Artivion Inc (AORT) 2005 Q2 法說會逐字稿

Good morning, ladies and gentlemen, and welcome to the CryoLife second quarter 2005 conference call. [OPERATOR INSTRUCTIONS.] It is now my pleasure to introduce your host, Mr. Steven Anderson, CEO. Sir, the floor is yours.

Good morning, everyone. This is Steve Anderson, the CEO of CryoLife, and I would like to welcome you to CryoLife's second quarter '05 conference call. With me today is the Company's Executive Vice President, Chief Operating Officer, and Chief Financial Officer, Ashley Lee. This morning we announced the Company's operating results for the second quarter and the first half of this year. Our second quarter results coincide with the guidance that we gave at the end of the first quarter, where we indicated that we felt that the Company would move sideways for a quarter or two.

However, based on the results of the second quarter, I'm pleased to confirm that the corporate recovery that began in the fourth quarter of '04 continued into the second quarter of this year, with revenues for the second quarter of '05 increasing by 12% over the second quarter of '04. After excluding the impact of settling the securities class action and change in value of the derivative, the adjusted loss for the second quarter of '05 was $1.7 million, or $0.08 per share, in comparison to a net loss in Q2 '04 of 3.4 million, or $0.14 per share. Revenues for the first half of '05 were 34.9 million, which is a 15% increase over the same period of '04. After excluding the impact of settling the securities class action and the change in value of the derivative, the adjusted loss for the first half of '05 was 3.2 million, compared to a net loss of 10.4 million in '04. The adjusted loss for the first half of '05 was $0.15 a share, in comparison to a net loss of $0.46 a share in '04. The Europa subsidiary did particularly well, with an Q2 increase in revenues of 27%, and an increase of 22% for the first half of the year, with net sales being 4.2 million for the first half of this year.

At this time, Ashley will review this morning's earnings release and will comment on the Company's financial progress for the first half of the year.

Thanks, Steve. To comply with the Safe Harbor requirements of the Private Securities Litigation Reform Act of 1995, I would like to make the following statement. Comments made in this call which 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, or predictions of the future. All statements made during this conference call that do not reflect historical results or information should be deemed to be forward-looking statements. It is important to note that the Company's actual results could deliver materially from those projected in such forward-looking statements. Additional information concerning risk and uncertainties is contained from time to time in the Company's SEC filings, including the Risk Factor section of our Form 10-K for the year ended December 31, 2004, and subsequent SEC filings.

This morning CryoLife reported financial results for the three and six months ended June 30th, 2005. During our last conference call we communicated that, by and large, we expected to move sideways during the second quarter of this year compared to the first quarter. Excluding the settlement of the class action lawsuit and the charge associated with our preferred stock derivative, our results are pretty much in line with those expectations. Total revenues for the quarter ended June 30, 2005 were 17.2 million, compared to 15.3 million in the corresponding period in the prior year, representing an increase of 12%. Total revenues for the six months ended June 30, 2005, were 34.9 million, compared to 30.4 million for the corresponding period in 2004, representing an increase of 15%. The net loss in the second quarter of 2005 was 14.4 million, or $0.61 per basic and diluted common share, compared to a net loss of 3.4 million, or $0.14 per basic and diluted common share in the second quarter of 2004.

Excluding the $11.8 million charge associated with the settlement of the shareholder class action lawsuit and the $900,000 charge related to our preferred stock derivative, the adjusted loss in the second quarter of 2005 was 1.7 million, or $0.08 per basic and diluted common share. The net loss for the six months -- first six months of 2005 was 15.7 million, or $0.68 per basic and diluted common share, compared to 10.4 million, or $0.46 per basic and diluted common share in first six months of 2004. Excluding the $11.8 million charge associated with the settlement of the shareholder class action lawsuit and the $784,000 charge related to our preferred stock derivative, the adjusted loss in the first half of 2005 is $3.2 million, or $0.15 per basic and diluted common share, in comparison to $0.46 per basic and diluted common diluted share in the first half of 2004.

BioGlue revenues were 9.6 million for the quarter ended June 30th, 2005, compared to 9 million in the corresponding period in '04. BioGlue revenues in the second quarter increased 7% over the second quarter of 2004. BioGlue revenues were 19.4 million for the six months ended June 30, 2005, compared to 17.6 million in the corresponding period in 2004. BioGlue revenues for the first six months increased 10% over the corresponding period in 2004.

