Curt R. Hartman - CONMED Corp. Luke A. Pomilio - CONMED Corp..

Rich S. Newitter - Leerink Partners LLC J. P. McKim - Piper Jaffray & Co. Matthew Mishan - KeyBanc Capital Markets, Inc. Mike Matson - Needham & Company LLC.

Good afternoon, everyone. Before we begin, let me remind you that during this call, management will be making comments and statements regarding its financial outlook, which represents forward-looking statements that involve risks and uncertainties as those terms are defined under the federal securities laws.

The company's actual results may differ materially from its current expectations. Please refer to the risk factors and other cautionary factors in today's press release, as well as the company's SEC filings for more details on factors that may cause actual results to differ materially.

You will also hear management refer to the certain non-GAAP adjusted measurements during this discussion.

While these figures are not a substitute for GAAP measurements, management will use these figures to aid in monitoring the company's ongoing financial performance from quarter-to-quarter and year-to-year on a regular basis, and for benchmarking against other medical technology companies.

Adjusted net income and adjusted earnings per share measure the income of the company, excluding credits or charges that are considered by the company to be special or outside of its normal ongoing operations. These adjusting items are specified in the reconciliation in the press release issued this afternoon.

With these required announcements completed, I will turn the call over to Curt Hartman, CONMED's President and Chief Executive Officer, for opening remarks. Mr.

Hartman?.

Thank you, Amanda. Good afternoon and thank you for joining us for CONMED's second quarter 2017 earnings call. With me on the call is Luke Pomilio, CONMED's Executive Vice President and Chief Financial Officer. Today, I'll provide a brief overview of the financial and operating highlights for the quarter.

Luke will then provide a more detailed analysis of our financial performance and an update to our fiscal 2017 financial guidance. After that, we will open the call to your questions. Looking at the quarter, we are pleased with our performance and the results we have delivered to-date.

Total company sales in the quarter were $197.2 million, an increase of 1.9% as reported, and an increase of 3% in constant currency over the prior year period.

From an earnings perspective, second quarter GAAP net income totaled $6.1 million or $0.22 per diluted share compared to a reported net income of $2.9 million or $0.10 per diluted share a year ago.

Adjusted diluted net earnings of $11.4 million decreased 13.2% year-over-year, and adjusted diluted net earnings per share of $0.41 decreased 12.8% year-over-year. On a worldwide basis, General Surgery recorded its sixth straight quarter of positive gains and Orthopedics moved into growth in the quarter.

Growth was driven by ongoing strength from our international business which recorded gains in both General Surgery and Orthopedics for the fifth consecutive quarter.

Within international, General Surgery is doing well, having now recorded its sixth consecutive quarter of growth, largely from ongoing momentum in Advanced Surgical in the AirSeal platform.

In international orthopedics, strong gains were recorded across sports medicine category and key performances were turned in by Europe, Asia, and Australia and New Zealand. In the domestic markets, we recorded our sixth straight quarter of growth in General Surgery against the tough prior year comparison.

AirSeal again performed well and endoscopic technologies had another solid quarter on the strength of new product contribution and solid sales execution.

Finally, while much work remains, we are encouraged by the improving trends in our domestic Orthopedics business, which recorded a second consecutive quarter of sequential improvement and the best performance in four quarters. That said, we remain focused on accelerating growth of this business.

We're optimistic about our new products and signs continue to point to an improving trend for Orthopedics in the second half of 2017. Outside of the business results, our focus on new product innovation remains a key priority.

And today, we have introduced 14 new products, and keeping with our prior comments, we're on track to launch no fewer than 20 new products by the end of the fiscal year.

Overall, we're pleased with our financial and operating accomplishments to-date and we will continue to focus on new product introductions and leveraging our investments in manufacturing to drive margin improvement. We look forward to building on this quarter's momentum in the second half of the year. I'll now turn the call over to Luke..

Thank you, Curt. As mentioned, our total sales for the second quarter of 2017 were $197.2 million, an increase of 1.9% on a reported basis, and an increase of 3% on a constant currency basis versus the second quarter of 2016.

