Orthofix Medical Inc. (OFIX) Q3 2012 Earnings Report, Transcript and Summary

Good afternoon, ladies and gentlemen and welcome to Orthofix International Q3 2012 Earnings Conference Call. [Operator Instructions] Now I’d like to turn the floor over to your host, Senior VP and General Counsel, Mr. Jeff Schumm. Sir, the floor is yours.

Thanks, operator, and good afternoon, everyone. I’d like to welcome you to the Orthofix Third Quarter 2012 Earnings Call. Joining me on the call today is our President and Chief Executive Officer, Bob Vaters; Chief Financial Officer and newly appointed President of the Spine Global Business Unit, Brian McCollum; and Senior Vice President of Business Development and President of Biologics, Mike Finegan. I’ll start with our Safe Harbor Statements and then pass it over to Bob. During this call, we’ll be making forward-looking statements that involve risks and uncertainties. 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, October 24, 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 on the call include the risks disclosed under the heading Risk Factors in our 2011 Form 10-K and subsequent 10-Qs 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 third quarter 2012 results available on our website for reconciliation of these non-GAAP performance measures to our GAAP financial results. At this point, I will turn the call over to Bob.

Thanks, Jeff, and good afternoon, everyone. Thanks for joining us today for our third quarter 2012 earnings call. I’ll start by going over our overall performance in the quarter and then turn it over to Brian for further financial details. The third quarter performance was highlighted by a strong adjusted operating margin of 20.8% and adjusted net income from continuing operations growth of 13%. In addition, we now have a positive net cash position when adjusting for outstanding bank debt and obligations for our U.S. government settlements. In other words, we have 0 net debt. This level of profitability and financial capacity puts us in a very strong competitive position. For the first time in many years, Orthofix has the ability to invest in assets and activities that drive both organic and inorganic growth. We plan to use this capacity to further improve our market position. While I am not satisfied with the overall top line growth this quarter, I am encouraged by our growth in our spine global business unit. We have also again proven our ability to navigate through a challenging environment to consistently achieve operating margin expansion. So let me start by discussing our sales results in the quarter. Net sales were $114.8 million in the third quarter 2012, up 1% on a constant currency basis. Although we are pleased with continued positive results of our regenerative solutions, overall results were negatively affected by weak Physio-Stim sales and increased competition and a strike at the regulatory agency in Brazil which delayed product delivery and registrations. These issues negatively impacted our orthopedic revenue. Challenging economic conditions in our international spinal implant market also impacted overall total revenue. Foreign currency exchange rates negatively impacted net sales by $3.8 million, or 3.3%, when compared against prior year. Starting with our spine business, total spine sales were $79.4 million and grew 4% over the prior year. This was driven by another strong performance in our regenerative stimulation business, which was up 8% in the quarter. Continued focus on expanding distribution and taking market share provided a boost to the second and third quarters. Within spine, our repair implant and regenerative biologics business sales were flat during the quarter. As I mentioned, these results were negatively impacted by our international business, which experienced a slowdown related to economic conditions outside the United States. Our United States business, on the other hand, showed positive growth and was driven by Trinity Evolution and new implants such as the Forza Spinal Spacer System. The full market release for Forza was initiated during the quarter and is on display at the 2012 North American Spine Society Meeting this week here in Dallas. We believe the contribution from new products can drive volume growth through our current distribution channel. Forza is the most recent example of a series of new product introductions that will continue to contribute to revenue growth. Our flagship biologics product, Trinity Evolution, continues to be a driver and we estimate the total number of procedures is now over 60,000. We continue to be impressed with its adoption and our partner MTF and we remain committed to being a leader in the cell-based allograft market. We are very excited about the next generation biologic which we’ll be launching next year. We will proudly brand this as Trinity Elite. Our co-development and commercialization timelines remain on track as evidenced by the key development milestone payments we made in the third quarter and we look forward to providing more details of this exciting new product as we get closer to our launch in 2013. As a reminder, we market Trinity Evolution in both spine and orthopedic channels here in the U.S. As always, we are thankful to have such a wonderful partnership with MTF, the world’s largest tissue processor. Overall, our combined spine revenues worldwide represent 69% of our overall net sales. Moving on to orthopedics, our revenue is $35.4 million, down 4% on a constant currency basis. Weakness in the quarter was primarily driven, as I mentioned, by our Physio-Stim business. To optimize distribution, we’re in the process of implementing a program in select geographies in the United States where territory managers will have associates focused solely on Physio-Stim and calling on the clinic or office. This will free up territory managers to focus specifically on selling hardware and biologics in the OR. We believe that this new structure will stabilize our Physio-Stim platform and accelerate growth in hardware and biologics in the U.S. especially as we look to add complementary technologies. As I noted, Brazil was a source of weakness as sales were impacted by the increased competition we noted in the second quarter and a strike at the Brazilian regulatory agency. This strike caused a hold-up of products at customs which delayed the delivery of orders to hospitals and ultimately a delay in product registrations. While the strike is over, there’s a long queue for product registrations that is continuing to play itself through. We continue to invest in Brazil and have trained over 100 surgeons over the last 6 months in our recently opened training and education center. Partially offsetting this weakness was a strong performance from our new Galaxy Fixation system in international markets. We’ve now received 510(k) clearance in the U.S. The early success of this new system launched this year highlights our expertise and dominance in external fixation. We are very excited about the fourth quarter international launch of TRUE/LOK hex, a new hexapod ring fixator for a deformity correction and complex trauma treatment. This system is stable, fast, user-friendly and builds upon the strong brand recognition of TRUE/LOK and was co-developed with our partner, Texas Scottish Rite Hospital. As for the U.S. hardware business, we had a record quarter. We continue to see strong adoption of our internal fixation system for the foot and ankle launched earlier in the year and we believe this highlights the strength of our U.S. distribution network within the foot and ankle surgeon community and sets the tone for additional products to be launched in the segment. In addition to these 2 new hardware products, we continue to see strong adoption of Trinity Evolution in foot and ankle applications in the U.S. Overall, orthopedics revenue represented 31% of our total sales. Moving on to gross margins, overall gross margin for the third quarter was 80.5%, up 80 basis points over the third quarter of the prior year. The improvement was due mostly to favorable product and geographic mix. Brian will review some additional financial details, which led to an adjusted operating margin of 20.8% and a 13% increase in adjusted net income from continuing operations along with highlighting our significantly improved financing capacity. Brian?

