Ashley Lee - Executive Vice President, Chief Operating Officer, and Chief Financial Officer Pat Mackin - Chairman, President, and Chief Executive Officer.

Jason Mills - Canaccord Genuity Jeffrey Cohen - Ladenburg Thalmann Suraj Kalia - Northland Securities Joe Munda - First Analysis Brooks O'Neil - Lake Street Capital Markets.

Greetings, and welcome to the CryoLife First Quarter 2017 Financial Conference Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is now being recorded.

It is now my pleasure to introduce your host, Pat Mackin, Chairman, President and CEO for CryoLife. Thank you. Mr. Mackin, you may now begin..

Good morning, and thanks for joining the call, everybody. This is Ashley Lee, the CFO for CryoLife. Before we begin, I'd like to make the following statements to comply with the safe harbor requirements of the Private Securities Litigation Reform Act of 1995.

Comments made in this call that look forward in time involve risk and uncertainties and are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.

The forward-looking statements include statements made as to the company's or management's intentions, hopes, beliefs, expectations for predictions of the future. These forward-looking statements are subject to a number of risks, uncertainties, estimates and assumptions that may cause actual results to differ materially from current expectations.

Additional information concerning risk and uncertainties that may impact these forward-looking statements is contained from time to time in the company's SEC filings and in the press release that was issued last night. Now I'll turn it over to our CEO, Pat Mackin..

Thanks, Ashley, and good morning, everyone. I'm pleased to be here with you this morning to report on a very productive first quarter. CryoLife has gotten off to a solid start in 2017, and we are very excited about the prospects for the remainder of the year.

As you may recall, last quarter, we were impacted by several items which we believed we would be able to resolve in a relatively short time frame. I'm pleased to report that we made good progress on these items. However, we've not reached a final resolution in the On-X AAP issue in Europe.

I will provide you with a detailed update on each of these areas in a few minutes. Financially, we posted a solid quarter led by On-X, tissue processing and further margin expansion. Our gross margin improvement was driven primarily by tissue processing productivity improvements.

As we've stated before, our objective was to increase our margins through a combination of improved business mix and operational efficiencies. As you will hear today, we are doing just that.

I'll now take you through our quarterly update regarding our 2017 key initiatives, followed by Ashley, who'll provide a detailed review of our first quarter financial results and then we'll open the call to your questions. Our first key initiative for 2017 is achieving our full year 2017 financial guidance.

Revenue for the first quarter of 2017 was $45.1 million, representing growth of 5% on both a GAAP and non-GAAP basis. As a reminder, our non-GAAP revenue includes On-X revenues for the period in 2016 prior to the closing of the acquisition, and it also excludes revenues from the divested HeRO Graft and ProCol product lines for 2016.

Our Q1 revenue was slightly ahead of our expectations. Our growth was balanced between our key medical devices and tissue products and there continues to be strong demand for our products in the market. During the quarter, we made good progress resolving the short-term factors that impacted our fourth quarter revenue.

The first factor was a shortfall in cardiac tissue. As we commented during the Q4 call, tissue revenues can be unpredictable, making it difficult to forecast in the short-term, which is why we think full year guidance is the best indicator for growth of the business and more representative of the performance of that segment.

For example, I am pleased to report that our tissue processing revenues grew 10% in the quarter, including a 17% increase in cardiac tissue and a 6% increase in vascular tissue. As a result, although we had a great first quarter, we are still holding to our guidance to mid-single-digit growth in the tissue processing business for 2017.

We have shared with you our plans to employ new strategies to build traction in our tissue business and I'm pleased to report that we are already seeing the benefits of our new approach.

For competitive reasons, we will not get into the specifics, but we have reason to believe that our campaign as to why CryoLife is a preferred partner for procurement organizations is having an impact. The second factor that impacted our Q4 was BioGlue inventory management by our Japanese distributor.

More specifically, we commented on the Q4 call that distributor ordering patterns can be somewhat lumpy as is evidenced by the fact that our Asia Pacific business grew 27% in the first quarter compared to the prior year.

As previously communicated, our Japanese distributor indicated to us that they plan to grow their business in 2017 by 20% over 2016, and their order activity so far this year has been consistent with that goal.

The other factors that impacted our Q4 revenue were the suspension of the CE Mark for the On-X AAP products and an unexpected softness in the On-X OEM business. In terms of the CE Mark, by the end of the month, we plan to have submitted the data required to lift the suspension to our notified body in Europe and we'll await their response.

We're hopeful that the suspension of the CE Mark will be lifted no later than the end of second quarter. As a result of this, we now expect our Q2 revenue impact of approximately $400,000 to $500,000. As for the nonstrategic OEM business, this continues to be a headwind, as anticipated, and we have factored that into our guidance.

Reading our first quarter 2017 earnings, we delivered non-GAAP EPS of $0.09 per share. This was primarily driven by continued improvement in gross margins, which we reached 70% on a non-GAAP basis in the first quarter.

Our second key initiative for 2017 is to drive the On-X business and deliver low double-digit non-GAAP revenue growth of the On-X portfolio, excluding OEM. As I mentioned already, we had a great start to the year, with the core On-X business, which grew 12% on a non-GAAP basis, excluding the OEM business.

Total On-X revenues grew to $8.9 million, which includes an approximate $479,000 revenue reduction related to inventory buybacks from our Benelux and Canadian distributors. I'll have more comments later about our transition to a direct sales channel in Canada and Benelux.

It is clear that our On-X business is picking up momentum and we expect that momentum to continue. We continue to see the benefit of our larger sales force. In North America, excluding OEM, the core On-X business grew 12%. Our sales force continues to open new On-X accounts with around 120 new accounts added since the acquisition.