Tissue processing revenues were 7.4 million in the second quarter of 2005, compared to 6.1 million in the second quarter of 2004. Tissue processing revenues in the second quarter of 2005 were up 21% as compared to the second quarter of 2004. Tissue processing revenues were 14.9 million for the first six months of 2005, compared to 12.3 million for the first six months of 2004. Tissue processing revenues for the first half were up 21% as compared to the corresponding period in 2004.

Cardiac revenues were 3.5 million for the second quarter of 2005, compared to 2.8 million in the second quarter of 2004, an increase of 24%. Cardiac revenues were 7.3 million for the first half of 2005, compared to 6.3 million in the first half of 2004, an increase of 16%.

Vascular revenues were 2.7 million for the second quarter of '05, compared to 2.6 million in the second quarter of '04, an increase of 3%. Vascular revenues were 5.5 million for the first half of '05, compared to 5.1 million in the first half of '04, an increase of 6%.

Orthopedic revenues were 1.1 million for the second quarter of '05, compared to 574,000 in the second quarter of '04, an increase of 91%. Orthopedic revenues were 2.2 million for the first half of '05, compared to 883,000 in the first half of '04, an increase of 145%. For a more detailed discussion of the factors driving revenues, please refer to our Form 10-Q for the second quarter of 2005, which we expect to file prior to the end of this week.

Total gross margins in the second quarter of 2005 were 53% of total product and service revenues as compared to 38% in the second quarter of 2004. Total gross margins in the first half of 2005 were 54% of total product and service revenues as compared to 32% in the second quarter of 2004. Total gross margins increases resulted primarily from an increase in tissue processing gross margins during 2005 as compared to 2004. Gross margins for tissue preservation services were 17% in the second quarter of 2005, compared to a negative 25% in the second quarter of 2004. Gross margins increased as a result of certain increases in average service prices, and increases in tissue yields. Gross margins decreased from the 22% posted in the first quarter of 2005, primarily due to a slight decrease in tissue processing yields. Gross margins on tissue preservation services were 20% for the first half of 2005 as compared to a negative 36% for the first half of 2004.

We expect an improvement in gross margins on tissue processing services in the second half of the year. The extent of the improvement will depend upon the results of our ongoing process -- processing improvement initiatives and the continuation of the recent improvement in our procurement trends.

General, administrative, and marketing expenses were 21.6 million for the second quarter of '05, compared to 9.7 million in the second quarter of '04. Excluding the $11.8 million charge related to the settlement of the class action litigation, general, administrative, and marketing expenses were 9.8 million in the second quarter. General, administrative, and marketing expenses were 31.6 million for the first half of '05, compared to 19.8 million in the first half of '04. Again, excluding the $11.8 million charge related to the settlement of the class action litigation, general and administrative expenses were 19.9 million in the first half of 2005. You should refer to our SEC filings for more detailed discussions of factors affecting our results of operations.

We have eight outstanding product liability cases right now, which is consistent with our case load at the end of the first quarter of this year. We have recorded unfunded balance sheet reserves of $933,000 for known product liability lawsuits and claims that remain open. This amount represents our best estimate of these costs to resolve the known product liability litigation and claims. These reserves will be reviewed periodically and may decrease or increase in the future based on our experience.

Additionally, we have an unfunded reserve of $8 million for incurred, but not reported, product liability losses, offset by 2.3 million in estimated insurance recoveries, representing a net liability of $5.7 million. This amount has decreased from 6.5 million at the end of the first quarter of this year. These reserves will also be reviewed periodically and may decrease or increase in the future based on our experience. The SEC investigation is still ongoing, and we have no idea as to when it will be concluded. Again, you should refer to our SEC filings for detailed discussions of outstanding litigation.

During the second quarter, our cash balance decreased from 26.1 million at March 31, 2005, to 22.1 million at June 30th. This balance does not reflect the approximately $8 million net of insurance proceeds we expect to pay later this year related to the settlement litigation. Our cash and marketable securities balances decreased approximately $4 million during the second quarter of this year, compared to a decrease of 1.3 million in the first quarter of this year. These amounts exclude the proceeds from the preferred stock financing.

The change in the cash usage results from timing differences between when payments were made between the first and second quarters. Absent these timing differences, cash burned for both the first and second quarters of this year were comparable, that is, between 2 and $3 million. We would expect that number to decrease as our top line continues to recover, as we expect it to. Of course, this does not take into account any non-operating uses of cash, such as the settlement of the securities litigation.

