Orthofix Medical Inc. (OFIX) Q4 2013 Earnings Report, Transcript and Summary

Good morning, ladies and gentlemen, and welcome to the Orthofix International Q4 2013 Earnings Results Conference Call. [Operator Instructions] It is now my pleasure to turn the floor over to your host, Mark Quick, Director of Investor Relations. Sir, the floor is yours.

Thanks, operator, and good morning, everyone. I'd like to welcome you to be Orthofix Fourth Quarter and Full Year 2013 Earnings Call. Joining me on the call today is our President and Chief Executive Officer, Brad Mason; and our Chief Financial Officer, Emily Buxton. I'll start with our Safe Harbor statements and then pass it over to Brad. 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, March 27, 2014. 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 2012 Form 10-K/A, as well as additional SEC filings we make in the future. 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 our financial performance measures determined in accordance with GAAP. Please refer to today's press release announcing our fourth quarter and full year 2013 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 Brad.

Thanks, Mark, and good morning, everyone. As you can imagine, we have a lot to cover today. On today's call, our CFO, Emily Buxton, will give you an update on the restatement and our 2013 financial results. After Emily's comments, I will share with you a more detailed look at where Orthofix is in this transition phase, and then a few closing thoughts before we take questions. I'll now turn it over to Emily.

Thank you, Brad. This restatement marks an important milestone for Orthofix, and I'm glad to once again be able to speak with you today. I will summarize the restatement process and findings, but please refer to our recent SEC filings and our restatement press release for further details on these items. Monday, we filed our restated financial results through the first quarter of 2013, which were issued on an amended 10-K for 2012, and an amended 10-Q for the first quarter 2013. In addition, we filed our 10-Q for the second quarter of 2013. On Tuesday morning, we filed our 10-Q for the third quarter of 2013. The documents we filed described the scope of the independent review conducted by the Audit Committee, the accounting adjustments made in the restatement and the restatement's impact on our historical financial statements. Also in these documents, we discussed weaknesses we identified in internal control over financial reporting and our actions to correct these weaknesses. This morning, we're also reporting our Q4 and full year 2013 unaudited results. We expect to finalize and file our 2013 10-K by the end of the month. To give you a quick summary of the work that has been going on, we began an independent review last summer as a result of information that raised questions about whether the company had properly recognized revenue under GAAP in connection with distributor sales recorded in 2012 and 2011, as well as a significant return of some products that had been processed during the second quarter of 2013. The review, which was conducted with the assistance of outside professionals and gauged by the Audit Committee, focused primarily on revenue recognition related to distributor arrangements and inventory reserves. The restatement adjustments reflected in our amended filings are based on management's assessment of…

Thanks, Emily. While I'm encouraged by the progress we made in strengthening our procedures and internal controls of our financial reporting, I'm certainly disappointed about the events that have led us to this point, and about our performance last year. The financial performance you have seen in 2013 is not reflective of where the company should be operating and is not a benchmark, it's a low watermark. We expect stronger financial results in 2014 and are laying the foundation for further growth and stronger profitability in the years to come. Orthofix is clearly a company in transition. Since we last hosted a conference call almost 10 months ago, behind the scenes, we made a lot of headway in many areas. I will give you an overview of our progress regarding people, business processes and growth strategies. Let's start with people. We've identified, retained and built a new management team that includes highly talented people from within Orthofix, as well as from outside the company. Over the past 12 months, we have prudently added or replaced the vast majority of our leadership positions at the director level and above at Orthofix Worldwide. Additionally, over the last several months, we added 3 new directors to our board, broadening our collective base of knowledge and expertise while providing a fresh perspective. Last week, we announced that Ron Matricaria has joined the board and has been appointed Chairman. His experience and track record in leading companies as both a CEO and Chairman has been exemplary. Ron and I are very well aligned on the future direction and opportunities for Orthofix, and both agree that we are at the beginning of a new era at the company. We also announced that Kathy Regan who served as interim chair of the board since January is remaining…

[Operator Instructions] Our first question today comes from Matt Miksic with Piper Jaffray.