Thanks, Bob. Going through the income statement for the quarter, Bob covered revenues and gross margin, so I’ll start with operating expenses and move on to the balance sheet. Finally, I will provide full year revenue and earnings guidance. SG&A expenses were $63.1 million for the quarter, which were slightly down compared to the prior year. These expenses were up on a percentage of sales basis to 55% from 54% in the prior year, primarily as a result of additional bad debt expense along with an uptick in stock-based compensations following the replenishment and issuance of shares under the company’s long-term incentive plan. R&D expenses in the quarter were $6.9 million or 6% of sales, up 90 basis points from last year’s 5.1%. Included in this quarter’s expenses was $2 million or 1.7% of net sales related to the key co-development milestone payments to MTF that Bob mentioned earlier. Operating income from continuing operations when adjusting for the MTF milestone payment and a $300,000 charge for pre-judgment interest related to the certain settlements with U.S. government was $23.9 million or 20.8% of net sales compared to 20.1% in the prior year. This 70-basis point improvement was driven by the increasing gross margin as Bob previously discussed. Total stock-based compensation from continuing operations in the third quarter was $2.1 million compared to $1.3 million in the third quarter of the prior year as a result of the replenishment and issuance of shares under the company’s long-term incentive plan. Interest expense in the quarter was approximately $500,000 compared to $2.3 million in the prior year as a result of lower debt outstanding and lower interest rates. Our effective tax rate during the quarter was approximately 34.6%, which included favorable returns provisions adjustments from our 2011 tax return. On a normalized basis, the third quarter tax rate would have been approximately 37% compared to 38% in the prior year. Now moving on to net earnings from continuing operations. In the third quarter of 2012, we reported net income from continuing operations of $13.1 million or $0.67 per diluted share. After adjusting for the MTF milestone payments I mentioned earlier, charges related to pre-judgment interest of certain settlements with the U.S. government, and a foreign exchange loss, our adjusted net income was $14.8 million or $0.76 per diluted share. This represents a 13% increase over $13.2 million or $0.70 per diluted share in the prior year. Net loss from discontinued operations was $5.6 million or $0.28 per diluted share compared to $600,000 or $0.03 for the comparative period last year. This loss represents the resolution of certain retained liabilities from the sports medicine divesture. Our total cash position as of September 30, 2012, was $120.9 million, up from $78.7 million at the year end. This increase was a result of increase in cash flows from operations and proceeds from the exercise of stock options. As a reminder, $32 million of this cash balance is earmarked to resolve all outstanding legal matters associated with the Blackstone government investigation. The residual cash balance puts us in a position to make the payments related to the bone growth stimulation matter. During the quarter we made the payment of $7.5 million regarding the closed FCPA matter. In addition, through the year-to-date period, we repaid approximately $189 million of our outstanding credit facility with cash from the sports medicine divestiture along with cash on-hand, $20 million of this occurred during the third quarter. We’re now in a net cash position on our balance sheet when adjusting for the outstanding bank debt and obligations from our U.S. government settlements as Bob discussed. Our cash flow from operations for the first 9 months of 2012 were $68.4 million and included $41.5 million received from the escrow fund established during the Blackstone acquisition for which $32 million is earmarked to resolve all outstanding legal matters associated with the Blackstone government investigation. During the year-to-date period the company also paid the $7.5 million to close the FCPA matter. As a reminder during 2012, the company also invested more working capital in the form of accounts receivable associated with its MTF partnership. As you recall, there’s no inventory capital required by the company for Trinity Evolution as we are receiving a marketing service fee. This additional investment was made to continue to fund additional processing capabilities from the rapid acceleration of Trinity Evolution and is also important to a successful co-development and launch of the next-generation cell-based technology, Trinity Elite. Capital expenditures were $18.6 million compared to $17.3 million in the prior year. Now moving on to non-financial metrics. These non-financial metrics have been adjusted for the sports medicine divestiture for all comparable periods. Days sales outstanding, or DSO, were 125 days at quarter end, up from 114 days at the end of the previous quarter and up 99 days at year end. Our inventory turns at quarter end were 1.1 times, which was down slightly from 1.2 times at the end of the previous quarter, and was consistent with the prior year end. The increase in DSO during the period was related to the additional working capital investment made associated with our MTF partnership I previously mentioned, along with the investment in working capital required for the expansion of distribution and taking of market share in our regenerative stimulation business. Now on to guidance. The company expects net sales from continuing operations to be between $472 million to $475 million, up 1% on a reported basis or 3% on a constant currency basis for the full year 2012. This range represents the results of the first 9 months of 2012 and our expectations for the fourth quarter, which includes some of the near-term challenges that Bob pointed to. The company expects GAAP earnings per share from continuing operations to be approximately $2.84 to $2.89 per diluted share and adjusted earnings from continuing operations to be approximately $3.03 to $3.08 per diluted share. This revised range represents the results of the first 9 month of 2012 and our expectations for the fourth quarter. Please refer to the full year outlook update section of our press release from today for a more detailed reconciliation of this updated EPS guidance with the identified adjustment items. I will now turn the call back to Bob for closing remarks.