In March and April of 2005 we completed an offering of 417,000 shares of 6% convertible preferred stock at $50 per share, resulting in net proceeds of approximately $19.1 million. Upon any conversion of the preferred stock, we are obligated to pay the preferred shareholders all unpaid dividends that would have accrued through April 1, 2008. This is referred to as the dividend make-whole payment. The dividend make-whole payment feature is considered to be an embedded derivative, and, therefore, we have recorded a current liability on our balance sheet to reflect the fair value of the derivative. We will recognize future fluctuations in the fair value of this derivative as non-operating income or expense in our statement of operations. Additionally, upon any future conversions, we will have to take a non-cash non-operating charge for a portion of the dividend make-whole payment not previously accrued. The total of all charges associated with the derivative was approximately $900,000 in the second quarter of 2005.

Now, I'll turn it back over to Steve.

Thank you, Ashley. A few weeks ago we announced that we had commenced a collaborative research effort with the Magdi Yacoub Institute that is affiliated with the Imperial Hospital in England. The purpose of this research collaboration is to further our development of the SynerGraft technology in both xenograft and allograft tissues. This agreement is for three years, and the Company has the commercial rights to any marketable technology that evolves from this joint research effort. One aspect of this research involves the use of bone-marrow-derived mesenchymal stem cell technology in the development of a tissue engineered heart valve. Professor Yacoub is widely regarded as one of the premier cardiovascular surgeons in the world, and is considered an expert in both surgical techniques of cardiac reconstruction and tissue engineering.

For more information on the collaboration with Professor Yacoub's research institute, we would like to refer you to the film on the Yacoub Institute that is on our Company's website. In this film, Professor Yacoub discusses his results in using bone-marrow-derived mesenchymal stem cell technology in his efforts to develop a tissue engineered heart valve. Management believes that CryoLife is the only cardiovascular medical device Company pursuing a bone-marrow-derived mesenchymal stem cell implantable heart valve. Management believes that this technology, when fully developed, could possibly be used for vascular grafts, as well as for cardiac conduits. For your own personal copy of the Professor Yacoub DVD, you may call or write to Investor Relations at the Company.

The collaboration with the Yacoub Institute followed the development of the SynerGraft Model #100 AV Access device that is available overseas, and that had been going through a clinical evaluation at Oxford University for the past two years under the direction of Mr. Christopher Darby, a vascular and transplant surgeon at Oxford. Mr. Darby's group presented a paper on 25 implants of the Model #100 AV Access device over a three-year period at the European Vascular Society meeting that was held in Berlin, Germany in early May of this year. The Model #100 SynerGraft AV Access device has been implanted in about 300 people since 2001. Based upon an analysis of the few grafts that have been removed from patients, the Model 100 AV Access device will remodel in vivo with the patient's own cells. This graft is an unfixed graft, and management believes that it is the first successful tissue transplant of unfixed animal tissue into a human recipient without the use of immunosuppressant therapy.

For more information on the Model 100 SynerGraft AV Access device, you may view the vascular film that is on the Company's website. This film includes an interview with the implanting surgeon, Mr. Christopher Darby, and the first patient who received an implant of the SynerGraft Model 100 AV Access device about three-and-a-half years ago. If you wish to have your own personal copy of the SynerGraft AV Access DVD, you may call or write to CryoLife's Investor Relations department.

To reflect the Company's increasing focus on developing international markets and the introduction of our newest technologies in international markets, we have reorganized the Company's international activities under one new department. In July we announced the consolidation of all of the Company's international distribution under the umbrella of the International Operations Department. The person responsible for all the international operations of the Company will be Jerry Seery, who has been with us for 13 years in various marketing and executive positions, and who, for the past three years, was the President of CryoLife Europa.

Management believes that the international arena is a growth opportunity for the Company and a market that will continue to be receptive to the Company's innovative new ideas and technologies. Our international business increased 21% year-to-year in the second quarter, and we intend to capitalize on this growth. One international success story is BioGlue, which has a much broader approval in international markets than it does in the U.S. In international markets BioGlue is approved for dura mater sealing and other soft tissue repair, in addition to its many approvals for cardiovascular and vascular repair. The Company intends to focus much of its new product development efforts in the international arena.

The in-line products and the products under development that we market or intend to market in international markets include certain allograft tissues; the CryoLife O'Brien Stentless Porcine Heart Valve; the SynerGraft Model 100 AV Access device; BioGlue surgical adhesive; BioDisc, a nucleus pulposus replacement device; BioFoam, a surgical sealant; and BioDisc, BioFoam, and BioLastic are development-phase products at this time. At this time BioGlue surgical adhesive revenues account for about 90% of international sales, with 2% being the Model 100 AV Access device, and the balance being the CryoLife O'Brien Stentless Porcine Heart Valve and certain allograft tissues.