Domestic sales which represented 50.7% of total revenue, increased 1.3% as year-over-year growth of 3.3% in General Surgery was partially offset by a decline of 1.4% in Orthopedics. International sales which represented 49.3% of total revenue increased 2.5% compared to the second quarter of 2016 on a reported basis.

Foreign currency exchange rates including the effects of the FX hedging program had a negative impact of $2.1 million on second quarter sales. In constant currency, international sales increased 4.7% versus the prior year period. With that, I will review our two reporting categories with all growth rates stated in constant currency.

Worldwide Orthopedic revenue increased 0.9% in the second quarter, marking a return to positive growth following five quarters of sales declines. Domestically, second quarter Orthopedics revenue decreased 1.4% versus the prior year period. We continue to see sequential improvement in both single-use and capital sales for second consecutive quarter.

While we're pleased with this progress, our domestic Orthopedics business is to continue focus on new products and execution to accelerate growth in this area.

Internationally, Orthopedics revenue increased 2.4% year-over-year, representing a fifth consecutive quarter growth, with continued strength within our direct markets and our sports medicine category.

Worldwide General Surgery revenue grew 5.5% in the quarter, driven by robust performance from Advanced Surgical led by the AirSeal system, as well as Endoscopic Technologies. Domestically, second quarter General Surgery sales increased 3.3%, driven by strong Endoscopic Technologies and Advanced Surgical sales.

Internationally, General Surgery sales increased 9.7% due to strength across our direct markets and strong contribution from Advanced Surgical.

As previously discussed, we discontinued the sale of our Altrus tissue sealing device effective July 1, 2016 which caused $100,000 headwind in the second quarter, consistent with our comments on the first quarter call. This product line discontinuation is now anniversaried.

Now, turning to other components of the income statement, adjusted gross margin for the second quarter, excluding restructuring costs, declined by 220 basis points to 53.2% compared to 55.4% in the second quarter of 2016.

The decrease versus 2016 is attributable to a negative impact from foreign exchange of approximately 50 basis points as well as less favorable production activity of approximately 170 basis points.

Our second quarter adjusted gross margin was below the first quarter adjusted gross margin by 100 basis points, with about half the impact coming from product mix and the remaining impact coming from incremental expenses related to our manufacturing operations.

Our original 2017 plans call for higher spending and lower gross margins in the first half of the year, with a rebound to more normalized gross margins in the second half of the year. We're still on track with this improvement.

And for modeling purposes, we expect Q3 2017 adjusted gross margin to exceed our Q1 actual of 54.2% and expect Q4 2017 adjusted gross margin to approach 56%.

From a full year perspective, 2017 gross margin should be within our previously provided guidance range of 54.5% to 55.5%, but likely in the lower half of that range, given our results in the first two quarters.

Moving down the income statement, on an adjusted basis, which excludes the impact of amortization, selling and administrative expenses from second quarter was $77.2 million or 39.2% of sales compared to $77.3 million or 40% of sales in the second quarter of 2016.

As we've progressed through the second half of 2017, we continue to forecast full year adjusted SG&A in the range of 38.5% to 39.5%. Our business is seasonal, with Q3 sales typically representing the lowest quarter for the year and Q4 sales representing the highest quarter for the year.

Based on this, SG&A as a percent of sales tends to be lowest in Q4, and higher in Q3. Research and development expenses for the second quarter were $8 million, which was slightly higher than $7.6 million reported in the first quarter of 2017 and in line with the prior year period.

Based on the R&D spend in the first half of the year, we are now targeting 2017 R&D expense in the range of $34.5 million (sic) [$31.5 million] to $33.5 million, as compared to our previous guidance range of $33 million to $35 million. Adjusted EBITDA margin in the second quarter of 2017 was 16.4% compared to 17.7% a year ago.

The unfavorable impact of foreign exchange reduced second quarter 2017 adjusted EBITDA margin by 40 basis points. Turning now to a discussion of our income tax rate. Our adjusted effective quarterly rate decreased from 30.1% – decreased to 30.1% from 31.7% in the second quarter of 2016.

Through the first six months of 2017, our adjusted effective tax rate was 30.8%. For the full year 2017, we now estimate our non-GAAP tax rate of approximately 30.5% to 31.5% as compared to our previous estimate of 31% to 32%. This update reflects the higher forecasted benefit from stock option deductions.