Thanks, Brian. I’d like to take a moment to thank Brian for his contributions while serving as CFO. Given his operational and financial experience within the company, I’m sure he will do an outstanding job running our spinal global business unit. With our very strong balance sheet and financial flexibility, I am very excited about the future of the company. While there are many challenges in today’s global healthcare environment, I strongly believe this creates a big opportunity for us. We have our goals set very high in becoming a leader with our unique value proposition, which offers a combination of innovative repair and regenerative solutions. We are finally at a point where we can start to enhance this value proposition by adding breadth to our product offering and I assure you, this is our top priority. Our earnings growth in this environment is reflective of the relentless and sustained efforts by all the people of Orthofix and I’m very proud to lead them. With that, operator, let’s open up the line for questions.

[Operator Instructions] And we’ll take the first question from Matt Miksic with Piper Jaffray.

So I guess relative to our numbers on the spine implant side and the biologics side, that seemed to be, and not a lot unlike some of the other folks in your space where trends have gotten a little more challenging in Q3. If you could speak to maybe whether you see this as sort of a seasonal issue, whether you see it as a trajectory of the group, of the market, something ahead of elections? Or something Orthofix-specific in terms of the trends there? Or from your own perspective, was it right where you wanted to see it?

Matt, this is Bob. I think we’re pretty happy with the U.S. performance. Certainly, the continued growth of the Stim business is self-evident. And our performance in our spinal implant U.S. hardware business, certainly our biologics business, all of those did very well. Our softness was in our spinals implants business internationally, which is more of a transactional business. And frankly, just the activity wasn’t there and people are still running through inventories that they had previously purchased.

Okay. So some timing of stocking orders, is that the right way to think about it overseas?

Yes. But on the other hand, I don’t want to give you false hope because I’m not looking at any big turnaround in the international markets either. But certainly, that’s what affected us in the quarter.

And then on the Stim side, the performance in the quarter a touch better actually. As you say, you sound like you’re happy with it. Is that, speaking of a turn, is that something where we might be seeing a turn in trends?

Well, I think we’ve seen a turn over the last couple of quarters. I would only caution you that we did take some share, some of it was of a one-time nature. So it’s hard to sit back here and say we continue to look at some sort of 8% growth. But I do think we have seen the turn and we’ve seen it the last couple of quarters.