Within the last month we have added a cardiovascular distributor in India. India has about 60,000 cardiac surgeries a year, and we would expect our products for cardiac reconstruction -- BioGlue, the CryoLife O'Brien Stentless Valve, and certain allograft cardiac and vascular tissues -- to be marketed there. We have also recently added a distributor in Russia. Soon we will be seeking a sales manager to direct our sales efforts in South America and Latin America. And at this time, we are evaluating our distribution alternatives in China.

It was announced last week that CryoLife management has agreed, in principle, to the settlement of the derivatives securities lawsuit. Management believes that the settlement of this lawsuit, which was covered by the Company's insurance policy, removes an area of uncertainty that has surrounded the Company since 2002. This settlement has to be approved by the Court, and we expect their approval sometime within the next few weeks.

Last week we also announced that we had reached an agreement to settle the shareholders' class action lawsuit that was filed in August, September of '02. The settlement includes Company common stock, cash, and insurance funds, and totals about $23 million. For more specific information on this settlement, please refer to the Form 8-K that you can find on our website. The settlement agreement has to be put into its final form, and it also has to be approved by the Court before it can become final. We expect this to take 60 to 90 days.

We submitted our four-year implant data follow-up on 291 patients that have received SynerGraft processed human pulmonary and aortic valves to the FDA on June 2nd. We continue to wait to hear from the FDA regarding our 510k application for SynerGraft processed human valves. We hope to hear by the end of the third quarter, but have no control over when the FDA will respond. Only after approval will we begin processing human valves using the SynerGraft technology. If we receive approval by the end of Q3, we would expect to begin our ramp-up for SynerGraft processing in the -- in the fourth quarter. We would expect to publish our four-year implant data for SynerGraft processed human heart valves after approval. You will be able to access these results on our website at that time.

Other FDA initiatives that we have discussed in the past are as follows -- First, we are still on schedule to submit an IDE for BioGlue's use in the sealing of tears or holes in dura mater by the end of the year. You'll recollect that BioGlue was approved in international markets for sealing dura mater during neurosurgical procedures. There is extensive clinical data available documenting these implants, as well as a number of medical papers presented by surgeons around the world. The submission date for the PMA Supplement and the CE Mark for the BioGlue 10-milliliter syringe are now scheduled for October 5th. With a real-time review of this submission, we might receive approval before the end of '05. However, if we do not receive a real-time review, then we believe it will likely enter the market in the first quarter of '06.

The BioGlue spreader tip approval is now scheduled for late '05, early '06. This schedule slipped somewhat due to a material change in one of the plastic components. Although this change is minor, we had to redo the validations for the change of the material.

During the quarter we received notice that the United States House of Representatives has approved an appropriation for $1.8 million for the further development of BioFoam for use in trauma. This funding will be available for product development during calendar '06. As you'll recollect, we received an initial appropriation from the House last year for BioFoam development that totaled $1 million, which will be available to us in this year.

The validations of the orthopedic tissue preserved by the high dose of radiation process have been completed. We began distributing orthopedic tissues that have been treated with high dose of radiation in May of this year. We have completed our sterilization validation of this process, and anticipate labeling these grafts as sterile beginning in early August.

That concludes my remarks, and now I'll turn the call back to Ashley, who will provide some forward-looking guidance.

Thank you, Steve. I'd like to give some guidance for the remainder of 2005. Overall, we expect that our business will be somewhat up in the third quarter as compared to the second quarter. We expect a recent improvement in procurement trends, combined with certain processing improvement initiatives, to positively affect our revenues and margins in the second half of this year. For the third quarter, we believe that total top-line revenue will be in the range of 17 million and $18.6 million. For 2005, we expect full-year revenues of between 70 million and $73 million.

We expect BioGlue revenues for the third quarter of 2005 to be between 9.4 and $10 million. For the full year, we expect BioGlue revenues of between 39 and 40 million. We expect tissue processing revenues for the third quarter of 2005 to be between 7.3 million and $8.3 million.

For full-year 2005, we expect tissue processing revenues of between 30 and 32 million. The expected increase in tissue processing revenues during the second half of 2005 results from increases in procurement that we have begun to realize during the early part of the third quarter. We expect that tissue processing gross margins will improve during 2005. We are working on initiatives that are scheduled to be implemented in the second half of the year. We believe that they will have a positive affect on our future gross margins. We also expect a recent improvement in procurement trends to have a positive effect on margins.