Our diluted net earnings per share on a GAAP basis were $0.22 compared to diluted net earnings per share of $0.10 in the second quarter of 2016. The improved profitability on a GAAP basis was primarily attributable to additional business acquisition costs and restructuring costs that we incurred in the prior year period.

As we previously discussed and as outlined in today's press release, we exclude the costs of special items including acquisitions, restructurings, legal matters, gains on the sale of assets and debt refinancing net of tax, as well as amortization of intangible assets net of tax, from our calculation of adjusted diluted net earnings per share.

Excluding the impact of these items, our second quarter adjusted diluted net earnings per share were $0.41 versus $0.47 in the prior year period. Looking at the balance sheet, our cash balance as of the end of second quarter was $40.1 million, compared to $23.3 million at June 30, 2016, and $27.4 million as of December 31, 2016.

Accounts receivable days as of June 30, 2017 were 67 days, compared to 66 days in the same quarter a year ago. The inventory balance at quarter-end was $136.5 million, compared to a $140 million at March 31, 2017, and $136.8 million at June 30, 2016. Inventory days at quarter-end were 137 days.

Long-term debt at the end of the quarter was $484 million versus $488.3 million at the end of December 2016.

Excluding the potential impact from repatriation and acquisitions, and assuming payment of Lexion judgment, we now expect senior debt prepayments in 2017 in the $13 million to $17 million range, with a year-end 2017 leverage ratio of approximately 3.6 times.

Now turning to cash flow, cash generated from operating activities totaled $16 million from second quarter, compared to $18 million a year ago. Finally, as described in today's press release, we've revised our constant currency sales guidance for the year.

Based upon year-to-date sales performance, we now expect 2017 constant currency sales growth in the range of 2% to 3%, an increase from the prior guidance of 1% to 3%. Through the first two quarters of the year, our constant currency sales growth is 3.3%.

Our updated guidance reflects that both Q3 and Q4 2017 have one less selling day versus the prior year quarter, which creates the potential 1.6% headwind in the second half of the year. Foreign currency rates overall have moved favorably during the quarter.

As we've discussed in the past, we utilized a rolling hedging program to mitigate the short-term negative or positive impact of exchange rate changes. The hedging program somewhat delays the benefit of currency changes and a weakening U.S. dollar environment. In general terms, we hedge approximately 35% of local currency sales value.

Our local currency expenses provide a natural hedge such that we achieve a combined 75% hedge of our earning exposure. At this point of the year, we're fully hedged for 2017 and for a portion of 2018.

Based on exchange rates as of July 21, 2017 and inclusive of our hedging program, the negative impact to full-year 2017 sales from foreign exchange is now expected to be approximately 25 basis points versus our prior estimate of 50 basis points.

This estimate equates to a $1.9 million unfavorable impact to full-year 2017 reported sales versus 2016, compared to our prior estimate of $3.8 million unfavorable impact.

Given our hedging program in 2017 earnings impact of this change in foreign exchange rate is minimal and as a result we continue to expect adjusted diluted net earnings per share in the range of $1.85 to $1.95.

The adjusted diluted net earnings per share estimates for 2017 exclude the cost of special items, including acquisition costs, legal matters and restructuring costs, which are still estimated in the range of $16.5 million to $18.5 net of tax and amortization of intangible assets, which are still estimated in the range of $12 million to $14 million net of tax.

And now, I would like to turn the call back over to Amanda for Q&A..

Thank you. And our first question comes from the line of Richard Newitter of Leerink Partners. Your line is open..

Hi, guys. Thanks for taking the questions. So I just wanted to start maybe with the P&L.

The gross margin, Luke, I would like to get a clear understanding just of when you say mix, is that a geographic mix impact or if it's a product mix situation, can you elaborate on that and touch? And then just secondly, it's great to see kind of growth improving internationally, congrats on that.

But the operating leverage in the model is not moving quite in lockstep with the sales growth. I think you've said in the past there's a bit of a lag of consecutive quarters of growth, so that you would need to generate operating leverage.

So sitting where we are in the first half, what can you tell us about the cadence of operating leverage we should expect as we move through the year? Thanks..