Many of these accounts are still ramping up their On-X purchases. Our sales team has a significant opportunity to continue adding new accounts. These growth avenues give us confidence in the long-term potential of On-X in the U.S.

On May 2, the results of the On-X pivotal trial called the PROACT trial, which supports the reduced INR indication of 1.5 to 2.0 and the clinical advantage of the On-X aortic valve will be presented in a late-breaking clinical trial session at the annual meeting of the AATS, which is the American Association for Thoracic Surgery.

This is the first time this data will be presented in a major medical meeting. We also anticipate these pivotal study results will be published in a major peer-reviewed journal sometime in the near future.

We believe that both of these events have the potential to generate further interest in the On-X valve by physicians and accounts, which we believe should provide significant tailwind for the On-X platform, exclusive of the OEM business. Overall, we are pleased with the progress for our On-X business in Q1.

Our third key initiative for 2017 is to transition our sales channels in Canada, Belgium and Netherlands from distributors to direct. We have notified our distribution partners in these markets and are collaborating to ensure a smooth and orderly transition, which we anticipate will occur around July 1.

These transitions are impacting our revenues in the first half of 2017, including a $479,000 first quarter revenue reduction that I spoke of earlier. We have factored the financial impact of these transitions into our guidance.

As we complete the transition and move it into the second half of the year, we should begin to benefit in these markets from direct sales of the CryoLife portfolio and end-user market pricing and margin. Ashley will have more comments on this later in the call.

Our fourth key initiative for 2017 is to continue to pursue future growth drivers for the company through our clinical programs. This includes enrolling patients in our PerClot and BioGlue China clinical trials.

Since restarting the PerClot study under a revised protocol, we now have an IRB approval at 10 sites, including full site activation in 7 centers where patients are currently being enrolled in the trial.

We continue to gain momentum in the PerClot trial as more sites are activated and remain on track for our enrollment rate to support a potential FDA approval in 2019. For BioGlue China, we remain on track to begin enrollment in the second quarter with approval sometime in the second half of 2019.

Our fifth key initiative for 2017 is to continue to evaluate potential business development opportunities that will enhance our focus in critical mass in cardiac surgery.

Additionally, we are working to secure a commercialization partner for our NeoPatch, an internally developed allograft product initially targeting the $300-plus million market for amniotic tissue, and this is in the advanced wound care market, primarily for the treatment of diabetic foot ulcers and venous leg ulcers.

We've had positive initial meetings with potential partners with positive feedback on NeoPatch's product characteristics and clinical results. We hope to have news on this front in the coming quarters. Likewise, we remain very active and focused on business development as it's an important part of our overall strategy.

I will now turn the call over to Ashley for his financial review..

Thanks, Pat. I'll now review our results for the first quarter. Compared to the first quarter of the prior year, total company revenues increased 5% to $45.1 million. This was primarily driven by the acquisition of On-X and an increase in tissue processing revenues.

On a non-GAAP basis, revenues also increased 5% compared to the first quarter of last year. The non-GAAP revenue increase was primarily driven by an increase in On-X, tissue processing and BioGlue revenues, partially offset by a decrease in TMR revenues.

In connection with our strategy to go direct in certain OUS markets, we expect to repurchase approximately $95,000 of On-X inventory from our Benelux distributors and approximately $384,000 in On-X inventory from our Canadian distributor. The total of approximately $479,000 has been reflected as a reduction in first quarter revenues.

Excluding this revenue reduction, revenue for the first quarter of 2017 would have been $45.5 million. Please refer to our press release for additional information about our non-GAAP results, including a reconciliation of these results to our GAAP results. On a geographical basis, Q1 North American revenues, which includes the U.S.

and Canada, were $33.8 million, up 3% year-over-year, driven largely by the acquisition of On-X and an increase in tissue processing revenues. On a non-GAAP basis, North American revenues increased 4% for Q1 compared to the prior year, driven primarily by increases in On-X and tissue processing revenues.

Revenues from our European region were $7.1 million, up 6% year-over-year, primarily as a result of the acquisition of On-X. On a non-GAAP basis, revenues from this region increased 5%, driven primarily by an increase in On-X revenues.

And finally, revenues from Asia Pacific and Latin America were $4.1 million for Q1, up 22% year-over-year, primarily as a result of the acquisition of On-X and an increase in BioGlue revenues. On a non-GAAP basis, revenues from Asia Pacific and Latin America increased 12% year-over-year, primarily due to an increase in BioGlue revenues.

I'd like to spend some time focusing on individual product lines and specifically, tissue processing, BioGlue and On-X which combined, account for about 90% of our total revenues. As Pat mentioned earlier, we continue to drive improvement in our tissue processing business where both revenues and gross margins continue to improve.

In total, tissue processing revenues increased 10% for the quarter compared to the first quarter of 2016. During the first quarter, cardiac tissue processing revenues increased 17% year-over-year on a 9% increase in unit shipments.

Vascular revenues, which increased 6% year-over-year on a 7% increase in unit shipments, were $10.2 million, a quarterly record.

The initiatives that we spoke of in the last couple of calls are beginning to drive improvements in our top line and gross margin performance, and we remain confident about the overall prospects of the tissue processing business. BioGlue revenues in the first quarter increased 2% year-over-year to $15.6 million.

North American BioGlue revenues were $8.8 million in Q1, which was a decrease of 3% year-over-year. We believe the primary driver of the decrease was a result of some trailing of a competitive product, which we have previously spoken about.

I would point out that we have successfully competed against this product in Europe where we are the number one market player. OUS BioGlue revenues increased 9% year-over-year to $6.8 million. The increase primarily results from orders from our Japanese distributor and an improvement in our business in Brazil.