We expect general, administrative, and marketing expenses to be between 10 and $11 million for the second quarter. For the full year of 2005, we expect general and administrative expenses to be between 52 and 54 million. These amounts do not include any favorable or unfavorable future adjustments that may be made to address product liability claims or other litigation. R&D expenses are expected to be approximately 1 million for the third quarter. For the full year of 2005, we expect R&D expenses to be between 4 and $5 million.

In the future, we will be giving guidance only on full-year revenues, updated quarterly. We will not be giving specific guidance on gross margins, G&A expenses and R&D expenses. We will attempt to keep you updated on significant corporate developments that are likely to affect the outlook for the Company, but can make no guarantee that we will, in fact, be able to identify and communicate such factors to you on a timely basis. We do so because we wish to mitigate the risk associated with giving more detailed guidance.

That concludes my comments and I will turn it back over to Steve.

At this time, I'll open up the conference call for questions.

Thank you. [OPERATOR INSTRUCTIONS.] Our first question is coming from Raj Denhoy with Piper Jaffray. Please go ahead.

Great. Thank you. Just a couple of questions, actually. I noticed, pretty much across the board, you guys lowered your guidance for the full year a little bit. BioGlue is down a little bit from what it was coming out of the first quarter, as well as tissue. I'm curious to know if there's anything we should be reading into that or if this is just sort of fine tuning of estimates? I don't know if you have any more comments right around that.

I think it's really fine tuning of estimates, Raj. Some of the process improvement initiatives are taking a little bit longer than -- than we had anticipated. And some of the procurement trends and improvements took a little bit longer than we anticipated, too. As you recall, in previous conference calls we had mentioned that, over the past couple of years, we had intentionally limited incoming procurement while our yields were so low, and it's taken a while to get those programs back started again. But I don't think there -- it -- I think if you look at the -- the guidance as a whole, it's still a marked improvement over the previous year. We expect that the trend will continue to be an improving top line and an improving gross margin, and we expect that trend to continue out to 2006. It's just taking a little bit longer than we had anticipated.

Okay. Maybe I can drill down just a little bit on BioGlue. It was up only, roughly 7% in the quarter, which was a little lower than we've been expecting. Can you maybe comment on what price was versus units in BioGlue for the quarter?

Yes. Of the 7% increase for the second quarter, the majority of that 7% increase was pricing, as opposed to volume.

Okay. So it looks like the volume trends, obviously, are sliding a little bit. Is there something -- is there -- is it a competitive issue? Or what's going on with that business right now?

I think it really centers around the fact that the introduction of the 10-milliliter syringe has been delayed somewhat. It -- the present cartridge and gun aren't particularly easy for the physician to use. And a lot of the volume of BioGlue has been switched to the 2-milliliter, 5-milliliter syringes. The 10-milliliter syringe gets introduced later in this quarter or into the fourth quarter. I think you'll see that -- that volume expand again. And, also, although the spreader tip sounds like a small improvement, it actually will be a very big improvement. And I expect that to result in better sales in BioGlue, because it's going to make it easier for the surgeons to apply the glue and keep it where they want it to be when they're sealing suture lines.

So, I guess, is it fair to say, the acceleration of the back half of the year -- ? Sorry, go ahead.

It's just, basically, a timing issue, I think.

Yes, that's what I was going to say. So it's fairly safe to say that the acceleration you guys are looking at for the back half of the year to make the guidance is pretty predicated on these two products getting out -- the spreader tip as well as the 10-milliliter?

Yes.

Okay.

Yes, I'll point out one other thing, Raj, too. I think if you look at the BioGlue revenues over the last couple of years, you will see that the fourth quarter -- you'll see that -- that BioGlue revenues have begun to accelerate in the fourth quarter of the last two to three years. So we're hoping and expecting that trend to continue, also.

Okay. Fair enough. And, then, just one on the tissue, and I'll get back in line. I guess tissue gross margins declined a little bit sequentially, to 17% in the quarter. It sounds like some of the processes you guys have in place, or are planning to put in place, didn't get there, but we'd seen a nice trend up in this quarter, and then it dipped here a little bit. What can we really look for towards the back half of the year? I mean, do you think it gets back on the same trajectory it was? Or, maybe, you could give us a little bit of guidance there?

There were some delays in getting some of the processing improvements implemented. We had indicated at the end of the last -- at the last conference call that we expected the margins and the business, essentially, to move sideways during the second quarter and -- and even though the tissue processing gross margins were down to 17, from 22%, we really don't view that as a significant step backwards in any given period of time, especially, a short period of time. Our yields can fluctuate, but we're really not concerned about this decrease that we saw in the second quarter. Going forward, in the third and fourth quarter, where do we expect the gross margins to be? We haven't given any specific guidance on tissue processing gross margins in the past, and probably not going to do it now. But I would expect the gross margins in the second half of the year would be equal to or better than what we experienced in the second -- in the first quarter of this year for tissue processing.