Sure, Rich. Let me start with the first part of the question. We had about 40 basis points of mix and that was split evenly between our domestic business and our international business. So the way to think of that is 20 basis points in each location. And outside the U.S., it's a combination of product as well as geography outside the U.S.

And in the U.S., it's product. As you may recall, we had about 10 favorable basis points of mix in the first quarter, and I would say what we saw in the first quarter was within the normal variation you see in the business. As far as leverage, I think what we're looking at is largely a function of gross margin.

And in my prepared comments, I laid out with specifics how we see gross margin unfolding for the year. And I think for a couple of quarters now, we've talked about how the first half of the year would be lower than normal. I think as we exit the year, as I said in the 56% range, I think we'll start seeing the leverage that you're looking for..

Okay.

So maybe even one more quarter, operating leverage doesn't quite manifest, but really the fourth quarter, we should really start to see kind of the operating leverage materialize, is that fair?.

Yes, I think that gross margin will drive a lot of the operating leverage in the short run. And as I've laid out, we'll be improving the third quarter, but even more so in the fourth quarter..

Okay, great. And then for you, Curt, your R&D is stepping up nicely and that's always been kind of the longer term goal of yours. And I think you said you're on track to launch at least 20 new products by year end now.

So maybe, can you talk to us about some of the products that you're more excited about, have you seen any contribution at all yet, or is it all still out in front of you from the ones you have launched, and how many should we expect and in which quarters? Thanks..

Yes, obviously, I've said from day one, the transition – the transformation at CONMED is first about people and then letting those people step into the role, evaluate and make the changes that are necessary, and innovation would follow, products would follow.

And at the beginning of the year, I kind of laid out our history of product introductions and said that we would get 20 of them out the door this year.

And through six months, we've put 14 out in front of our customers at various tradeshows starting at Akademie and then SAGES and then more recently at DDW, Digestive Disease Week, which is a big show in the GI space. And if you look at what we've put out, I'm obviously excited.

I've said about what's going on in orthopedics and how those new products matter to the sales team on a global basis earlier. We've not had a lot to – of exciting new products and we think we did a good job at Akademie. And obviously, we're still in the early innings on that in terms of results.

But we're pretty excited about what we're seeing, the market enthusiasm, candidly it starts with sales force enthusiasm and I've seen a lot of good feedback on a global basis from some of the new products.

Really impressed with what we're doing so far in CuffLink, just picking-up steam that's been out now for one year effectively and really seen the quarter-over-quarter impact, and that coupled with some of the things we did on the shaver family, really starting to address the issues that have been long-standing for our company.

Looking at the rest of the portfolio, we're on track for the 20, at least 20. We're obviously pushing the teams for more and I feel good about the investments in the market here of what they are driving. Obviously, adding to that is the M&A piece.

We've had a small acquisition that closed at the very beginning of this quarter that fits into orthopedics and the knee space. Its proprietary peak shape memory polymer, goes into the $500 million global ACL soft tissue fixation market. It's candidly a gap in the offering.

So another nice GAAP filler for us, it gives our sales force a reason to call on that customer with something new, and it ties in nicely with the GraftMax and MTF portfolio that we already have there. So those type of things are important, just as well as the bigger things and we're excited by both sides of it..

Thank you. And our next question comes from the line of Matt O'Brien of Piper Jaffray. Your line is now open..

Hi, good afternoon. This is JP in for Matt. Thanks for taking the questions and congrats on the quarter. I had a couple, I just want to circle back to the gross margin side, just obviously the guidance you've given for kind of a back half ramp.

And in the past, you guys have talked about kind of eliminating lower gross margin, SKUs, and ramping up kind of utilization in terms of the capacity you have right now.

How much is baked – how is just the cost kind of side of things versus just the revenue continuing to accelerate on the fixed costs in the back half for your assumptions?.

Yes, JP, I'd say at this time we're getting very little leverage from the topline growth, because topline growth really hasn't been that significant to-date. So, a lot of what we are benefiting from is a lot of the plan consolidation work that we've done in the past.

But, also as I've talked about on previous calls, we spent a substantial amount of effort looking at the procurement side of the business and reducing our raw material costs, which is a large component of our overall cost to sales. So, I think it's a combination of really a lot of the cost savings activities that we've completed.

