points to 14.8% of sales. We have previously discussed our expectations for achieving higher operating and EBITDA margins by continuing to leverage our infrastructure. Sales are expected to advance at a greater rate than cost increases due to the benefit of new products that should generally have gross margins greater than the company’s current average as well as overall market growth from our current products. Single use products generally have higher gross margins than capital products. So the next shift to a higher percentage of sales coming from single use devices helps the expansion of margins. Further, we will continue to review our cost base to ensure the business is operating in the most efficient manner possible with regard to both the cost of manufacturing products and the SG&A line. With regard to manufacturing efficiency, we have previously discussed the relocation of manufacturing activities for our surgical video systems from the Santa Barbara, California location to our plant in Mexico and Florida. Research and development as well as well as marketing will remain in Santa Barbara. The consolidation of these manufacturing activities is almost complete and should be finished in the third quarter this year. We also recently announced the consolidation of the Tampere Finland location into our United States locations. The restructuring activities for this most recent consolidation has started and will extend for the next 12 months as we make an orderly transition. We anticipate that the Tampere consolidation will result in annual savings of approximately $4 million once complete. For the second quarter of 2012, adjusted earnings per share were $0.43 compared to $0.35 per share in the second quarter of 2011, representing a year-over-year increase of 22.9%. EPS on a GAAP basis was $0.36 compared to $0.30 in the prior year period. The adjustments for unusual items in the second quarter are reconciled in the press release issued this morning and include costs associated with the ongoing manufacturing and administrative restructuring program and legal costs related to a contractual dispute with a former distributor, which is now resolved. For the remainder of 2012, we expect to incur additional pre-tax manufacturing restructuring costs of $5 to $6 million as we complete the manufacturing transition from the Santa Barbara location and continue the consolidation of the Tampere facility. Turning now to cash flow, cash provided by operations was $25.6 million compared to $19.5 million in the second quarter of last year. As we expected, the operating cash flow in the second quarter was much improved from that of the first quarter and in line on an annual basis with the $103 million of cash from operations that we achieved in 2011. We discussed on our last conference call how the first quarter’s cash flow was affected by a voluntary one-time payment of $6.5 million to the pension plan to increase its funding and by incentive compensation payments resulting from the earnings of 2011. For the final 2 quarters of this year, we expect that operating cash flow will be even better than that of the second quarter due to the anticipated increasing income, particularly in the fourth quarter. Please note that although we borrowed $57 million in January this year to help fund the MTF transaction, through June 2012, our cash flow has already permitted repayment of $32.5 million. On the balance sheet at June 2012, the cash balance stands at $16.2 million. Pays and receivables are equal to 65 days, an improvement of 2 days from the December 2011 amount and much improved from the 76 days in June 2011. Inventory declined $9.3 million compared to December last year. Further, the day’s investment in inventory declined to 163 days compared to 173 days in December last year. Finally, as of June 2012, the debt-to-book capitalization calculation was 22.1% compared to 20% at December 2011, as a result of the borrowing associated with the MTF transaction. At June 2011, the comparable ratio was also 22.1%. Overall, we are pleased with the strong earnings and solid cash flow that CONMED delivered this quarter. Going forward, we will continue to improve the operational efficiency of our business and achieve higher margins in order to drive shareholder value. With that, Chenne, we’d now like to open the line for questions.

[Operator Instructions] Your first question comes from the line of Matt Miksic with Piper Jaffray.

I wanted to get -- you’ve gone through some of this in your prepared remarks, but maybe if you could give some color on how much of the trends that you’re seeing in your single-use products for arthroscopy? How much of that do you feel is pull-through, carry-through of some of the products you had launched recently and some of the new anchor products that you’ve launched and how much of that can you talk about, being some sort of change in the market dynamics? Or do you think it’s just 100% new products and share?

Well, what we’re talking about is, I guess, organic growth for arthroscopy line, that was 5.8% in the quarter, and that was led by sales outside the United States, and in terms of new products, Sequent had sales of about $1 million in the quarter. The Y-Knot product was not even fully launched until the 1st of June. We were in a limited launch with maybe only 12 reps selling it, but still that managed to have sales of about 500,000 for Q2. So I think that’s a combination of good growth outside the U.S. for single-use sports med products, plus these new products is what’s leading organic sales growth for sports med.

Okay. And any color on the trends here in the U.S., in terms of sequential compared to Q1, either whether it’s pricing or changes in patient utilization over the past compared to recent quarters?