Okay. Maybe -- sorry, I guess, I will just ask one last question, then, I'll get back in line. It seems like profitability for you guys, at on a P&L basis is something that we could -- started to look very real. Have you guys given any thought to when we could actually turn the corner here?

Again, we haven't given any guidance on the bottom line, too. But if you look at the operations of the business, the last couple of quarters we've been, on an operating basis, somewhere around a $1.5 million loss, and that's been, on a revenue base, in the low 17 millions. And we think with the recent improvement in the our procurement trends and some processing improvement initiatives, we expect to make in the second half of the year, we think that the revenue guidance, albeit lowered, we think that it is certainly achievable for the second half of the year. And you can kind of guess as to what an $18.5 million revenue line, and hopefully moving into the early part of next year would -- revenues above that particular amount, what that could mean to profitability. So we're not going to give any specific guidance, but we're optimistic and hopeful that we can get there sometime in the near future.

Okay. Fair enough. I'll get back in line. Thanks.

Thank you. Our next question is coming from Keay Nakae with Unterberg. Please go ahead.

Yes. Just wanted to drill down a little deeper on the BioGlue sales. In the U.S., did you actually see a decline, then, sequentially as well? Or how significant of a decline, perhaps, in the U.S. from Q1?

We actually saw a sequential -- small sequential decline, I think, on the top line. But if you actually look at the number of units that were actually going out the door, they actually increased. And as Steve mentioned a minute ago, there were some delays in getting the 10-ml syringe out to the marketplace. And as a result, the people that were using some of the 10-ml cartridges were using 5-ml cartridges. So the actual top line might have suffered a little bit, but the actual units actually increased slightly. I don't have the specific numbers in front of me right now, Keay, but we can talk about that a little bit later.

Okay. And can you give us an update on your discussions at the FDA with respect to your vascular graft?

They're ongoing. I don't know there -- I don't really have anything to report at this time. As I said in my comments, we've submitted a lot of information to them on the SynerGraft Heart Valves, the human heart valves we've -- that been following over the last three, four years. And we're really just waiting for them to respond. I don't know if I can really expand on that at all. We are expecting to hear something, certainly, no later than mid-September.

And -- and that end point on that, Steve, why do you -- why do you think it's that data? Are they under a clock at this point? Are we really in, kind of, no man's land, here, as far as -- ?

They're not under a clock. They don't have to respond in any specific time frame. But just from what their standard response times have been to 510k applications, that's kind of a date that we've picked to expect to hear something from them.

Okay.

They may ask us for more additional data, which they have done from time to time. But as far as we're concerned, we've submitted everything that we need to for the completion of the 510k application.

Okay. And can you give us any initial feedback on the launch of the Clearant processed bone tendon bone graft?

The initial feedback that we're getting back from the physicians is really good. Just about everything that we had processed under the Clearant methodology during the second quarter we had shipped out. And just to give you some specifics for -- for our tendon business used in ACL reconstructions, about 30% of all of our units in May that we shipped out were Clearant processed, and about 25% in the month of June. And the reason that it was down is because we really were being very careful in the amount of tissue that we processed utilizing that method initially, until we could gauge what the market response was. But the market has seemed to be very accepting of -- of those tissues and enthusiastic about them, so we're in the process of ramping up our production of -- of tendons that actually go through the Clearant process.

Is the goal to have 100% of those treated that way?

I think we're going to let the market determine that. I think there're always going to be some physicians that might not want to use irradiated tissues. There seem to be a lot that do want to use them. So I think, ultimately, the market will determine what we do there.

And, then, as far as the sterilization claim, you mention that you're looking to do that, perhaps, sometime this month. Do you need any kind of FDA sign-off on that? Or just having completed the validation, you feel like you're in a position to go ahead and put that labeling on it?

We don't -- in order to -- to label a product sterile, you don't need to get the approval in advance from the FDA. Now, as part of our ongoing efforts with them, we voluntarily submitted a package of information to them prior to making a -- a sterile claim on -- on the labeling. So we're still in the process of working with them and waiting to hear something back from them. But it's not something that you really need in advance, but as a courtesy and in the spirit of cooperation with them, we voluntarily submitted that information, and we're waiting to hear back from them.

Okay. Great. Thanks.

Thank you. Our next question is coming from Raymond Myers with Emerging Growth Equities. Please go ahead.