As I look forward, and as I've talked about in the past, over the longer-term, I think we have great opportunity to get gross margin leverage to start to get the topline moving on a regular and sustained basis..

And just to add on to Luke's comment, that topline movement really impacts the manufacturing/gross margin in future periods, because it's not immediately recognized.

And some of that gross margin degradation in the first half of the year is a result of unfavorable absorption that occurred last year in the fourth quarter and early this year, as we had to go back about ramping manufacturing back up.

So, as we've kind of sunset that and we've got a couple of quarters now under our belt, with a little bit of a growth on the topline and work that through manufacturing, you'll start seeing some of that come back through gross margins..

Got you. And then back to the – on your guidance, you raised the bottom end of the organic target. Is that really, just given our performance of ortho? And then as we think about obviously, you have a tougher comp in Q3, but Q4 you'll probably be exiting closer to the 3% to 4% organic range, when you normalize for the selling day you talked about.

Is that the right way to frame up 2018? Is it kind of a 4%-ish, is that a good target to start with?.

I think, when we looked at guidance, we recognized that through six months we're at 3.3 constant currency, two less selling days, as Luke commented, is about 1.6 growth points. Factors that had us comfortable pulling the bottom up, number one, are international.

Our international business has been on a consistent trend for five quarters in a row, growing both General Surgery and Orthopedics. And this quarter, constant currency was 4.7. Year-to-date, there are at 4.3, so that's on the higher end of where we are. Obviously, we're encouraged by what's happening in Domestic Orthopedics.

They've got more work to do in the second half of the year, and I'm not going to promote that until we see the actual numbers, because it's about new products, it's about sales execution. And the Domestic General Surgery business, which is made up of a couple of different businesses, has been performing well and we need to see those trends continue.

So, those are kind of all the factors that we put on the table when we talk about pulling the bottom end up. Relative to 2018, we're probably not going to talk about that yet, we're not ready to offer guidance on that. We want to finish 2017 before we venture forward on that..

Thank you. Our next question is from the line of Matthew Mishan of KeyBanc. Your line is open..

Good afternoon and thank you for taking the questions. Hey, Curt, I just wanted to go with AirSeal with a question, as it relates to the growth that we're seeing from Intuitive Surgical.

I know you don't want to comment directly on what AirSeal is growing at, but how should we be thinking about – I guess if Intuitive's procedural volumes are growing in that mid-teens rate, but how should we think about AirSeal's growth rate in relation to Intuitive's?.

I would say a couple of things. Number one, we don't have 100% coverage of every Intuitive robot out there. But obviously if they're growing mid-teens on a procedure basis, it's a very good proxy for what we should be growing in those accounts, keeping in mind AirSeal would not be used in every single Intuitive surgical procedures.

There are some procedures where it's applicable, there are some procedures where it's not applicable, and I don't have that exact data in front of me. But it's a relatively decent proxy and I would just say we continue to be encouraged overall about AirSeal. On an absolute revenue basis, it's our best quarter since we've owned it.

And as I came into the year saying we are at early stages in international and international is doing a great job with AirSeal. And you're always going to have those two components, there's the capital and there's the single use, and as long as we see the single use volumes continuing to trend higher, that's a good proxy for utilization.

And you're going to have ebbs and flows on capital sales. That's just the nature of the marketplace we are in. So we're really focused on utilization, we are really focused on expanding into the low impact side, those things take a little bit of more time. But we remain pretty bullish about AirSeal six quarters in..

Okay.

And then, as AirSeal becomes a larger piece of the overall portfolio, how should we think about that in relation to your ability to drive gross margin improvement, is it – given the mix?.

Well, obviously, I think going back to when we originally did the acquisition, we set out a target of gross margin of 58% to 62%. And I think we said, we ended last year kind of right in the middle of that, and added volume and the growing influence of the consumables both tend to do positive things for the gross margins.

So it's – the more AirSeal we sell, the more additive it is to the gross margin. Now, we've said all along that there is additional portfolio items that should be pulled along over time. The Synergy sale, if you will, and we still believe that to be true and we continue to see more signs of that.

The General Surgery category has gross margins that are accretive to the overall company average. So whether it's more AirSeal or more General Surgery, it's overall additive, and both of those are good things..