So there's a lot of questions, I'm sure as you know, but I'll focus on just a couple here to start. First, I guess one of the things taking the margin -- turning the margin -- taking the margin information you provided, it seems like the spread between spine stem and Spine Fixation profitability was quite a bit wider than we thought. And you've mentioned there were some reserves taken in there. I guess how much of that delta is explained by those reserves? Maybe how much of that delta and profitability is possibly explained by the way you were accounting for instrument sets or other costs and cost of goods? That kind of color would be very helpful, and then I have a couple of quick follow-ups.

Sure, Matt. There's no question we have a significant margin differential between the 2 businesses. Our spine stimulation business -- excuse me, our stimulation business, BioStim, is our largest margin business, and our Spine Fixation business is our lowest margin business. And that was affected somewhat in 2013 by a heavier discounting. And -- but we have some things in place going forward that we think will change that picture a little bit. In terms of the inventory reserves, Emily, you want to take that?

Sure, so we took some additional inventory reserves. When our sales went down we had to reserve more of our inventory on the Spine Fixation side. And so that's about $6 million there.

One other thing, Matt. One of the reasons that we separated these businesses was specifically for this purpose so we could see the margin difference and really have visibility into these businesses and apply the proper corrections where we need to.

Okay. That's helpful. And I guess one of the other sort of changes that we saw, and you touched on this in your prepared remarks about the transition in orthopedics more to an OR sales force and sort of rolling up maybe the specialty. It sounds like more of a specialty field for [indiscernible] across the board. I guess it'll be helpful as we kind of pick through the numbers and understand sort of what the historicals are, and where everything used to be reported. I guess how much of BioStim -- or how much of orthopedics was Physio-Stim before? And if you can give us some sense of the proportion of BioStim that's orthopedics. I apologize if I missed that, we were kind of juggling a couple of calls here this morning.

No problem, Matt. The percentage of Physio-Stim within the BioStim business is a little above 10%.

Okay. So just -- so we're clear, that was previously reported in orthopedics, right? When you had spine stem and then you had a bucket reporting line called orthopedics.

Yes, that's right.

Okay. And then I guess one of the questions that comes up when you realign your reporting structure like that, and you sort of have talked a lot about that realigning into SBUs for greater transparency and I guess focus operationally. Given the challenges that you're presented within spine, given the market there, you talked about a pipeline of products for this year. But is this portfolio -- the portfolio you expect to go with? Or are you going to continue to kind of evaluate pluses and minuses -- you're potentially pruning some of the lines that may just make less strategic sense over time.

Yes, in the Spine Fixation business, that's what you're talking about, correct, Matt? Just to be clear?

Well, I guess I'm asking the question broadly across all the lines. I mean it's Stems, is obviously a big part, big important part of your business in driving a great deal of your profitability and cash flows. But I guess in the other product lines, I'm wondering how you're thinking about the portfolio?

Sure. And I'll be happy to talk about that. So let's start with Spine Fixation. We are -- we're close to having a full line of Spine Fixation products that will give our distributors more of an advantage. And some of our distributors also carry other lines, because we don't have all the products. So this year in 2014 will be one of our best years ever actually for new product launches. You may have seen that we launched our SAMBA SI Screw, which is a new and upcoming market, which we are very, very excited about, and that's out in the market now in a limited market release. We also have our Centurion Posterior Cervical System coming out, and this is a complete posterior cervical system that's really state of the art. And this was in development for probably close to 4 years, because there's so many components to it, but it really completes our cervical line very well. With one other addition, our LoneStar which is a standalone cervical system with our [indiscernible] titanium coating on it, which is a great technology as well. And then later in the year, in a limited market release, we'll be introducing Skyhawk which is our lateral system. That's -- as you know, that's the fastest growing area of spine. We have not had a product there that really took hold at all. And the retractor is really the difference in that product, and we have a very unique retractor. So when I look at this business, with these 4 new products coming online, that's a significant driver for us. The other thing it does is that it fills out our entire portfolio with just a few minor niches that we don't cover standalone DVRs [ph] and things like that. But it's…

[Operator Instructions] Our next question is with Imron Zafar with Jefferies.