Thank you. Actually, let me just pick up where Kay left off there about the sterility validation. Ashley, help me make sure that I'm understanding this correctly. You submitted a package of materials to the FDA. They have not yet provided a response to that package? Is that correct?

No, they haven't.

That's correct.

Okay. So when you say that you're planning on launching with a sterile label sometime in August, is that based on an expectation that they will get back to you? Or what is driving your change in labeling?

Well, we hope and expect that the information that -- that we sent to them would be adequate. And based on the timing of when we sent that information in -- and I'm not exactly sure when that date was, Ray -- we would hope to hear something back from them in the near future.

So basically you're hoping to hear back -- a favorable response from them in August, and, therefore, then you would go ahead and use the sterility claim after you hear from them?

We hope to, yes

Okay. All right. Good. And you have indication that you'll be getting a favorable response in August, obviously?

We just are expect -- we're just waiting to hear from them.

Okay. Great. Good. Back to the BioGlue, there was a small reduction, sequentially, in BioGlue revenue. Help me to understand why there was a reduction in revenue. We've had a growing trend for quite a while now. I know it's lumpy from quarter to quarter, but why the reduction in the second quarter?

I think it's basically a switching from the 10-milliliter cartridge to 2-milliliter and 5-milliliter syringes that carry a considerably lower price.

Even if -- so if they switch from a 10-milliliter to a 2-milliliter they wouldn't use two 5 milliliters, they would use fewer, is that the idea?

Yes. They might not have to use more than that. I mean, I think that a doctor's experience as they go forward in using the product is that less is probably better in most situations, and -- and, so, as they get used to the syringe product, it's easier for them to handle, it's easier for them to control the application of the glue. And it's perfectly understandable to me that they would -- they would end up probably being more efficient than they would be with the larger gun and cartridge.

Got it. So they were switching from a 10-milliliter in the gun to, now, a smaller unit in the syringe.

Yes.

I understand. Now, why wouldn't you increase the price of the product delivered through the syringe or is that not possible?

Oh, it's possible. We just made a decision not to do that. I think you're going to see that the BioGlue sales recover here when the 10-milliliter syringe is introduced because, of course, that will carry a much higher price than the 5-milliliter. So with that -- that introduction should take place in international markets more quickly than it would take place here, also. At least that's the way we're anticipating it to be.

Can you -- can you disclose to me what the price for a comparable 5-milliliter cartridge for the syringe versus 5-milliliter for the gun would be?

We don't have a 5-milliliter that fits the gun.

Okay. So give me the 10-milliliter gun and the comparable 5-millimeter syringe.

Yes, I don't have the price -- the pricing right off the top of my head, Ray, but I could get back with you on that.

Okay. That would be an interesting calculation for me on -- and I assume you'll be increasing prices in the future, so that provides some upside opportunity. When -- when do you expect the full launch of the OA femoral condyle allografts?

It's ongoing, as we speak.

That is, ongoing -- to give you a little bit of flavor for what happened in the second quarter, we generated about $200,000 in revenues from our OA program in the second quarter, and that's compared to $50,000 in the first quarter. So that program is still in the process of being launched. It is cryopreserved, as opposed to freshly processed. But we're still in the process of launching that program, and we are optimistic that we're going to be successful with it.

In the first quarter, Ashley, you had said that revenue was constrained by an on and off inventory issue -- that you were building inventories. Is that still the case, you're building inventories, is that a constraining factor?

For the OA program?

Yes.

No, we're actually -- we've got inventory on hand now. We're still continuing to process inventory. But one of the things about having cryopreserved OAs, as opposed to fresh OAs, is that when they were fresh, the doctors really had no choice in when a procedure was scheduled because the grafts really were not implantable after about a 40-day period. Now that they are cryopreserved, they have a much longer time frame in which to schedule surgery. So there's not as great a sense of urgency on the surgeon's part to schedule the implants on a -- on a very near-term time basis. So we've got -- we've got inventory on hand. We've got a lot of cases scheduled. And, again, we're optimistic that that program is going to continue to grow.

The trajectory from 50 million in the first quarter to 200,000 in the second quarter, obviously, is a steep ramp. What should we think about the trajectory as we move into Q3 and Q4?

I haven't given any specific guidance on that. If you look at our -- our overall guidance for our tissue processing program, the orthopedic piece of that, probably, we're guessing somewhere in the neighborhood of 2.5 to 3 million in the second half of the year, and OAs will be a part of that. So I don't think you're going to see it jump to 0.5 million or 0.75 of a million in any of the latter quarters of this year. I think you're just going to see a slow, steady progression of that program.