Thank you. Our next question comes from the line of Mike Matson of Needham & Company. Your line is open..

Hi, thanks for taking my questions. I guess, my first would just be regarding margins, and I know there's been a couple of similar questions asked, but I guess I'm thinking kind of a longer term perspective on things. So, you've talked about your margins being below your peers and I know the focus on getting the revenue growth up.

But now that, you seem to be on track with that part of the story, I'm just wondering, to drive the margins higher to close that gap with your peers, is that really about just simple leverage growing revenues faster than some of your fixed costs, or are there real opportunities to kind of take out some costs.

You know, actively cut costs both from a COGS and SG&A perspective over the longer run obviously, I'm not talking about the second half of this year?.

Yes, Mike, what I'd point to is a slide that's in our investor deck. So, over the last two and a half years, when our topline has been sort of flat, absent currency which unfortunately had a substantial unfavorable impact across over the last three years. We increased EBITDA margin by roughly 350 basis points and that was on a flat topline.

When I think of the long-term potential of business, I think of three things. First is, we as a company have always done a pretty good job of taking cost out and we'll continue do that. Number two, we really need to pivot from some of our lower margin legacy products, to products like AirSeal.

And I would say, as of today, we're doing a good job there and we need to continue to do that.

And beyond that, we're taking cost out in an environment where our topline was shrinking, I think to the extent we get the topline increasing on a regular basis, that will give us great opportunity to get operating leverage, not only with gross profit line, but also on the SG&A line..

Mike, I would just add to that, just as a reminder, we came into the year and said that we were going to continue or start making some investments into our manufacturing environment, that would be detrimental to the gross margins and the benefits would not be realized for -- until future period.

So, 2018 and beyond, and we've been doing those and we talked about things like SKU rationalization purchasing, but there is other factors inside the four walls that can drive cost out of production areas that our team has been aggressively focusing and prioritizing.

In addition, there is the other side, which is on the sales channel side, specifically in some of the international markets, where we've had to go about rationalizing the distribution channel, whether it's a direct market or export, and going to bigger distributors versus having a bunch of distributors, let's consolidate into a couple of larger distributors who can do a better job representing the portfolio.

And that work doesn't happen as you referenced, it doesn't happen in one quarter, two quarters and it occurs over time. I will give you a real example, I was -- actually I guess it was just last week, I was with our team in Europe, and we were talking about the export portion of Europe.

And three years ago, when I started, there were 72 distributors in the export portion of Europe, which covered Middle East, North and South Africa. Today that number is down under 40 distributors.

So, we've eliminated 30 distributors, but the 40 distributors that remain are larger distributors, have more bandwidth, we have better relationships with them. And those things are all beneficial to the financial profile of the company over time. So those – it's a number of initiatives that we're going to drive.

We are not sitting here waiting for topline to improve. We're driving everything to try to get a better financial profile for the company..

Okay, thanks. And that kind of leads into my next question really just on the international business, I heard of some commentary around the direct markets, but how are those distributor markets doing, I guess? I know there were some issues there last year..

Yes, I think all in all they are better, they are stable. They are far more stable than we experienced in the first 18 months to 24 months. In the second quarter, we had, let's just call it a sudden resignation of a distributor that impacted sales.

But we were in a position to take that business direct and you'll start seeing the benefit of that business being direct in the second half of the year. I think more than anything, we weren't trying to hide a problem with the export market.

We were trying to highlight that some of our direct markets are doing really well in the overall grand scheme of international, specifically Europe. The team is a great team, they are really focused on the customer, really doing nice things with new products.

Our Asian team is doing a great job, our Australia, New Zealand team, a big important market for us, had a great quarter. So we're really trying to highlight those places that have really gotten in front of it with new products and with customers..

Thank you. And at this time, I'm showing no further questions. I'd like to turn the call back over to Mr. Hartman for any closing remarks..

Okay. Well thank you, Amanda and thank you everybody for joining us today. We appreciate the time you've invested in CONMED and hope that the update here was beneficial. We look forward to speaking with you on our next earnings call, which will be held on November 2, 2017. Thank you, and have a good day..

Ladies and gentlemen, thank you for your participation in today's conference. This does conclude the program. You may now disconnect. Everybody, have a great day..