And then one, if I could just draw in one sort of question on a topic that’s gotten a lot of attention in the last month or so is physician-owned distributorships. If you could maybe give us your latest thoughts on where you stand there in terms of involvement or avoidance, or whether it’s impacting your business at all? Just any color you can provide on where you come down on physician-owned distributorships that will be helpful.

Sure. As we said before, we made a decision, I guess a couple of years ago now, to not participate in physician-owned distributors. And we continue to hold that stance, number one. Number two, I don’t think we’ve seen any meaningful effect in our business from it.

We’ll take our next question from Dave Turkaly with JMP Securities.

Could you just remind us approximately how big that OUS spine implant business is today?

This is Brian. Hey, we really haven’t broken out the OUS, U.S. business. What we do say on a global basis of all of our product lines, about 25% of our global sales across all of our businesses are OUS. We haven’t broken out spine orthopedics specifically. But a large part of that OUS, 25%, is coming in our orthopedic business, so not a big part at all.

And then on the orthopedic side, I know you guys had some newer extremity lines, but I think it had been growing well. I’m imagining that most of the weakness, I know you highlighted Physio-Stim and OUS but how did they do in the quarter here in the U.S.? And in terms of Physio-Stim, is this something here that’s a market share thing? Or is this more just kind of a -- or how would you explain the weakness there?

Hey, David. This is Brian again. I mean, what we said in the U.S. on the metal side was a record quarter for us. We launched 2 new products at the beginning of this year in the foot and ankle space, and so that’s been well received. The problem we’re running into is that our sales reps have to choose. Do they sell in the OR or do they sell in the clinic setting? And so what Bob alluded to in his comments were, we are now at a position to where we can control that distribution a little bit better and focus them specifically on the OR or on the clinic setting. And so that’s what we believe will help drive Physio-Stim into Q4 and also in 2013.

We’ll take the next question from Michael Matson with Mizuho.

I just wanted to start with the receivables. It looked like a pretty big increase both sequentially and year-over-year. Just wondering what’s going on there. And is there any risk that you’re not going to end up being able to collect some of those receivables?

Hey, Michael, this is Brian again. You’re right. We did have an increase in our AR and in our DSO, part of that has to do with the decision we made with MTF as part of our new agreement to fund the next generation Trinity Elite product that we announced today. The second is when you go out and generate new business and you convert accounts in the stimulation side, the biggest piece of working capital in the stimulation is the accounts receivable number. And so what you’re seeing there is starting from 0 in some of those accounts and an increase in AR to get that up to a normal run rate. We do have the risk of not collecting, but we also had some additional bad debt expense in the quarter. So we’ve been able to absorb any additional bad debt expense coming from those activities, so we don’t necessarily see that as a huge risk outside of what you currently see in our financials.

And then you talked about your international spine business being weak, I guess that’s with stocking distributors over there. And then I just was wondering in your orthopedics business, because I think that uses stocking distributors to some degree in Europe as well. Did you see a slowdown there? I know it sounded like Brazil, the issue is more on the international side was in Brazil. And then I guess the second part of the question would just be, in both of these product categories with the stocking distributors, do you think that it’s fewer procedures happening? Or do you think that they’re just trying to work down their inventory levels because of -- they’re trying to rein in their working capital?

It’s Brian again. I’ll try to take them one by one here. The first one, in markets to where we have direct subsidiaries, which is most of the markets outside the U.S. on our orthopedic side, we seem to be doing okay. Because they are not the restocking distributors. Those are directly to hospitals in those countries. You pointed out and you’re right in Brazil where we are direct, was the market that really hurt us this quarter. So I wouldn’t say that the stocking distributors necessarily were a big deal in the orthopedic side. It was primarily Brazil and we gave pretty good color on that. The second question, what was your second question, again?

I guess, well in spine in Europe, in the case where you use stocking distributors, do you think, I don’t know how much visibility you actually have into what’s going on with their business, but do you think it’s procedural decline? Or do you think that with the credit crunch environment that they are just trying to reduce their working capital, just run on lower inventories or something?

Yes, I think it’s just a function of the economy to be honest. You’re right, we don’t have visibility into their sell-through, that’s correct. I would say the economy in general is probably slowing procedures and is probably slowing their ability burn through some of the inventory.

Okay. And then my final question is just on the biologics business. I know you said last quarter it grew 48%, I didn’t hear you give a number, so I assume it slowed down considerably. But can you give us an update on what the growth was this quarter?

It’s Mike Finegan. No, we had continued strong growth. We’ve had many, many quarters of strong growth and this quarter was no different. So our total biologics business grew 20% and that includes both the spine and orthopedic channel.