Well Matt this is Rob. We did see an increase in the United States in our single use sports medicine products. Not a huge one very frankly, but an increase. So that leads to me to believe that the increase is primarily from the new products and that utilization is still rather consistent and not necessarily increasing at this point.

Okay. Just stable or should we expect kind of sideways downward pressure for the rest of the year?

No, I expect it to be stable -- it has been stable, let's put it that way. I think what we expect is that historically we see a drop off in the summer months because of surgeon vacations, vacations -- we're not talking about Europe, but vacations in Europe tend to cause a decline as well. And then the fourth quarter historically is the strongest, so we would expect that same level of activity this year.

Okay. That’s helpful. I’ve been hopping between calls here, so I apologize, but I may have missed the update on Altrus and just your -- you had given some great color and an update at your analyst meeting and I just wanted to get a sense as to whether those trends have continued? Whether you feel like you had sort of gotten any other side of the supply and manufacturing constraints that you had and where you are in that roll off?

Yes. With Altrus we’re seeing improvement. We are seeing -- the supply issues, we believe, are behind us. We’re even seeing that our yields are starting to improve, some of our cost improvement measures are starting to take hold, we’ve completed several, of course you won’t get the benefit until the inventory cycles through. In the quarter, we had $500,000 in sales of Altrus product, we’re doing roughly 50 cases a week and I would say that unfortunately for the last 3 weeks we’ve been stuck at 50 cases or procedures, but we do expect that to start improving. We have now 51 surgeons that are converted to Altrus, and by our definition that means that those surgeons have changed their preference card and are using the Altrus exclusively for their tissue-sealing, vessel sealing needs. That’s an increase from the last call in the first quarter. We are seeing progress, we are making progress. I’d like to remind everyone that we still had some issues in April, so when I look at Altrus I think we’re moving forward from the point of time, I would say May and June, I would expect to see significant increases from this point forward.

Okay. And then one last one on maybe just some of the tone that you’re getting from your hospital customers on the capital side rather. I know it’s not a big part of your business, but it had moved around a bit and been a bit more challenging for a lot of folks. What sort of commentary or decisions are you seeing deferred or pushed down or policy changes, priorities in the hospital side for capital?

I think for the kind of capital that we sell, Matt, it is susceptible to delays, with surgical video that can be delayed and I think we’ve seen some of that this year. Sales are relatively flat, which I think is good; that’s what we expected in surgical video, and we’re not expecting much more than that this year. For next year, we’re awaiting the new products that would come out in the first half next year, so without changes in technology, I think people are waiting. On the powered instrument front, we had an extremely strong quarter in the second quarter last year, so we have just a tough comparison right now. If we look at the historical trends of powered instruments and drew a graph of the sales of powered instruments, it will be fairly stable to slightly up, which I think is what we would expect as a result of the kinds of procedures these devices are used in. So I don’t necessarily think the decline that we’re seeing in powered instruments is indicative of an issue. I think it’s just that it can be a choppy business from time-to-time, so we had a very good quarter a year ago and this quarter is more in line with what we saw in history. And the same is true of the electrosurgical generators; that can be a choppy kind of a business where we can get an order for $1 million from a governmental agency in one quarter and then have nothing of that sort in another quarter. So, generators were very strong in the second quarter last year and there is just a tough comparison. So I think that the story with generators is the same as it is with the powered surgical instrument hand pieces. Fairly consistent over time in terms of the sales, but it can be choppy based on these large orders that come through.

Okay. So it doesn't sound like sort of a change in the direction of the curve or the levels of spend; it’s more sort of the typical quarter-to-quarter bumpiness?

I agree with that comment, Matt.

Your next question comes from the line of Jeffrey Cohen with Ladenburg Thalmann.

I wondered if you could talk about CapEx for the second half of the year? Would you expect it to be largely in line with how the first half looks?

You mean our CapEx expenditures?

Yes.

Yes, I would agree with that. We have $11 million or so in the first half and so in the neighborhood of -- well, we expect $20 million for the year. So I guess the second half would be a little bit less than the first half.

Got it. And any commentary on the tax rate for the quarter, which I see was a fair amount lower than Q1, how would you expect that to look as far as modeling purposes for the second half of the year?

Yes, in the second quarter we had some favorable adjustments amounting to $300,000 or $400,000 from resolution of some matters with the IRS. In the third quarter, I would anticipate that the tax rate would be in the neighborhood of 36%, which would be more or less what we had expected for the entire year. But then in the fourth quarter, I’m hopeful that the congress will extend again the research and development tax credit so that we would have some benefit in the tax rate for that in the fourth quarter so that that may drop into the say, 34% range again.

Okay, got it. As far as some of your comments related to margins and margin expansion, correct me if I'm wrong, you had said that you would expect that that would not backup from where it was during Q2?

Well, I don’t know if I quite understand your question Jeff, but we expect margin improvement as we go through the rest of the year. We're expecting that the gross margin in the third quarter would improve over the second and that operating margin would also improve over the second, and that’s based upon the operational activities that we’ve been working on here, and knowledge of how our production variances flow through the P&L. So, overall, we are expecting gross margin to improve in the second half of the year over the first half and that would also help drive operating margin improvement.

Got it. Briefly the $5 million to $6 million in pre-tax restructuring cost, how do you expect that might look between the third and the fourth quarter? Would you expect that to be fairly even?

Yes, I would expect it to be fairly even.

Okay, and one more quick one. Could you perhaps talk about or discuss a little bit about some of the rebranding initiatives as I have seen a few new product catalogues?

Well, our marketing and communications team has been working on improving our brand, for lack of a better term, so many of the new catalogues have a new look, so that’s, I think, a positive for us to help our sales people sell the product. There is more to that to come, I'm sure. We have a very good team in that group and I'm sure we will see changes in how we communicate with our surgeon customers.

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

You did touch on the fact that you have tough comps in powered surgical and electrosurgical. Looking back at it, there was a very sudden acceleration in both of those businesses in the first half and for 2 quarters, then there was it decelerated again. Can you just talk about what you think was the driver behind that?

With electrosurgical generators, we had significant orders from the U.S government, in fact, in Q1 and Q2. And of course [ph] last year, so of course we did not have those this year. We also -- talking about this year a little bit with electrosurgical generators, there really has been a lot less activity in general, requests for proposals and evaluations for electrosurgical generators, although I will say that really in the last month we’ve seen that activity pick up a bit, so I think we are looking for a slight improvement in the second half of the year on generators.

Okay, so it sounds like you're talking about really the second half maybe flattening out and then picking up again in 2013, is that fair?

Well, yes, certainly the comps would be certainly much easier because of the performance in Q3 and Q4 of last year, and I am encouraged by some of the activity, at least in electrosurgical generators, for this year and we did mention earlier that we would expect an improvement in power instrument handpieces once we come out with our lithium-ion battery offering.

Okay, and then just shifting to the MTF deal, the press release said we had $7.2 million in revenue for the quarter. I assume that’s net of the amortization.

Yes, that’s right Dalton.

Okay, that gives you a total of $14.7 million for the first half. I think that you had previously said you were expecting $33 to $35 for the full year, so is there some seasonality in that business?

No. A little over $14 million, $14.7 million net. The amortization is $3 million or thereabouts for the first half. So that gets us into $17 million on a half-year basis gross, and so just multiplying times 2 that gets us to the $34 million, $35 million, which we had expected. So…

So I guess I misunderstood. I thought the $33 to $35 was the net, but…

No, no the $30 to $35 is gross.

Your next question comes from the line of James Sidoti from Sidoti & Company.

Just 2 quick ones. One, on the currency. You said you were able to hedge rate to about $41 for this year as far as the euro goes, where do you see that coming into 2013?

Well, we've done a little bit of hedging for 2013, Jim. For the EUR, we have got some rates locked in at about $1.31, $1.32, but it’s not a large piece of our EUR exposure. It might be 20% or so of our EUR exposure. So, we still have either some hedging to do or we’ll just end up being somewhat exposed I guess to day-to-day currency exchange rates on that score. As a reminder, the euro is roughly 35% to 40% of our total foreign currency exposure and that represents about 15% of our total sales.

All right, and you have some sales and marketing organizations over there, so there is some natural hedge to that.

Yes, that’s exactly right. And I must add that the Canadian rates are remaining fairly good as well as Australia, and the pound is off a little bit, but not as much as the EUR.

Okay, so you might see a little bit of degradation in the EUR next year, but like you said, it’s about 35% of your international sales?

Right, exactly.

All right, and then, have you come to any kind of conclusions regarding the medical device tax regarding what…

Let me just back up a little bit. It’s 35% of our exposure, so it’s not 35% of our foreign sales. Foreign sales are 50% of our business, but only about 35% of our total sales or 2/3 of our foreign sales are denominated in currencies other than the dollar.

Okay. Right, I understand. And then regarding the device tax, have you come to any conclusion how you’re going to account for that?

In terms of the device tax, our plan right now is to make every attempt that we can to pass that tax onto our customers in terms of either price increase on the actual prices of the products or potentially line item on our invoice. See how that works out.

Okay. But if it’s not a line item on the invoice, I assume you’ll book it as revenue and then would you expense it in your gross margin line or in your SG&A line?

I’ll tell you, Jim, that’s still up in the air. My preference would be to break it out as a separate line item, as a non-operating cost similar to interest expense, but, I don’t think any of the companies involved have made a decision yet on how they’re going to show that.

All right, and then as far as your U.S. sales that are subject to that tax, should we assume that, that’s a 100% or are there some sales that, on your patient care lines sales to other companies, would not be subject to that tax?

Well, 50% of our sales are here in the U.S. Now, what sales would be excluded? I think the MTF distribution revenues would not be taxed, so that’s some amount, that’s $35 million, $40 million that would not be taxed. I’ve got a question about service revenues, the revenue we received from servicing products, so that would be a slight adjustment to the 50% factor, but if you are trying to do a rough calculation, it’s probably 45% to 50% of our sales would have the tax.

Your next question comes from the line of Andrew Fleming with Heartland Advisors.

I just had a quick question on your debt. I thought you paid down a bit this past quarter, can you just comment where you expect it to be by the end of the year?

Well, as we mentioned, we expect the cash flow to continue to be good, and with that cash flow, we would anticipate reducing the debt. So, we have paid down $30 million so far in the first half, and so I guess my expectation would be at least another $30 million on the debt for the rest of the year.

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

Rob, first on SG&A to sales. You might have already mentioned this and I missed it, but it did have a pretty decent bump-up at ratio year-on-year, and what drove that?

Well, it’s the MTF group that joined us in January, so we don’t have much in the way of cost of sales related to those MTF revenues, but we've added some 30 people to the organization and they all sit, from an accounting perceptive, in SG&A, so it’s the cost of those programs.

Based on that though, Rob, you also had in the first quarter, but your year-one-year increase in SG&A in the first quarter was only 30 basis points, but was a 190 basis point in the second, so I get the sense it's something beyond that.

Well, there is obviously some ups and downs in the cost of running the business on a quarter-to-quarter basis. I think we had some favorability in the first quarter in some items like benefits and whatnot. So I can’t point to any specific things, Bob, to be honest with you, but I think the bulk of the change is a result of the MTF Group that joined us.

Okay. And then Rob, you mentioned the movement of some of the manufacturing to Mexico. Any sense in the second quarter of what percent of sales Mexico represented and any estimate of what it will at the end of this calendar year?

Well, I think this year’s principal activities with Mexico is the Santa Barbara change, so I think we’re going to be approaching 25% or so of our production in Mexico, so that should occur here by the end of the year, Bob.

Okay, and then firmly on Altrus, you have mentioned these 50 cases per week, and you had sort of been stuck there for the last 3 weeks. If each device is something on the order of 700, although maybe you can clarify that, and they are using just one per procedure, it would seem like the dollar revenue in July would be tacked to be considerably less what it was in June or May. Could you help me out with the math here?

Well, I think you’ve got the math right, and I think the summer is an interesting time, Bob, because physicians go on vacation, so sometimes it’s hard to get to them, very frankly. I don’t think it’s indicative of anything to do with our product, but I do think that it’s oftentimes difficult to roll out new devices in the summer months.

Your next question comes from the line of Mark Landy with Summer Street Research.

Just a quick question, I think probably more from 30,000 feet, if we have a look at really what’s going on in the markets, procedure volumes remain difficult, economic headwinds, government policy has a lot of uncertainty around some of its future. The management of product lifecycles and then how they dovetail with competitor’s lifecycles and offerings. Are they all kind of hitting at the same time or is one of those really standing out as more of a challenge than the others?

Well, Mark, I have looked at a number of releases from other medical device companies over the last few days, and it seems like all of us are somewhat disappointed in top line growth. I think ours overall at 3.5% or so is in line with what other companies are seeing, but obviously we’d like it to be more than that, and a good deal of our growth this year is a result of the MTF arrangement, so that on an organic basis we’re more or less flat in the second quarter, although up for the entire year, so I think what we are seeing is not too dissimilar from what other companies are exhibiting, and frankly I think it’s the global economy, I think the economy worldwide is soft right now and that’s hindering the normalized growth that we would typically see in our business. So we’re hopeful that that’s going to change over the next several quarters, but in the short-term, I think that we’re going to be somewhat hampered by factors outside of our control.

That, I think begs some of the questions, if innovation is rewarded in better economic times, would it make sense to perhaps manage the product lifecycles a little bit just to try and time the launches with some improvement in the economic outlook or is that just too much of a crapshoot and you would rather just have the sales force peddling and pushing the latest and the greatest opportunities?

Well, my personal opinion is that the latest and greatest is always going to win out no matter what the economic situation is, so things like the Y-Knot product that we just fully launched in June and the Sequent device that we launched last year, the shoulder restoration system that we launched last year, I think all these products are going to be beneficial for us, so the ramp may not be as robust as what would occur in boom times. I think that it’s still favorable to roll these things out when they are ready.

Okay. Good point. Just moving onto some of the government business that you mentioned, what portion of that business is with the military, if any?

Well, we have quite a bit of -- not quite a bit of business. I don’t know what our total business with the Veterans Administration is. We have some there. With the actual military, I would say it’s fairly low. Joe has already mentioned some electrosurgical generators that we sold to the government a year or so ago. And frankly, I’ve kind of forgotten if that was a military procurement or a state department procurement, so it’s varied, I would say our largest portion of government business is to the Veterans Administration.

Okay, good. And then I think just one of the general trends from the releases that we’ve gotten thus far is that the U.K. seems to be one of the brightest spots, perhaps now maybe even globally, specifically in Europe, and perhaps for the whole orthopedic market and not geographically, is it a wild card to think of some disruption to that business over the next 2 weeks given the Olympics in London that could have some impact on third quarter results, or is that really trying to analyze things too deeply?

Yes, we have to say we haven’t thought about the impact from the Olympics. We will say that the U.K. was a bright spot for us in Q2; it grew 23%, and so it did actually much better than the Eurozone. Eurozone actually declined for us a bit, maybe 7%. That's a surprise for us, but the U.K. being as strong as it was and we just certainly hope it continues.

[Operator Instructions] Your next question comes from the line of Dale Dutile with The Boston Company.

The question about currency and those EUR hedges you talked about earlier seem more and more valuable here. I’m just trying to understand how those manifest in the P&L that we’re seeing in the second quarter?

Okay, what we've accomplished this year is to have hedged about 80% of our foreign currency exposure, so we calculate our exposure based upon what we expect our foreign currency sales to be less the expenses that we have in the foreign currency. I’ll make it easy. So if we expect sales to be €1,000 or €100,000, we would expect that we have expenses against that in the local subsidiary of say, €50,000. So our exposure is €50,000 and we would hedge 80% of that or say, €40,000. So the hedges that we’ve entered into have shown to be a benefit this year because we entered into them last year when the rates were much more favorable to us, and the benefit of those hedges, we recorded as a revenue item. So it doesn’t totally offset the reduction in sales as a result of the currencies being lower today than they were because sales are translated current item-for-item, euro to dollar, euro to dollar at the current rates, but we’re only recording a hedge benefit of about 40% against those sales.

That makes sense, okay, so there is no cost impact, the accounting is all in the revenue line item?

That’s right, there's a benefit in SG&A to some extent because the costs are lower than what they would have been.

Because they’re euro denominated?

Because they’re euro denominated.

So if I wanted to try to estimate how much they’re kind of benefitting now using your example, your kind of €100,000 and €50,000 of local expense, and you hedge that €50,000 exposure at 80%, I mean, I could essentially assume, because your head spot rates are kind of low, $120s versus your heads are about $141, kind of 12%, 13%. So that hedged amount would be 12% to 13% lower in dollar terms than if you haven’t had the hedge?

Yes, that will be right.

Okay, that’s helpful. And just secondly on your single use stuff is 7.5%, I just want to be clear, that includes MTF, or it does not include MTF, the growth in single use products?

Well, our total growth in single use products has a currency of 7.8%. That includes the MTF association, yes.

Okay, so MTF would be the majority of that $7.2 million?

$7.2, right.

At this time, there are no additional questions. I would now like to hand the call over to Mr. Corasanti for closing remarks.

Thank you very much for joining us on today’s second quarter conference call and we look forward to talking to you again on our third quarter conference call. Thank you.

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