We continue to expect upside in BioGlue from our expanded indication in Japan, our ongoing strategy to go direct in select OUS markets and our anticipated regulatory approval in China in 2019. On-X revenues for the first quarter were $8.9 million, a 6% non-GAAP increase compared to Q1 of last year.

Excluding OEM, non-GAAP On-X revenues increased 12% compared to first quarter of 2016. The $8.9 million in revenue does not include the approximate $479,000 in revenues that were reversed in connection with our decision to go direct in Canada, Belgium and the Netherlands.

North American On-X revenues were $5.3 million for Q1, which represented a 3% year-over-year non-GAAP increase. Excluding the OEM business, the North American business was very strong, posting a non-GAAP increase of 12%. We believe this is the better indicator of the strength of the current North American On-X business.

OUS On-X revenues for Q1 were $3.6 million, which represented an 11% year-over-year non-GAAP increase. Our Q1 non-GAAP On-X business in Europe increased 26% year-over-year. Our Q1 non-GAAP On-X business in Asia Pacific and Latin America decreased 3% year-over-year.

Moving on, tissue processing gross margins improved to 57% for the quarter, up from 48% in the first quarter of 2016. Product gross margins were 71% for the first quarter of 2017. Product gross margins reflect the $2 million write-up of On-X inventory that we repurchased from international and domestic distributors.

If you exclude the $2 million, product gross margins for the first quarter would have been 78%. Our overall gross margins for the first quarter were 65% compared to 64% in the first quarter of 2016.

If you exclude the $2 million write-up of On-X inventory, overall non-GAAP gross margins would have been 70% for the first quarter compared to non-GAAP gross margin of 66% in the first quarter of 2016.

As we move forward and continue to execute on our gross inefficiency initiatives, we expect that gross margins will further improve over the coming years. Regarding our effective tax rate. We recorded a tax benefit of 28%.

The benefit results from a 2017 change in accounting for the tax treatment of the difference between book expense and deductible expense related to vesting of stock awards and exercise of nonqualified stock options.

In prior years, this difference was reflected as a component of shareholders' equity versus the current year, where the difference either reduces or increases tax expense. If you exclude the effect of this item, our effective tax rate would have been in the mid-30% range.

On the bottom line, we reported GAAP net income of $2.2 million or $0.06 per fully diluted share in the first quarter of 2017 compared to net income of $2.5 million or $0.08 per share in the first quarter of 2016.

Non-GAAP net income was $3.2 million or $0.09 per share for the first quarter of 2017 compared to non-GAAP net income of $3.2 million or $0.10 per share in the first quarter of 2016. A complete reconciliation of GAAP to non-GAAP net income and earnings per share is included in the press release that we issued last night.

As of April 23, 2016, we had approximately $58 million in cash, cash equivalents and restricted securities. We had approximately $71 million outstanding on our senior credit facility and had our full $20 million revolving credit facility available to us. The interest rate on our credit facility is approximately 3.7%.

With the exception of our effective tax rate, we are reiterating our initial 2017 financial guidance as detailed in the press release that we issued last night. For the second quarter, as was discussed earlier, we are now expecting a $400,000 to $500,000 revenue impact due to the On-X AAP issue.

In addition, we are going direct a quarter early in Belgium and the Netherlands, which will result in a $150,000 inventory burn down by our distributor. Considering these factors, we believe, second quarter total revenues will now be in the range of $46.5 million to $47 million.

I would note that our revenue guidance does not include any contribution from NeoPatch or potential acquisitions.

We reiterated our full year revenue guidance based on our expectation for our second half 2017 revenues, which should benefit from our selling direct in Canada, Belgium and the Netherlands, the anticipated reintroduction of the On-X AAP in Europe and continued growth in the On-X business.

Due to the change in accounting for the tax treatment of stock compensation related to equity-based awards, we now expect our effective tax rate for the full year of 2017 will be in the mid to upper 20% range.

On a quarterly basis, we expect our tax rate to be in the low 30% range in the second and fourth quarters, and around 20% in the third quarter due to expected vesting of stock awards. These estimates will be affected by our stock price at the time of vesting of restricted stock awards and timing of exercises of nonqualified stock options.

That concludes my comments, and now I'll turn it back over to Pat..

Thanks, Ashley. So you've heard this morning 2017 is off to a solid start following the successful Q1. Demand is generally strong for our products and we expect that to continue. The sales force's learning curve with the newer products is diminishing and we're continuing to see that reflected in the numbers.

On-X continues to grow substantially faster than the market. We believe we are still early in capitalizing on On-X full potential. We also expect further expansion of our tissue business and to effectively compete in the U.S. surgical adhesive market.

Moreover, our decision to centralize our focus in select clinical areas and going direct in several markets is yielding positive results. CryoLife has established a strong business focused on cardiac surgery that promotes organic growth and can also be leveraged through acquisition.

On that subject, we are pleased with a number of compelling pipeline product development opportunities that offer us potential to further leverage our infrastructure and management depth. Last, we remain confident in our 2017 guidance. And even though NeoPatch is not currently in our numbers, we are working hard to change that.

Altogether, we have positioned CryoLife to be a higher growth and a more profitable company, with a leadership position in the cardiac surgery market segment. We're very excited about the future prospects for the company. And finally, I'd like to sincerely thank our employees whose contribution and dedication led us to a successful start of the year.

With that, we will now open the lines for questions.

Operators, can you please open the lines?.

Thank you. [Operator Instructions] Our first question is from Jason Mills with Canaccord Genuity. Please proceed with your question..

Great. Thank you, Pat.

Actually can you hear me okay?.

Yeah, good morning..

Good morning. Good start to the year, Pat. Wanted to start with just the overall top line. Obviously, you beat expectations a little bit this year, but I know your aspirations, Pat, are significantly higher, your goals to get double-digit growth.

