Orthofix Medical Inc. (OFIX) Q4 2011 Earnings Report, Transcript and Summary

Good afternoon, ladies and gentlemen, and welcome to the Orthofix International Sponsored 2011 Fourth Quarter Earnings Release Conference Call. [Operator Instructions] Now, I'd like to turn the floor over to your host, Mr. Jeff Schumm. Sir, the floor is yours.

Thanks operator, and good afternoon, everyone. I'd like to welcome you to the Orthofix fourth quarter 2011 earnings call. Joining me on the call today is our President and Chief Executive Officer, Bob Vaters; Senior Vice President and Chief Financial Officer, Brian McCollum; and President of Biologics and Senior Vice President of Business Development, Mike Finegan. I'll start with our Safe Harbor statements and then pass it over to Bob. We will be making forward-looking statements that involve risks and uncertainties and all statements other than those of historical fact are forward-looking statements, including any earnings guidance we provide, and any statements about our plans, beliefs, strategies, expectations, goals or objectives. Investors are cautioned not to place undue reliance on such forward-looking statements as there is no assurance that the matters contained in such statements will occur. The forward-looking statements we make on today's call are based on our beliefs and expectations as of today, February 23, 2012. We do not undertake any obligation to revise or update such forward-looking statements. Some factors that could cause actual results to be materially different from the forward-looking statements made by us in the call include the risks disclosed under the heading, Risk Factors in our 2010 Form 10-K and subsequent 10-Q's filed with the SEC. If you need copies, please contact my office at Orthofix in Lewisville, Texas. In addition, note that on today's call we will refer to certain non-GAAP financial measures in which we exclude certain items from our GAAP financial results. We believe that in order to properly understand our short-term and long-term financial trends, investors may wish to consider the impact of these items as a supplement to financial performance measures determined in accordance with GAAP. Please refer to today's press release announcing our fourth quarter 2011 results available on our website for a reconciliation of these non-GAAP performance measures to our GAAP financial results. At this point, I'll turn the call over to Bob.