I wonder if you could just provide a little bit more clarity on how we should think about operating profitability over the next couple of years? Or I guess put another way, how do you balance the necessary investments into the business such as fee in some of the operating investments you talked about with the contacting group, et cetera? And then kind of getting the profit margins to where they should be on a normalized basis? I just want to know how -- should we think about margins contracting over the next couple of years based on these investments or just some more color on how we should think about the model would be helpful.

This is Brad. Yes, I think there's a couple of things to think about here. Definitely, we have made a lot of cuts in a lot of areas, but we've also -- now that we have more refined and better strategies for each business unit, we've got certain investments that we want to make. As an example, in our BioStim business, we really haven't put in -- we haven't put -- we've done a lot of basic science research, but we haven't done the clinical cost of efficacy and that sort of thing that we need to do, and we need to build on that scientific research, basic science research, I should say, and look for new indications with new investments there. We're going to be investing in our infrastructure, there's no question about that. I think you're going to see that our G&A, while quite a bit higher than I would like to see it in 2013 will be flat -- should be flat in 2014. However, there's a reason for that. Right now, we have some gaps in our processes in our IT and other areas where instead of world-class processes, we have to use a little more brute force and put more people to get the job done. So as we bring these new systems and things online, and improve our processes, I expect over as we get into 2015 and '16 that our G&A percentage will drop significantly. The other area that I mentioned that we're investing in this year is increasing our R&D spending. We still have tremendous growth opportunities in all of our businesses, and we are adding additional $5 million in research and development to push that business along. So as we go forward to your point there's one other factor that affects your question directly and that's our ASPs. So if I think about this business by business, our BioStim business has been stable for many, many years. We saw a slight decline in 2013, about 1.5%, but nothing major. Our Biologics, actually our ASPs have gone up. Extremity Fixation, we're holding our own. And then in Spine Fixation, we took a pretty big hit in 2013, I think a number of people did, but part of that was a little bit self-inflicted. We did quite a bit of discounting that we didn't control, as well as we should. And we've got some initiatives going to help control that better going forward. So as we get into '15 and '16 to kind of wrap that all up, we expect our overhead costs, and our sales and marketing costs, our R&D costs and our G&A, sales and marketing and G&A to go down and R&D to go up, and we'll get back where we belong on our operating margins as we move forward in the next couple of years.

Okay, so putting it all together, just to be clear. The mix benefit on gross margin coupled with the higher OpEx, so the net result in 2014, 2015, then the net result should be lower operating margin and then better profitability there after? Is that fair to say?

No. No, I would say as we said in our very limited guidances that we expect to improve our bottom line in 2014, and we expect to probably improve it, a little bit accelerate that improvement as we get into '15 and '16.

Okay. And then in terms of the balance sheet and potential uses of cash. I just wonder what levels of opportunities are you considering in terms of asset -- assets, tolerance for dilution in terms of doing any deals?

Yes. Good question, Imron, I'm sure it's one that quite a few people have. At this point, we have a lot of work to do on our foundation. And so I don't want to put more weight on that than we already have. We want to get our -- everything aligned and moving the right direction and all of our processes in place. With the IT structure we have right now, it would not be a good idea to add any significant acquisitions to that. That said, we're certainly going to be looking at tuck-in technologies and products that can contribute to our current distribution channels on a smaller level. And as we come out of the -- make this transition through improving our -- the foundation of this business and our processes, then we'll take a different look at a lot of -- a number of things. Anything that's going to be return to good shareholder value with near-term cash accretion, we're going to be interested in.

Okay. And then just lastly in terms of the Spine Stim sales force. It sounds like there hasn't been any meaningful attrition or churn there. Is that fair to say in terms of the stability of that business?

That's fair to say, absolutely.

That is all the time we have for questions today. I would now like to turn the floor back to management for closing comments.

Yes, I want to again thank all of our stakeholders for your patience during the last 10 months while we've been preparing Orthofix for the next chapter. We've turned the page and are a different company today. Starting with our people, processes and growth strategies, all supported by a culture of integrity and performance. I look forward to talking to you all personally in the weeks ahead and early in May on our Q1 earnings call. Thanks so much, and everybody have a good day.

Thank you, ladies and gentlemen, this does conclude today's conference call. You may disconnect your phone lines at this time and have a wonderful day. Thank you for your participation.