But I just wondered in light of the current portfolio, what's going on with your direct business on On-X, the tissue business bouncing back quite nicely this year. Asia-Pacific really being quite good.

I'm wondering can you get to 10% growth, can you get to double-digit growth with your current portfolio? Or will you need to augment with M&A? And I have a couple of follow-ups..

Yeah, thanks, Jason. I think so. I mean we were pleased with the quarter, and I think hopefully you guys picked up in the comments we've even had actually a better quarter than reported because we reversed some revenue, $479,000 of revenue. So, we basically came in at $45.5 million.

I think our guidance actually reflects our current feeling about the business. Again, we can do better and we hope to do better. But you saw tissue in the fourth quarter was down somewhat. I mean, it was lighter than we expected and then we had a huge Q1. And I made some remarks in the comments. Tissue can fluctuate.

Some degree, it's the dynamics of that market where there's lots of fluctuations on the procurement side, there's fluctuations on the customer side, but we see a steady demand on the tissue kind of in the mid-single digits range.

And so I – we're growing tissue double digits this quarter and we'd love to do that for the year, I think that we're trying to be a little bit more cautious in saying we think that's more of a mid-single-digit business. We saw the same thing kind of with Glue in Asia.

We had a distributor kind of destocking in December, which kind of hurt us in the fourth quarter and then they come back and grow 27% in the first quarter.

So I think one of the things I just – we're going to kind of remain kind of grounded on our guidance, which is we – and I said that on the call back in February that we believe that this portfolio, as it stands today, can grow in the 5% to 7% range. We've also seen nice improvement in the gross margin and we're very aggressive on the M&A front.

And I think we're one deal away from getting this to a double-digit growth company. But I want to make sure that we're also being kind of prudent about the guidance and – well, as you commented, we will strive for better. I want to make sure that people feel confident in what we're telling them on the 5% to 7% range..

Thanks, Pat, that's helpful. And it wasn't a criticism, I was just trying to get a sense for how you're looking at the synergistic opportunities that you just spoke, within your portfolio currently and how M&A may augment that.

I guess just secondly, North America in the quarter was I think a little lower probably than you'd like to see it on the go forward basis. It's kind of offset by the strength that you're seeing in Asia Pacific, obviously with BioGlue Japan coming back, that helps.

I'm wondering as you think about North America, and you mentioned On-X, and the number of accounts that you've opened since the acquisition is surprisingly good to us.

I'm wondering what your – how do you see your North American business evolving both prior to doing potential M&A? And then what M&A can do in light of the environment with megamergers that are going on that we've seen recently over the past couple of years and perhaps going forward, what sort of opportunity that opens up for CryoLife with perhaps assets that could be nonstrategic to some of the firms that you used to work at, for example, becoming available.

So what opportunity do you see in North America for your business, both organically and through M&A? It seems like perhaps the biggest opportunity exists for the company going forward [indiscernible]..

Yes, I would agree with that, Jason. I think so – we always talk, when Ashley and I speak with investors, we talk about to really understand CryoLife, you need to understand our three big product platforms, tissue, Glue and On-X, and that represents 90-plus percent of our business. In fact, the U.S. had a very good first quarter.

The majority of our tissue is – actually all of our tissue is sold in North America because of regulatory reasons. 10% growth in tissue in a business that was growing kind of 1% over the previous 5 years. So we are very pleased with the North America performance on the tissue front. On-X growing 12% in the U.S. I think that's a very strong performance.

A number of accounts we're opening. So I think that, that just keeps getting stronger. I also talked about we've got a late-breaking trial at AATS in a few days. We're looking for a – after that have a publication in a major journal. So we just keep getting tailwind behind On-X and our reps get stronger. We're doing a lot of direct to patient on the web.

This is a product that lends itself to patient education. Why would you get any other mechanical valve if you could take 50% less Coumadin and have a 65% less bleeding? So I think tissue and On-X are both growing double-digit in the U.S. I think the only disappointment in the quarter in the U.S.

was BioGlue was off a little bit, and we somewhat expected it. We knew we had a competitor coming in the market. We've seen some trialing. They have not been really effective in taking any of our business, but when the trailing goes on, it does kind of hurt our revenues a little bit. And we actually had planned for it. So the U.S.

pretty much hit their plan for the quarter. But I think the thing that – to remember, and you were getting there in your comments, between our U.S. sales force are going direct in Canada and our management team, we're pushing 60 people, 60 feet on the street in this segment, which is a very strong position.

And we're looking at some opportunities that would be significant – I mean, significant upsides in the U.S. marketplace, and I think that don't forget that the chassis we've developed here really allows us to look at some unique products and companies that, because of that infrastructure and that chassis, that we could leverage significantly.

So I'm excited about some of the things we're looking at and we'll see if there's a lot of hurdles you got to get over to get the deal done. But I do think this company's well-positioned. I mean, we're growing, we're profitable, we've got a great sales team and we've got the resources to acquire.

And I think there's some very unique properties that will really change the company and make this a double-digit business – really growing double-digit for years to come..

That's helpful color. Thanks for that. And then just lastly for me, you mentioned the PROACT study being presented for the first time in a major medical meeting. I think for investors that have asked you about it in every meeting for the last year and half that may come as some surprise.

I guess question on that, what do you think that will mean to the end market? Obviously, a lot of physicians that work hard every day that may not necessarily read the news or read press releases may not know as much about PROACT as investors do. And for some physicians, publication means everything.

So could you talk about what could – what those 2 things both, presentation and the eventual publication, could mean to the awareness about PROACT? And maybe give us an update on your thoughts about the PROACT II study with the [indiscernible]. Thank you, Pat. I'll get back in the queue..