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

Is any way you can quantify the impact from Brazil because it sounded from your commentary that that was going to be a residual factor for the next couple quarters at least?

I’m sorry, could you repeat? Did you say the impact from Brazil?

Correct.

I mean, we don’t usually break that out, but it certainly was the major driver for the decline in the orthopedics revenue, the 4% decline in the orthopedics revenue.

And just I guess a bigger picture question on anything on insurance authorization push back in spine Stim or I guess the portfolio more broadly?

We didn’t see any more than usual pushback. I wouldn’t say that it affected the business. We always have insurance reimbursement issues that we work with every quarter. But we didn’t see anything disproportionate this past quarter.

And then in terms of the M&A strategy. Any -- still expectations for deals in the near term?

Yes. I mean we’re actively working both organically by improving the pace of our pipeline and inorganically by looking at products and companies that will enhance our product portfolio. So we’re very active there. And to the extent that we have anything that’s worth noting, we’ll let you know. I mean what’s really relevant here is that we’ve gotten our balance sheet in a 0 net debt position, and with north of $100 million of EBITDA, we’ve got ample capacity to do many different things.

And then one last product question on this Trinity Elite product. Any more detail you can provide there in terms of expected premium? And I think that’s also 100% gross margin. What kind of gross margin impact that could have when you launch that product?

Yes. So this is Mike again. As we get closer to launch, we’ll more fully characterize that technology and talk about the financial impact. All I can tell you is that we continue to look at the biologics market as a great opportunity for us. It’s a market that rewards innovation and we are very well-positioned on the innovation side. We’re very well-positioned in the really kind of the full array of products that we have. And we expect Trinity Elite to be a super technology as we move forward.

Ladies and gentlemen, last question we have for today is coming from Charles Croson with Sidoti & Company.

Most of mine have been answered so just a couple of quick ones on here. Bob, you were talking about that one-time in nature of a spine in the Stim gain. Can you give a little more detail on what that one-time gain was?

It’s simply, we took some market share in the wholesale business that I’m not sure is repeatable in the same fashion. Although it is business that we think we’ll keep. But I’m just I answered in reference to the growth rate for the quarter. I think it did help our growth rate in the quarter and I don’t know that it’s going to be sustainable to the growth rate. I do think that the business is sustainable.

And then I have a quick question here and I apologize if you mentioned it during the opening remarks. Can you kind of walk through the reasoning for switching Brian to the global sales role? It just seems a little unusual for someone to go from a CFO role to a sales role and that. I just haven’t seen it in my time.

Well, I won’t be offended because I did the same thing many times in my career, so I won’t take that personally. But if any of you know Brian, Brian has a substantial amount of operational and financial background. In fact, Brian has probably the most experience in the Stim business of anybody in our company, and quite frankly, of anybody I can think of in the industry. So I think this is a natural segue for Brian. We’ve been targeting -- broadening Brian’s exposure to an operational job and this fit well for him. So I couldn’t be personally more excited. We worked together for the last couple of years and I think he’s going to do fantastic.

And then last question is on the Boston USAO. Any further comments on that?

No, other than we have another court date in mid-December. Again we signed our agreement with the U.S. attorneys back in, I believe, in July. And so we expect to have something to say then and hopefully we’ll move past that very shortly. I also expect shortly that have something to say about the completion of the Blackstone matter. So I think we’re in good shape in all those matters. Again the next court date is December 13, I believe.

We have a follow-up coming from Dave Turkaly with JMP Securities.

Just quickly, I was wondering if you guys could comment on pricing at all. Just, either unit mix in your spine business versus the price impact and maybe in ortho, any color at all?

I think the spine price decline is -- we’re seeing it less than it was. I think that we are, I mean, overall as a company, we were at 80.5% gross margins. So I feel very good about our overall mix of business and our overall pricing. And I feel better about spine pricing this quarter than I did in previous quarters. Having said that, spine pricing is by no means robust. Okay. Well, thank you, everybody. I’m glad you were able to listen to us today. I couldn’t be more pleased by some of our financial metrics, our gross margin up to 80.5%, our strong beat on earnings, our operating margin of 21% and our adjusted net income gross of 13% and with 0 net debt, I think we have a lot of flexibility. We continue to look forward to adding to our product portfolio and pushing ways to improve the top line. With that, I thank you. We’re all going to NASS. So if I see any of you in NASS, I’ll be glad to talk to you further. Have a great day. Thanks.

Thank you very much, ladies and gentlemen. This concludes today’s presentation. You may disconnect your lines and have a wonderful day. Thank you for participation.