Okay. That helps. The quarterly preferred stock accrual was 244,000 in the second quarter. Is that where we should approximately expect that to be going forward?

For the derivative?

Or the preferred stock accrual. The derivative, I think, was 900,000?

Right.

What about the preferred stock? Is that now flat? I think the first quarter was probably, for a partial quarter, and this might be for the full quarter. Am I understanding right?

The preferred stock accrual? Are you speaking to the dividends or -- ?

Yes.

Yes, the dividends, it's 6% of the face amount of the preferred stock that's paid on an annual basis. So 6% of whatever the remaining balance is of the preferred stock, and divide that by 4, and that should give you a good estimate of what the dividend payout will be a quarter.

Okay. So it should be consistent and then declining.

Well, a lot of it depends, too, on whether any of the preferred shareholders convert their preferred stock into common shares. That will, obviously, decrease the amount of dividends that we pay on a quarterly basis going forward.

Right. There seemed to be a little improvement in the international revenue relative to the U.S. revenue was down a little sequentially. Is -- other than the strides you're making internationally, is there anything else we can read into that?

No, I don't think so. I just think that business is improving and going well. And we're going to have a continued -- more of a focus on developing our international business going forward, as I said in my comments.

Right. Okay. Good. Well, thank you.

Thank you, our next question Stephanie Haggerty with Register & Akers. Please go ahead.

Good morning.

Good morning, Stephanie.

How are you?

Good.

I wanted to ask a couple of questions. Now that we're starting to settle some of these shareholder suits, all this other litigation, is the legal cost component in the SG&A line going to go down? I mean, at what point are we going to see some relief? I'm sure you're looking forward to that, too, in your legal expense.

I would say probably in '06, Stephanie, we should probably be able to see some relief. There's still some tidying up that we have to do with some of the litigation that's ongoing right now. So I wouldn't expect any meaningful decrease in legal fees for the remainder of this year. I would expect to begin to see some relief starting in '06. To what extent --

Can can you quantify that?

It's hard to quantify at this point. It just depends on the timing of when some of these remaining things get wrapped up. But because of the fact -- I mean, the two shareholders items were significant items. With those gone and the case load and the product liability lawsuits decreasing, again, I would expect an improvement, but until we actually get some them resolved, I would hesitate to quantify what type of benefit we might see.

Okay. One other question, Ashley, just on the guidance -- and if my math is wrong, forgive me -- but you were estimating research expenses for the year at 4 to 5 million?

Yes.

Well, in the first couple of quarters it was $920,000-some --

Right.

-- and 1 million in the third, and to get to 5 million, we would have to have a fairly decent spike in research spending in the fourth.

Right.

Is that possibility there and what would it be for?

What Steve had indicated is that we have the $1 million appropriation from the Government for the development of BioFoam.

Okay.

And we were just recently received the okay -- well, we expect to see -- receive the okay to start spending that money in the very, very near future. So we expect that our R&D expenses will increase in the second half of the year, largely due to that program.

All right. That's it for me. Thank you, very much.

Okay.

Thank you. Our next question is coming from Keay Nakae with Unterberg. Please go ahead.

Yes, just wanted to revisit the process improvement initiatives. You had guided that they would be -- be worked on in Q2. It sounds like there's still some work to do there. But when could we see some of these major initiatives wrapped up?

I would say probably in the latter half of this year. I mean, latter half of this year some the things that -- for some of the things that we're working on right now, but it's an ongoing process, Keay. I mean, we're going to be constantly looking at ways to improve our processes and to improve yields into '06, '07, and going forward. So there are -- there are a couple of things that we are working on right now that we think could potentially have a very favorable impact on margins. It remains to be seen. We have to finish the validations and get the processes implemented. But a couple of things that we're working on right now we could potentially see them implemented in the latter half of this year, maybe late this year.

Okay. And, then, a companion to that, I guess, your procurement activity, are you still holding back in being as aggressive as you could be there and waiting until, perhaps, some of these more significant process improvements are validated and completed and in place?

We are not being as aggressive in the procurement area as we could be. We're bringing certain groups back online that we have -- that we've worked with in the past. And we're doing that in a step-by-step basis. So we could be a lot more aggressive there, and I would -- I would expect as we move to the end of the year that our procurement will continue to show significant improvement.

Okay. Thank you.

Thank you. At this time, I would like to turn the floor back over to you for any further or closing remarks.

Well, we've enjoyed meeting with you at this quarter, and we look forward to having our next conference call on reporting on the third quarter in about three months.

Thank you. This does conclude today's teleconference. You may disconnect your lines at this time and have a wonderful day.