Yeah. Thanks, Jason. Yes, so, I mean, I think, one thing in marketing in the medical device world, like any – like even the consumer device world is it's never one thing, it's a multitude of things that drive a franchise. So, obviously, when we acquired On-X, we felt they had a great product and great data in PROACT.

We've quadrupled their feet on the street. So having 60 reps in North America talking about On-X versus 15 reps talking about On-X, that's a huge deal.

The work we're doing on the web with basically patient kind of specific programs for patients who are going to have to have a valve surgery so they can learn about their different options is one of the avenues. Having a presentation at a late-breaking session at the major cardiac surgery meeting is another one of those.

Getting a publication in a major journal is another one of those. The PROACT II, starting the PROACT II trial is another one of those. So I mean, it's the constant kind of reinforcement and repetitiveness of the message over time over multiple venues that drives a brand. And I think we're seeing it, and it's early.

We've only owned the company for a year. And I think again we're seeing some very positive results of that. As far as PROACT II, we've done a ton of work on PROACT II. I think we're at a point right now where we've got a protocol and we're kind of working to finalize that and we're going to be going to meet with the FDA to get their feedback.

So that's something that we're very excited about, and our clinicians are excited about and our patients are excited about. And that I think will also provide a really unique way of looking at this valve going forward.

So again, it's all of these things together that I think will make a difference in that product and to continue the growth going forward..

Thanks, Pat and Ashley..

The next question comes from Jeffrey Cohen with Ladenburg Thalmann. Please proceed with your question..

Hi guys, thanks for taking the questions..

Good morning, Jeff..

Hi, Jeff..

I guess I'll pursue a little bit on Jason's questioning regarding On-X. And could you talk about, over the past number of months, number of centers, number of physicians, number of hospitals as far as training's going on.

And what kind of steam have you picked up there? And could you also remind us as far as the AAPs outside the U.S.? What percent of revenue has that been historically? What percent maybe in the U.S.

and what percent it could be once it's back on line there?.

Yes, so as far as the account opening goes, it's a fairly easy metric. So rough numbers, when we acquired On-X a year and a couple of months ago, they had about 450 accounts in the U.S. We've been adding about roughly 30 accounts a quarter, and we're now up close to 600. So there's about 1,000 hospitals that -- this is in the U.S.

only I'm talking where we have this kind of data. There's about 1,000 hospitals that do kind of heart valves. So we still obviously have room. That's consistent with the market research that we did. So we're looking at adding up to 30 hospitals per quarter and it's been consistent over the last five quarters.

So we believe those accounts coming online, going through the trialing process, going through the approval process, getting consignment contracts, getting inventory on the shelf and then they can start to use the product which again, as we’ve commented previously, take some time.

And every quarter, we're looking at opening hopefully 30 more accounts until we get to full penetration of the U.S. market. As far as the AAP goes, yes, it's -- in Europe specifically, it was about I think a little over $1 million last year. This quarter last year, Q2 last year, we did almost I think $420,000.

So you can see why -- and that is business actually, we've been opening new accounts and that business was growing significantly. So that's where we came up with the $400,000 to $500,000. I mean, we did $420,000 last year and the business was growing so that kind of can go up and down quarter-to-quarter but specifically this time last year.

And that's a -- you can do the percentage of the overall European business. We can find that for you while we're talking.

But we were hoping -- that was probably the one disappointment in the quarter is we were hoping to get out of that situation at the end of the first quarter so we will be back online live in the second quarter, which this didn't happen -- and I've been doing this for 25 years and one thing I've never been able to do is predict what regulators are going to do.

This is not easy to do. So I mean, we're working hard to get this back on the market and until we get an update, I really can't say more than that..

Yes. And Jeff to follow-up on your question, as far as 2016 revenues, the AAP represented about 3% of our European business so it wasn't a huge part of it. And then overall, corporately, it was less than 1% of our business..

Yes. And this issue with AAP is isolated to the EU. I mean it's in the CE Mark countries only..

Okay.

And you hope to have some color when you submit and hopefully that'll get back online during 2017?.

Yes. I made the comment in the call was that, we are hoping to get this resolved in the second quarter so we'll be back in business, if you will, by July 1. But again we'll update you. I really can't really give you more than that.

We submit stuff and then they have to decide what they're going to do but again we're hopeful that we can get back in by July 1..

Okay. And then my second question is if you could provide us some color -- further color on the tissue business. It seems like it's growing dramatically well this quarter.

Is it related to -- could you talk about -- is it picking up share, number of users out there, what's really driving it? Pricing? What's drive -- particularly on the vascular side?.

Yes, so it's hard to say. I mean, from a -- we don't get great third-party data like we do with some of our products. It's because it's a I think a small and fragmented market. I will say that the overall strategy of the company to focus on the cardiac surgery segment, and in North America with 60 feet on the street, certainly goes a long way.

I think that's one piece of this. It's just the channel structure and the brand of CryoLife. I think number two, we've had a big effort around this extremely positive SynerGraft data. And I don't want to get in all the particulars of what we're doing there because I'm sure our competitors are listening to us on the phone call here.

But the fact of the matter is our clinical data on SynerGraft, at a decade, you have a 17% chance of a reoperation if you get a SynerGraft valve from CryoLife, and you'll have a 40% chance of reoperation if you get a non-CryoLife SynerGraft. And we are taking that message to our customers and it's resonating.

And we're going to keep going until we feel like patients out there are getting the best technology. So that certainly has had something to do with it. And then supply-wise, I mean, I think our tissue operation here in Atlanta has done a very nice job keeping up with tissue supply. And you can see with the margins. I mean, margins were 57% this quarter.