Thanks, Jeff and good afternoon everyone. Thanks for joining us on our fourth quarter 2011 earnings call. Hopefully, you've all had a chance to see our press release today. I'll start the call by providing some key highlights that led to a record revenue, improved adjusted operating margin, as well as our big jump in earnings per share. I will then turn it over to Brian to give more detail on financial results and 2012 guidance, followed by some general comments before kicking it off for Q&A. The fourth quarter top line growth was driven by our strong performance in both our orthopedics and sports medicine global business units and continued success of our regenerative biologics offering. We are encouraged by the third straight quarter of sequential growth in our Regenerative Spine Stimulation business, which was flat year-over-year for the quarter. Our focus of improving operating efficiencies, as well as an increased mix of regenerative biologics and orthopedic sales led to the strong adjusted operating profit results. The company's operating cash flow generation and resulting free cash flow continues to strengthen our balance sheet, which provides us a strategic advantage to invest in our business. This is particularly the case with stimulation, where many of our competitors do not have such a luxury due to their debt burden. I will start with our top line results, which we pre-announced in January. Net sales were $151.5 million in the fourth quarter 2011, up 5% from $143.8 million in the fourth quarter 2010. On a constant currency basis, sales were up 6%. Overall, our Spine sector remained essentially flat at $78.6 million. These results were driven by strong biologics revenue growth, which was offset by market-driven weakness in implants. In addition, stimulation products where flat compared to the prior year, but were up again sequentially. Notable here was our continued success with our proprietary, Trinity Evolution stem cell allograft, as surgeons are looking for safe alternatives to autograft and BMP-2. Offsetting the strength in biologics was our spinal implant business, which as I mentioned was impacted by continued pricing pressures and reimbursement scrutiny for fusions. While we expect these challenges to continue, at least in the near term, we are improving our product launch cadence and feel good about our position to optimize and expand our distribution footprint in order to offset these issues. In particular, with our unique mix of implants to repair the spinal anatomy along with biologics and stimulation solutions to regenerate bone, we believe we have a unique value proposition for our customers and ultimately patients. We will continue to invest in products and new technologies that enhances value proposition as evidenced by our recent announcement regarding our new development agreement with MTF. Through this agreement we are collaborating to deliver another natural and novel biologics solution that is complimentary to Trinity Evolution and is responsive to surgeon’s increased demand for natural bone grafting. Again we expect this launch to be in 2013. Our combined Spine revenues worldwide represented 52% of our overall topline sales. Moving on to Orthopedics, our revenue was $44.5 million, up a reported 16% or 17% on a constant currency basis. This increase was led by our market leading external fixation product offering, which continues to benefit from our direct markets globally and the non-elective nature of many trauma products. Local markets, which experienced high growth, were the UK, France, Germany and Brazil. At the recent American Academy of Orthopaedic Surgeons annual meeting, we announced the outside U.S. launch of our Galaxy external fixation system. This system is designed for use in complex, orthopedics trauma applications and brings simplicity and stability to a new level. In addition we are pleased with the initial response to our U.S. internal fixation product launches in the foot and ankle market. At AAOS, we also launched our ankle compression nail for hindfoot fusions and our new Lapidus Plate for midfoot fusions both of which will contribute to our 2012 revenue. As with our Spine business, we believe our orthopedics hardware product offerings to repair bone along with our biologics and stimulation solutions for regeneration create a unique value proposition for the patient, surgeon and hospital. Orthopedics revenues represent 29% of our total sales. Moving on to Sports Medicine, fourth quarter net sales were $27.5 million, up 10% from $25.1 million in the fourth quarter 2010. The fourth quarter of 2011 includes revenue from a billing capability that was added during the first quarter of 2011. This drove about 7% of the growth and over the past year, this business has returned to growth as a result of a number of new products and the integration of this billing capability. Sports Medicine revenues represented 18% of our overall total revenues for the quarter. Revenues from Divested Products were down to $900,000 from $1.7 million last year. These smaller trailing revenues were expected after we made the strategic decision to exit some non-core businesses like anesthesia and vascular. What you continue to see here are tail revenues to support our vascular partner, Covidien. Moving past revenue on our income statement, our overall gross margin for the fourth quarter was 76.8% compared to 77.3% in the fourth quarter of 2010. Gross profit in the quarter was impacted negatively by pricing pressures in spine implants and Sports Medicine along with an unfavorable geographic mix as all-U.S. contributed 25% of total sales compared to 22% in the prior year. Let me now turn over to Brian for more financial details including our 18.1% adjusted operating margin, our 23% increase in adjusted net income and also our guidance for 2012.