That's up 2,000 basis points from two years ago. So the supply's there, the channel's there, the data's there and our operations are there. And put that altogether, we're putting up double-digit numbers on tissue. Now I made a comment in the call -- I mean, we're not going to guide to double-digit tissue growth.

We think, over a year period, because there are some kind of ups and downs in that business with just the supply chain from procurement to our hospitals have freezers, they sometimes stock. Once the freezers get low, they'll fill them up. So I mean, we don't want to have -- we have a great quarter.

We don't want people -- everybody kind of running around cheering and then we kind of come back a little bit. So we feel confident that this business will grow in the mid-single digits like we guided to back in February..

Super. Okay, perfect. That’s it from me guys. Thanks a lot for taking my questions..

Thanks, Jeff..

The next question comes from Suraj Kalia of Northland Securities. Please proceed with your question..

Good afternoon gentlemen..

Hi, Suraj..

Hi, Suraj..

Congrats on a nice quarter. So Pat, a few things. Let me start out with the most obvious question.

Are you seeing any impact on On-X from PARTNER II or PARTNER III enrollment or sites, in intermediate or low risk?.

Yes, I mean -- yes, so the initial protocol of PARTNER III, they had a lower age limit of 65. And as you know, in the mechanical valve market, both the guidelines and clinical practice are typically -- and again it can vary by some surgeons go a little bit higher, but typically the mechanical valve market segment is patients under 60.

So it's almost like a Venn diagram with two circles that never touch. I know that they actually had a hard time enrolling so they actually changed the age limit. So I think again, from center-to-center, we've not seen a lot. I also -- I've seen some papers and I know you're very much up on this field.

Just the whole idea of putting a TAVR in a 55 or 60-year-old, I think is -- with the current data that's out there, I think it's a real issue. So I mean, I had a dinner last night with a patient who had an On-X valve and he went through this very decision.

He's a 55-year-old guy, needed an aortic valve surgery and he had to go through the whole catheter tissue mechanical. And when he did his research on the Internet, he quickly found that -- and this is obviously in the data that younger patients -- tissue valves break down in younger patients faster. It's a proven fact.

So what he didn't want, like many of the patients who are doing this research on the web, he didn't want to have multiple operations over a lifetime where the risk of surgery and complications goes up almost exponentially. And he was more than happy.

I mean, he was -- on the flip side, and again as you well know, taking a blood thinner for the rest of your life is not something that most people are excited about.

But what he kind of did this the balance of the best of both worlds, which is he can get an On-X valve, which he can have for the rest of his life, and take half of the blood thinner and have a 65% reduction in his bleeding profile was really appealing to him. And I think that's part of why we're seeing, I think, the positive growth in this segment.

But as we've talked, the TAVR market is still -- there's a lot of unanswered questions.

There are a lot of things that are out there that -- obviously cardiologists are driving this but everything from pacemaker implants to the longevity of the devices, to the microemboli and I mean there's a lot of unanswered questions, and I think going younger than 60 years old, I personally think is fraught with a lot of issues..

Fair enough. Pat, you mentioned and I think so I got this comment right that we are one step away from being a double-digit growth company. And I think somebody asked a question to that effect also but let me kind of harp on it again.

Any color you can provide on what complementary product or segments would help you all, notwithstanding what happens in your negotiations in your biz dev strategies? But just what are the things as categories within cardiac surgery, I presume, that are intriguing to you all?.

Yes, it's -- I get that question a lot. As you can imagine it, as much as I love to add the color, it's obviously a problem for a lot of reasons.

I think what we've tried to do is in the last couple of years since I've been here, two and a half years since I've been here, is I think we've done a very nice job stabilizing a business that has some nice product lines. The On-X product line was added. We've made significant improvements in the tissue side of the business.

Glue with what we're doing internationally as well as the China trial. So as I made the comment to a prior question, we think this is a portfolio that can grow 5% to 7% and increase in profitability over time. But it's -- the most important part of it it's a chassis that is now really, as I said, one step away.

I mean, we still have to go direct in Spain, Italy, the Nordics kind of when we do that and we've got to work with our partners on that, but there's multiple markets we can go direct in. There's clinical trial strategy, there is R&D strategy.

But there are companies out there that are in good-sized markets that when you marry them up with CryoLife, would be a very unique company. And I'm not going to go any further than that because it's just -- I do not want to paint a road map for our competitors or for anybody else. And again, when we have something, we'll let folks know.

But there's stuff out there that would literally be a significant growth driver, immediate double-digit growth and provide double-digit growth for kind of years to come, if you will..

Fair enough. Pat, in the U.S., and Ashley, correct me if I got this wrong, North America On-X numbers were $5.3 million.

And I'm just averaging out roughly in terms of, let's say, even if I use last quarter's numbers of 550 centers, the math indicates that roughly each center is, again on average, there'll be a bell curve I understand that, roughly there are about two On-X cases per quarter per site in the U.S.

I guess when I compare it to TAVR, which is right now at least our math indicates close to 19, and overall surgical valve utilization is roughly around 28 per quarter, give or take, in the U.S.

Pat, I understand there are 1,000 centers but out of these 600 centers, let's say over the next four to six quarters, how do you think utilization can move on On-X specifically?.

Well, again, there is an -- the simplest way to do it is there's an existing mechanical market. So I mean, instead of talking about what happens between mechanical and tissue and TAVR, there's an existing mechanical market that's fairly sizable, both in the U.S. and OUS as you well know. And I think this is really a -- for us in the U.S.

is a share battle. And I think the things I've talked about as far as the patient education on the web, the PROACT trial being presented at AATS, the publication of major journal following with a Nowak strategy with PROACT II. I think all of these things both help the share capture as well as even potential shifts into tissue.

And again, we'll -- that will remain to be seen. But I do believe that those -- all those different things will impact both our utilization as well as the share shift over time..

Got it. One final question for Ashley. Ashley, remind us in terms of the incremental cost of going direct in Europe, whether in the Benelux countries or other places. Thank you for taking my questions..

Yes. So we're looking at adding just a limited amount of reps. Some of the geographies that we have spoken about on the call are somewhat small over in Europe.

The cost of going direct is included in the guidance that we've given from a G&A standpoint, we've guided to roughly around $23 million per quarter, give or take, a couple of hundred thousand just depending on which particular quarter it is. But the cost associated with going direct is included in the guidance that we've given..

Thank you. Our next question is from Joe Munda with First Analysis. Please proceed with your questions..

Good morning guys. Thanks for taking the questions.

Can you hear me okay?.

Yes, good morning, Joe..

Good morning. I want to focus a little bit on the sales force and the go direct. Pat, just touching off a little bit, and I guess piggybacking off of Suraj's question. You talked about other countries particularly Spain and the Nordics going direct there and you've got to talk to partners.

I guess, can you walk us through the decision making process on your end of, a, the timing. And b, what really swayed you to essentially go from distributor relationship to a go-direct strategy? Thanks..

Yes. And maybe I could use Canada since Canada's already public and we already talked to our partners there. I mean, it's probably a good example. I mean, we were doing roughly $3 million in Canada with our product line through distributors. That's basically tissue, On-X and Glue.

And we had two different distributors because when we acquired the On-X portfolio, that was in a different distributor than who we had with tissue and Glue.

But when you get to $3 million and partly you have to look at the geography but Canada you can cover with there's three big markets there, right? It's Montréal, it's Toronto and it's kind of the West, primarily based out of Vancouver. When you look at that, when you take the middleman out of the equation, that $3 million turns into $4 million-plus.

Your margin goes from 60% to 75%. And you actually have a direct rep that's doing nothing but selling your product as opposed to a distributor who's selling other people's products.

And we felt like with our portfolio of On-X, which is a heavy clinical sales as you just heard with our clinical data on SynerGraft, we've opened several new accounts with SynerGraft in Canada with Glue.

So I mean, it makes sense just on the economics of taking the middleman out and getting end-user revenue and end-user margin, once you get to a certain critical mass and we hit that in Canada. And we feel like we're going to grow significantly from there because we're going to have our own direct people.

So that's really the analysis when we look at some of these other geographies, how many people, how many feet on the street do you have to put there? What's your current business? When you take the middleman out, what does it do to your end-user business? And how much can you grow from there and does it work? Are you more -- are you growing faster on the top line and more profitable on the bottom line after you take into account the one-timers that have to take six to 12 months to flow through? So we've been -- we did France.

We did some here in the U.S. with On-X. We've now done -- we're in the process of doing Belgium, Netherlands, Canada. So we're being pragmatic. I mean, one of the challenges is during that as you saw in France and as you're seeing in Canada in Benelux, you've got to reverse revenue to buy back inventory, even the sales for the quarter.

So it somewhat causes some challenges in your P&L from this kind of quarter-to-quarter every 90-day reporting but it's the right thing to do strategically for the company because as soon as we acquire something, we can just drop in those direct bags which is actually very difficult to do when you come to distributors.

So hopefully that provides the color you were looking for..

Yes.

In staying with Canada, for example, converting it, how many feet on the street do you need in Canada for that business?.

Yes. I think, starting out, we're going to start with three..

Okay, okay. Thanks. As far as the sales force, you talked about 60 in the U.S.

I believe on the last call, it was 51, did you add staff?.

No, the comment I made was feet on the street in the U.S. and Canada as we go direct July 1, right? So we've got 51 reps, that stayed the same and that's full op. We've got seven managers in the U.S. plus the three Canadian reps. That gets you, in my math, to like 60, 61..

Okay.

And then I guess OUS, how should we look at that? Has that changed significantly since the last quarter?.

No. I mean, it's pretty consistent. I mean we're about 30 in Europe. And that's I mean, outside of North America and Europe, we're all distributor and we plan to stay that way for some time. So that really hasn't changed at all..

Okay. So based on the current structure, essentially in the U.S., you talked about being 60% penetrated for On-X in U.S. hospitals.

Does the current sales force footprint, if you will -- is that sufficient enough to get that next 40%? Or do you think that you're going to have to continue to add some sales force to get there?.

No, our channel in the U.S. with the current portfolio, is perfectly sized for the opportunity. So we don't need to add anybody..

Okay.

And then on the BioGlue issue with the competition, any feedback or what you're hearing from customers? And what gives you the confidence that what you witnessed in Europe is not going to -- or what you witnessed in Europe you're going to be able to overcome those issues here in the U.S?.

Yes, I mean, so we always take new competitor seriously but I think that there are several factors that are playing in our favor. And one, I start with the channel, that's a big deal. We have a -- as I just said, in North America, we have a 60-person direct channel calling on heart surgeons every day.

We're in cases for tissue, we're in cases for heart valves for On-X, we're in cases for Glue, so our reps are in the OR kind of talking to heart surgeons all the time. This competitor doesn't have a channel. They don't have a direct channel. They're going through distributors. It's not a big focus for them. And then look at the product.

I mean, the product from -- this product's been in the market for 20 years. It's a staple in every single cardiac OR. We've got a couple of hundred clinical publications on this product. This competitor has one.

And if you look at just the testing and the bench testing of the products, this product is nowhere near the same kind of strength and profile of BioGlue. So again I face lots of competitors and it's part of the business. And as we saw in Europe, they've got some trials, and then they never stuck.

So that's what we're planning on doing here and we've got the sales force to make sure that they don't stay around..