Thanks Bob. Going through the income statement for the quarter, Bob covered revenue and gross margin, so I'll start with the operating expenses and move on to the balance sheet. Finally I will provide some clarity on our revenue and earnings guidance for the full year of 2012. SG&A expenses were $81.5 million for the quarter at 53.8% of sales compared to 59.4% in the prior year. This improvement is the result of the various consolidation and operational efficiency initiatives, as well as reduced legal spending as various matters wind down. However, these improvements were partially offset by higher expenses related to product liability matters and the Sports Medicine business unit. As recently noted, we made significant progress to resolve 3 outstanding U.S. government matters during the quarter and we incurred approximately $500,000 in legal fees related to these matters. In addition, we continued to incur out-of-pocket litigation and settlement costs associated with product liability claims related to our former pain care product lines we divested in 2008. These out-of-pocket expenses were $2.5 million during the quarter. We are currently in arbitration to resolve a dispute with the access carrier of the secondary layer of insurance coverage. The arbitration process is underway, and a final hearing on this matter has been scheduled to occur in the second quarter of 2012. R&D expenses in the quarter were $5.8 million or 3.8% of sales, down 110 basis points from last year's 4.9%. This highlights our focus to eliminate activities that are not directly related to developing and bringing our products to market in the near term, as well as certain improvements in our operational efficiencies. We continue to focus our resources and validate the investments we are making in research, development and clinical to ensure an appropriate return on these activities and increase the probability of commercial success. Further, our assessment of investments and R&D activities also include the required working capital investments for successful launches of new and/or enhanced technologies as this is a critical component of establishing a more robust and sustainable pipeline. Adjusted operating margin in the quarter was 18.1%, up 230 basis points from 15.8% in the prior year. Adjusted operating income does not include the $10.5 million charge announced earlier this month regarding resolutions of various U.S. government matters. Included in both reported and adjusted operating income was $2.5 million of additional litigation and settlement cost associated with the pain care product liability matters and approximately $500,000 in legal costs associated with the progress with various U.S. government resolutions. This accounts for approximately 2% of net sales in the fourth quarter of 2011. Stock-based compensation in the fourth quarter was $1.3 million, which compares to $1 million in the fourth quarter of 2010. As a result of one-time tax benefits related to the government resolutions, our effective tax rate in the quarter was approximately 10%. Also as a result of the government resolutions, the full amount of expense taking for these matters will not be deductible for tax purposes. Therefore our full year 2011 effective tax rate was 105%. On a normalized basis excluding the impact of the government resolutions our effective tax rate was approximately 39% for the full year, which was consistent with 2010. Now, moving on to earnings, in the fourth quarter 2011 we reported net income of $12.4 million or $0.66 per diluted share. Adjusting for charges related to the resolution of U.S. government matters and a foreign exchange loss, our adjusted net income was $14.9 million or $0.80 per diluted share. This compares to $0.68 per diluted share in the prior year. This improvement is a result of the efficiencies realized of various cost reduction initiatives that have occurred over the past 12 months to 18 months along with the rationalization of various R&D projects. Our total cash position as of December 31, 2011 was $80.3 million up from $36.5 million at year-end 2010. This buildup of cash during 2011 puts us in a position to make the payments related to the government settlements. Our cash flows from operations for the full year were $64.8 million, which was up 52% compared to the prior year. Subsequent to year end, we also reached an agreement with the representative of the former shareholders of Blackstone resolving all outstanding Escrow indemnification claims under the Blackstone Merger Agreement established in connection with the acquisition of Blackstone in 2006. Under this agreement approximately $41.5 million in cash was distributed from the Escrow fund to the company of which $32 million is recorded as a payable to the U.S. government and the relator in accordance with the company's settlement in principle of the Blackstone medical government investigation. The remaining $9.5 million in cash received by the company from the Escrow settlement relates to the reimbursement of claims submitted by the company since the merger. Capital expenditures for 2011 were $25.8 million compared to $26.4 million in the prior year. As a result of option exercising, we received approximately $20.1 million of proceeds in 2011. Now moving on to non-financial metrics. Day sales outstanding were 89 days at quarter end, slightly down from 90 days in the previous quarter and up from last year's 86 days at the end of 2010. Our inventory turns at year end were 1.5 turns, which were consistent with prior year. Now on to guidance. During 2012 the company expects to generate between $595 million and $605 million in net sales or approximately 3% to 5% growth of reported net sales in 2011. If foreign currency rates hold near current levels, the company anticipates reported growth to be negatively impacted by 1% to 1.5%. Consistent with our historical trend, we expect to start 2012 at the low end of the 3% to 5% growth range, while moving towards the high end of the range as we progress throughout the year. Moving on, we expect GAAP net income for the full year 2012 to be between $2.85 and $2.95 per diluted share and adjusted net income to be between $2.95 to $3.05 per diluted share, which will result in approximately 7% to 11% increase in net income per diluted share compared to 2011. The adjustment to net income includes our estimated $3 million investment with the Musculoskeletal Transplant Foundation related to our recently announced development agreement. Furthermore included in both reported and adjusted net income is $2 million to $2.5 million per quarter in legal expenses related to the pain care product liability matters. In addition, we expect stock compensation expenses to be approximately $8 million or $0.26 per diluted share. And finally we anticipate our effective tax rate to be between 38% and 40% for 2012. I will now turn the call back to Bob for closing remarks.

Thanks, Brian. These strong fourth quarter results mark the close of an important year of transition for the company, highlighted by several key achievements that together represent an important point of inflection for the company. Let me summarize. We substantially resolved our outstanding government legal matters, which will allow us to redeploy funds to drive long-term, high-quality revenue growth through clinical and R&D investments going forward. We made steady and sequential improvements in our regenerative stimulation business, which continues to represent an under penetrated revenue opportunity with our Class III devices and has superior clinical results and patient benefits. Just this week, we hired Brad Niemann, a terrific leader with a long history of commercial success in the business. We rationalized R&D to gain productivity so that we can bring products to market faster with a greater probability of commercial success. We refocused our strategy in both our regenerative and repair platforms, differentiating us from most other companies in the space and giving us more opportunity to grow our already diversified revenue streams. We've positioned the Company to continue the promise of growing earnings in excess of sales, which we believe will increase shareholder value. And finally, we improved the management team with key new hires and promotions to ensure a successfully executed strategy across all of our initiatives. While we still have challenges ahead in this dynamic environment, I'm very happy with all of these achievements and give great thanks to all the employees of Orthofix, who together have positioned us well as we move through 2012. With that operator, I'm ready to open up the line for questions.

[Operator Instructions] We'll take our first question from Bill Plovanic with Canaccord.

This is actually Kyle on for Bill. So, just one quick question, obviously a big number in Orthopedics. Wanted to see if you could break out, how much of that is direct versus stocking? And then also if you would be willing to comment on the contribution that Trinity provided Orthopedics in the quarter?

This is Bob. First of all, your first question we can’t break it out. We wouldn't break it out, but I can tell you we don’t really have stocking much at all. To the second point, I’ll let Mike address that.

Yes, so our Trinity business was a very big contributor to the quarter. We don't break out Orthopedics and we kind of look at it as an entire business. And then its entire we had very strong growth. So, that's kind of how you should think about the biologics component.

Great. And then kind of building off of the biologics there, I know that on the last quarter you commented about the Collage launch. I wondered if you could give us a little more color on that? Has it been fully launched into the field? Has it been receptive? And just kind of your vision for that over the course of the year.

Sure, this is Mike again. We are -- I would characterize Collage as, we’re ahead of plan in terms of what we set out to do. It's a good contributor to our business in biologics. That said, our primary focus continues to be on Trinity Evolution, it’s a higher margin product for us. And the technology is really the lead technology in the market. So, I’d characterize Collage as ahead of plan, doing what we wanted it to do. We’ve got a lot more opportunities with it. We're not terribly penetrated in our network. But again our emphasis really continues to be on Trinity Evolution, because it's the right technology at the right time with a very receptive market.

We'll take our next question from Imron Zafar with Jefferies.

I wanted to ask about margins, first on gross margin. Can you just talk a little bit about what the various drivers were on the Delta on that margin, in terms of ASPs, mix, et cetera?

Imron, this is Brian. Yes, our gross margin for the quarter was at 76.8%, which was down about 50 basis points from the prior year Q4 in the prior year, 2 things factoring into that. We've had some pricing degradations in the Spine and the Sports Medicine business, probably about 1/2 of that degradation and then our o U.S. versus U.S. mix. So if you recall Q4 of last year we were at about 22% of our sales come from o U.S. in our total sales. This quarter we were up to 25% of our global sales coming from o U.S. territories, which typically have a lower gross margin.

Okay and then on the operating line, in the past you've talked about this year end 2012 EBIT margin target 18% to 20%. Can you just give us an update there given that if you strip out the legal expenses I think you’re probably already well into that range? Can you just talk about sort of maybe longer term what the margin target is?

Well, we're still committed to the 18% to 20% exiting '12 because we have to go back and determine how much we're going to reinvest in the legal spend that occurred during 2011 back into the R&D line. So, right now even though our adjusted is, as you pointed out, in that range already, the low end, we still have the target to exit 2012 because we need to invest in the R&D line of this business. So, we're not changing the target, we're still projecting the 18% to 20% leaving 2012 and we're comfortable we can do that. And once we solidify that we'll think about setting a new target, but that's still our target.

Okay. So, in other words it's still 0 from gain in terms of any rationalization on the legal side would just go on to the R&D line?

Well, we’re not, calling out exactly how much we're going to reinvest and how much we're going to let fall through to the bottom. That's the assessment we’re going through and as we've been rationalizing R&D projects, that's the assessment we’re making. Now, Bob on the...

Yes, this is Bob. We have a strong commitment to redeploy the savings from legal to both investment in R&D and improve earnings. And you’ve seen that in our guidance with our 7% to 11% increase this year.

We'll take our next question from Michael Matson with Mizuho Securities.

Yes, so the product liability expense that you are assuming in your guidance of $2 million to $2.5 million a quarter for 2012, that’s about 7 -- that could be about $0.07 of EPS a quarter. I think you just answered this in that you're saying that some of that would be, if and when you’re able to get some of that money back from the insurance company that some of that would be reinvested, but some of it would fall through to the bottom line. Is that correct or...?

Mike, this is Brian. What I was talking about was the legal expenses primarily related to the BGS in the Mexico matter that we spent during 2011. That's where some of that will fall through. As it relates to the pain care, our guidance is conservative. We’re assuming that this liability is out there for the full year as of right now, but arbitration has been scheduled for the summer, and so we’re -- that’s the visibility we have right now. So depending on how that goes, we will make the same assessment we did for BGS in Mexico on what's to drop to the bottom.

Okay. So would you put out some sort of guidance update when you know what the outcome of the arbitration is, or you’re just kind of waiting until your next quarterly reporting period to do that?

Mike, this is Bob. We’ll probably give an update quarterly. Because there's many real cases. We’ve actually done a good job with some of the cases winning and some of the smaller ones settling, but yes I think we're going to update every quarter.

Okay. And then for your spending $3 million I guess on Trinity -- on this Trinity new agreement, so that’s all going to be going into R&D. Is that correct? And then can you maybe give us some more details on the new product? I don’t know if it's going to be called Trinity or not, but what the product is, et cetera, and whether or not the economics of the arranger is similar to the current Trinity arrangement with the marketing fee and so forth?

This is Bob. Yes to your first question and no to your second question. And frankly, we just don't want to give, for competitive reasons, we don’t know really want to give a lot of detail about -- and frankly we're still working on how we are going to market the Trinity -- I’m sorry, the MTS new deal. But I can tell you we're extremely excited and just it’s really a function of how well we've done, how excited we are about the overall biologics portfolio.

Okay. And then, you probably have been getting this question a lot, but just regarding the medical device tax that’s starting in 2013, and it's going to have a particularly big impact on you guys relative to some of the bigger companies. So just wondering what your plans are, because that could eat into a lot of your potential earnings growth in 2013.

This is Bob. One of the major initiatives and goals of improving our operating margins was to absorb that. I could say this, we're watching closely. We'll do what we can to absorb it through operating leverage and some of the benefits we have started here in our consolidation. And we’re just going to stay tuned to it. But you're right, it's certainly harder for a company that's small than a company that's bigger. But we've been planning on it for quite a bit of time and continue to look for efficiencies to cover it.

Okay. And then my last question is just on, what have you assumed in the guidance, your earnings guidance for the legal expenses from the DOJ stuff for 2012?

This is Bob. We’re not going to give any specifics, but we’ve assumed a much more normal run rate to the legal expense overall. And so what we're seeing here is the lion's share of the legal expenses related to the activities are behind us.

We'll take our next question from Matt Miksic with Piper Jaffray.

This is Sachin [ph] stepping in for Matt Miksic. Could you expand on where you think you are in terms of penetration on the opportunity for Trinity Evolution across your account and distributors? And given your experience with the products so far, how large do you -- does this product could be for you over time, or this year, next year, whatever timeframe you're comfortable sharing? Thanks.

Yes, this is Mike. So I'd say the first question about penetration. We -- consistent with the full year, we've had very strong growth in the fourth quarter. We continue to see and expect very strong growth moving forward. In terms of penetration in our network, we don't characterize it as a percent number penetrated, but we still have ample room within our own network to grow the business. And in addition to that, we have opportunities with new distribution, and also frankly, people outside our network who are coming to us because they recognize that we do have the right technology at the right time with a receptive market. So I would just talk about the prospect of growth as being, we continue to see great opportunity and we're going to continue to execute around it.

All right. Follow up on that, could you talk about whether you see this product as a means of pulling your other implant product lines into an account or is it the other way around?

Yes, so this is Mike again. We lead often with Trinity Evolution and we lead with that, because again it's really the right product market at the right time and we’ve got the right partner. So it's a great product for us to walk into a place where we’re not doing business, introduce that technology, begin to do business there and then begin later to filter our metal products. And that's really how we have adopted our sales model and it gives us good opportunity across the whole portfolio.

All right. I have a follow-up on Spine business. The opportunities there you're seeing out there, can you talk about where you stand on physician owned distributors, whether you have any customer structure this way and what your exposure is there? Also if you could, what kind of activity have you seen there? Are new PODs increasing or flattish given the pending regulatory evaluation of these structures?

This is Bob. I guess about 1.5, 2 years ago we made a productive decision not to do business with POD. And we continue to watch that closely, so that's the answer to that. I didn't really understand the second part of your question. Could you repeat that please?

Given that that's a flat pending regulatory approval pending regulatory evaluation restructures?

Again this is Bob. We’re all looking -- we really don't understand your question.

We'll take our next question from Stan Manny with Manny Investors.

I might have a couple of questions. One is, Mike can you put your arms or give us some estimate of what you think the market potential for Trinity Evolution is in your view U.S. and o U.S.?

Yes, sure it’s Mike again, and Trinity Evolution is really a U.S. product first and foremost. It’s not a technology that we can be -- intend to be successful with overseas and that relates to overseas markets’ general receptivity to human and cellular tissue-based products. So we considered to be a U.S. opportunity primarily and with some small exceptions to that. In terms of the overall opportunity, we haven’t characterized it in terms of the gross number, but the market is a gigantic market. The Infuse piece to market is $700 million, $800 million and it continues to -- that piece of it continues to ship to other sectors within the biologic market. So, in terms of demand and opportunity, we've got pretty unlimited opportunity. I think the bigger question for us is how much can be made and in the short term and in the foreseeable future, we’re not limited there. So we're going to continue to push forward. We’re going to continue to execute and continue to grow it and I'm exited about the opportunity.

Okay. You're limited on sales because of availability of production? I thought that was not the case.

No, no, we’re not limited. We are -- my one point was that we’re not limited. Now it -- so that was a problem some time ago, but it hasn’t been a problem for us in a long -- in quite a bit of time.

Okay, now Infuse had a drop in the last quarter, or fourth quarter, of about 20% or more in their sales. Are you seeing an influx or a shift over to Trinity Evolution from Infuse customers?

You bet.

Okay, question, just I know that Zimmer has got a tissue-based product for ankle repair. I also note that you mentioned -- somebody mentioned that you now are starting to go into the ankle market. Does that mean that Trinity Evolution might have a new avenue of usage and potential?

Yes, Stan, it's Mike. So Trinity Evolution -- we market Trinity Evolution for foot and ankle procedures today. But that is specific to bone growth and stimulating bone growth for fixation. The product you alluded to with Zimmer is more of a articular cartilage technology. So it's used in the knee primarily. But again, we've been in foot and ankle. We've got expertise there through our Orthopedic business and our orthopedic channel. We sell Trinity Evolution there, we’ll continue to sell it there and it's a great market for us.

Okay. Last question is on the stem market. You were flat. Does that mean you kept market share, lost market share? Can you kind of fill us out on how we're doing on stem? That is a high product that you’ve not dominated, but you've had largest -- biggest market share.

This is Bob. Thanks for the question on that. First of all, really pleased with the third straight quarter of sequential growth. Having said that, I’m never going to get overly excited about 0 growth. But it's hard to really tell on the market, because not everybody publicly reports the information. I do think there's still an impact on the market from surgery accounts. But I will say that our outlook for the coming year is way better than it was last year. And we've sorted through our problems and including, we've upgraded the management team as well as I mentioned in my comments opening. So, it's hard to really be precise on it, but really happy with the improvements we've made, but I'm looking up. Frankly I'm looking at -- for a lot more from our group this coming year.

Okay, just last on Stim. How has the Cervical-Stim done throughout this period?

Stan, this is Brian. The cervical was probably about a 4 or 5 quarter issue ago where there were some folks going investigational. That activity is not heightened really anymore outside what we normally see from payers. So, there’s really not a lot of impact from a cervical perspective that related to reimbursement so it’s doing quite well actually.

It's done better than the general stim, other stim.

Well, you’ve got to understand that when lot of the procedure -- fusion procedures are getting pushed off, they’re in the lumbar spine, because it [inaudible] discs, so naturally cervical doesn’t have that pricing or that pressure from a volume procedure. So, yes, it’s done a little bit better.

Ladies and gentlemen, I'm showing no further questions in queue.

Okay, this is Bob, just in closing. Thank you everybody for showing up. We’re very pleased with our fourth quarter. We are extremely excited as we enter 2012. We think a lot of our opportunities are ahead of us. We’re pleased to get the major elements of our government investigations behind us, and really look forward to the coming year, and we'll speak to you again on the next quarter call. Have a great day.

Thank you, very much. This concludes today's presentation. You may disconnect your lines. And have a wonderful day. Thank you, for your participation.