Okay. That's helpful. And then my last question, essentially NeoPatch, could you provide us, if you could, with any color, stage of discussions, outlook? Last quarter you were talking about a marketing partner. Does that still hold true? Any other color there would be great..

Yes. No, I think we've been pretty direct here. I think, the company, our R&D team has done a nice job developing NeoPatch. I mean, we've got the core competency in tissue processing, which enabled us to come up with this product and we've got some great engineers that developed it. But this is not our call point.

I mean, the wound care, diabetic foot ulcers is not going to be our call -- is not and will not be our call point. So we've been very direct that we are not going to commercialize this ourselves. We are looking for a partner that has the sales, marketing, reimbursement expertise in that marketplace. It's a big market and it's growing quite quickly.

And there are several players that are interested in working with us. We're obviously kind of working down the path to find out which is the best one and our hope is to get something done this year. And I think it would be a great thing for the company. Because frankly, there's going to be no more cost to CryoLife.

We're going to wrap up the first-in-man trial this summer and get it published and presented. And our goal is to get a deal done so that we're the tissue processor for the partner and then we're going to strike a deal where we share in the revenue and the profit. So this will be a new product line where we really have no cost.

So I think for investors, it's all upside from this point. We're really not spending anymore money. And we're just going to try to leverage the investment we've made. And it's a great product. The results are great, the customers love the way it handles and I think we should be able to get something done this year..

And you have sufficient capacity to do so?.

Oh, yes..

Okay. Thank you..

Thank you. The next question is from Brooks O'Neil with Lake Street Capital Markets. Please proceed with your questions..

Good morning and congratulations on a terrific start to the year. To me, one of the big things going on here is the margin expansion.

So I was hoping you might, a, just confirm that you're done with the inventory step-up cost; b, talk about whether the spending in the first quarter was kind of in line with what you expected or whether you have some positive surprises; and then, c, and probably most importantly, what in your mind is driving the margin expansion? And sure sounded like that could keep on going in a nice way so hope it can..

Maybe I'll make some comments and maybe Ashley can refine them a little bit. So one, the inventory step-up was a Q1 issue last year where we went and we bought out all the U.S.

and international distributors for On-X, and that was kind of -- you had to buy -- it's an accounting gyration which Ashley can talk about, but you had to buy it back for what you sold it for, put it on your balance sheet until it flows through it's kind of stuck there. It kind of slows your margin down or impedes your margin. That's kind of gone now.

So that was a huge part -- that was $2 million this quarter. So if you look at our product line, again, I talked about the big three. What's really driven the margin expansion is I would say two things. One is tissue gross margin has gone up 1,000 basis points since last year and 2,000 basis points since two years ago.

So a business that's growing double digit with a 2,000 basis point improvement over two years, I would say, is a significant contributor to your margin expansion. The second piece is on the product side. You heard from Ashley that if you take out that one-time $2 million inventory step-up, our product gross margins are 78%.

That is being driven by our highly profitable BioGlue product line and our highly profitable On-X product line. And I think that's one of the great parts of the story. In the U.S., and people, I think, lose sight of this, we're getting 90% gross margin on Glue and 90% gross margin on On-X. So as we grow those business, I mean On-X grew 12% in the U.S.

and that's a 90% gross margin. So I think you can see the components that are driving the gross margin of our franchise..

That's fantastic.

And all of that is just going to keep getting better, right? As you grow the top line and then just keep flowing through that higher margin?.

Yes. I will tell you that -- I mean, two years ago, two and a half years ago, our gross margins for the corporation were 60%. So we're now sitting two years later at 70% when you take out this onetime step-up. I would say we're a couple of years ahead of where we thought we were going to be.

We're obviously going to continue to try to bring in highly profitable product lines and as we grow those product lines it will add to the mix. But my goal over the coming years is to get this product line to where we're typical med device in the 75% range.

Given that we have tissue, that means our product side are going to have to be higher than 75%, right? But I mean, -- I don't think you're going to see a 10-point margin, 1,000 basis point margin improvement next year going from 70% to 80%. It's not going to happen.

But I mean, 60% to 70% was a lot of work but we're in a really good place and I think we're going to gradually work our way up as close as we can to 75% over the coming five years..

Great. Fantastic. One other question. I'm just curious, you had a couple of divestitures, I think it was last year.

Is there anything else as you look at the current product portfolio that you think maybe it would be better positioned in another company?.

Yes, I think at this point, no. I think depending on what we do on the M&A front that, that may trigger something. But I think right now, I mean, we're certainly looking at different things. But obviously I don't want to get into specifics on that.

But I do think like we did with -- On-X was the catalyst to divest the nonstrategic dialysis businesses, ProCol and HeRO. I think that if -- for the next deal that we do, that may trigger some other actions down the road. But it's pretty much what we have that..

Sure, okay. Thanks a lot and congratulations. Look forward to the year..

Thanks, Brook..

There are no further questions registered at this time. I would like to turn the floor back over to management for closing comments. Thank you..

Yes. Well, first of all, we appreciate everybody tuning in for the call and we're happy about the first quarter. And we actually -- our over-performance allowed us to do some things with our direct strategy ahead of schedule, which we're happy about. Obviously we're working hard to get this On-X AAP back in the market.

But our big franchises, growing tissue double-digit, growing On-X double-digit and double-digit Glue growth outside the U.S. and while we're dealing with some competition here in the U.S., I mean overall we're very happy about the progress. And we're reiterating our guidance for the full year, as you've heard.

And we're still working aggressively on partnering NeoPatch and looking at some M&A opportunities. So we're -- I think through the first quarter, all systems go and we look forward to next quarter on the call. Thanks for joining..

This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation..