Artivion Inc (AORT) 2016 Q2 法說會逐字稿

Greetings and welcome to the CryoLife second-quarter 2016 financial conference call. (Operator Instructions) As reminder, this conference is being recorded.

I will now like to turn the call over to CryoLife management. Thank you; you may begin.

Good morning and thanks for joining the call. I'm Ashley Lee, the CFO of CryoLife. Before we begin, I would like to make the following statements to comply with the Safe Harbor requirements of the Private Securities Litigation Reform Act of 1995.

Comments made on 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, or predictions of the future.

These forward-looking statements are subject to a number of risk, uncertainties, estimates, and assumptions that may cause actual results to differ materially from current expectations. Additional information concerning certain 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 will turn the call over to our CEO Pat Mackin.

Thanks, Ashley, and good morning, everyone. I'm very pleased to report we posted strong results and advanced on each of our objectives in the second quarter of 2016. Our performance was bolstered by added resources and associated benefits we obtained through the acquisition of On-X.

As you will hear, our newly expanded cardiac surgery sales force is performing as we had hoped. We are getting momentum in our legacy markets, evidenced by an uptick in cross-selling, and we are seeing the impact of more feet on the ground as the On-X profile continues to rise.

The sales team is also making noteworthy progress on expanding the channel for On-X valves. And we believe the impact of these efforts will become more apparent in the second half of the year.

This morning, we will also be providing an update on the considerable progress we've made on the 2016 strategic initiatives that I laid out at the beginning of the year. Following my comments, Ashley will provide a detailed review of our second-quarter financial results. I will conclude with my closing remarks before opening the call to your questions.

Our first key initiative in 2016 is achieving our full-year revenue and EPS guidance. I'm pleased to report through the second quarter we tracked ahead of that objective. Second-quarter revenue of $47.1 million, representing growth of 33% as reported and 9% on a non-GAAP basis. Gross margin for the quarter was 64% on the bottom line. And on the bottom line, we delivered non-GAAP EPS of $0.13.

We entered the second half of the year with strong momentum and therefore are raising our full-year 2016 revenue guidance to the range of $180 million to $182 million and non-GAAP EPS guidance to a range of $0.32 to $0.34 per share. As a reminder, our non-GAAP revenues include On-X revenues for the period in 2016 prior to the closing of the acquisition and On-X revenues for the comparable periods of 2015. It also excludes revenues from the divested HeRO Graft and ProCol product lines for 2016 and 2015.

Our second key initiative for 2016 is realizing the potential of the On-X acquisition, with a goal of delivering double-digit compound annual revenue growth over five years. We reported $9.6 million of On-X revenue in the second quarter, representing growth of 7% compared to On-X revenues in the second quarter of 2015.

Sales are tracking where we hoped in the first half, as we are in the progress of finalizing our integration and working through any disruptions in our direct and distributor sales channels. As we work through these temporary headwinds, we expect sales momentum to increase.

In the US, our direct sales force of 51 cardiac surgery reps is actively introducing On-X to new positions and supporting the existing customer base. The team is benefiting from greatly reduced geographical territories and a more focused but larger cardiac surgery sales bag, leading to more sales and improved sales force productivity.

Furthermore, early feedback from the field continues to confirm that there is a low market awareness of the clinical benefits of the On-X aortic valve, leaving ample opportunities for our sales force to drive market penetration and revenue growth.

During the second quarter, we also made substantial progress transitioning US On-X customers that have previously been served by distributors to our direct sales force. While we ended most of these distributor relationships during the last -- late in the first and early in the second quarters, our direct reps were not able to fully engage with many of those accounts until we had new consignment agreements in place with these hospitals. In most cases, it took several months to be able to fully engage with these customers on a direct sales basis.

So our second-quarter results reflect only the partial benefit from transitioning these accounts to a direct sales model. We expect to have additional tailwind in the second half of the year due to this transition.

In Europe, we have 25 direct sales reps promoting the On-X product line and cross-selling our full portfolio of cardiac surgery products. This sales team is building strong momentum in the market, and as of June 1, we transitioned On-X to a direct sales model in Switzerland.

On-X is now being sold by CryoLife direct reps in all markets in Europe in which CryoLife operates directly. We do not plan on any additional transitions in 2016 (technical difficulty) sales. So as we look to the second half of the year and beyond, we remain highly confident in our ability to accelerate our performance.

Our third key initiative for 2016 is driving efficiency in our tissue processing business. Tissue revenue was up 9% in the quarter year over year, supported by growth in both cardiac and vascular categories. We were particularly pleased with the double-digit year-over-year growth for cardiac tissue, which rebounded after a softer first quarter. Vascular tissue revenues also remained healthy, posting 9% year-over-year growth.

In terms of margins, tissue gross margins also remain strong at 47% as we continue to benefit from the tissue processing improvements we implemented during 2015.

Our fourth key initiative for 2016 is continuing to grow BioGlue in US and international markets. Total BioGlue revenue was up 12% year over year in the second quarter, driven by strong revenue growth both in the US and international markets.

In North America, sales were up 9% year over year due mostly to our expanded cardiac sales force. Outside North America, BioGlue grew double digits, primarily benefiting from our transition to a direct sales force in France. Given the strong US and international performance, we remain optimistic on the growth potential for BioGlue.

Our fifth key initiative for 2016 is investing in clinical programs focused on gaining regulatory approvals that will significantly expand our future market opportunities. In the US, I am pleased to announce that we received FDA approval of a revised study protocol that will allow us to resume patient enrollment in our PerClot trial later this year.

As a result of the newly approved protocol, we expect faster enrollment and a more robust collection of clinical data in our PerClot trial than we had before. Given our current estimates for enrollment timelines and follow-up in data analysis, we continue to target FDA approval of PerClot in the first half of 2019.

Outside of the US, we continue to make progress on our clinical trial in China to obtain regulatory approval there for BioGlue. During the quarter, we received notification from the Chinese FDA that will classify BioGlue as a medical device, which simplifies and clarifies our regulatory pathway going forward. We are now proceeding with our clinical trial and currently estimate we could gain Chinese FDA approval for BioGlue in 2019.

Our last key initiative for 2016 is continued business development activity. The first half of 2016 has been very busy and also very successful as we execute our business development initiatives. On-X has allowed us to have a synergistic portfolio of well-regarded cardiac surgery products and a larger experienced sales team to address the cardiac surgery market. We have substantially completed the integration of On-X ahead of our expectations and we enter the second half of 2016 a much stronger company.

In terms of the HeRO divestiture, our transition supply agreement is over, as we recently made our last product shipments to Merit Medical. We now no longer expect to recognize revenues or costs associated with that product line. We also remain on track to transition manufacturing of our recently acquired PhotoFix product line to CryoLife in mid-2017 and expect to realize margin benefits once those transitions are complete.

We are proud of the progress we have made in returning our Company to growth. We continue to be active in evaluating additional business development opportunities to enhance our focus on cardiac surgery.

I will now turn the call over to Ashley for a detailed review of our second-quarter results and 2016 financial guidance. Ashley?

Thanks, Pat. This morning, we reported our results for the second quarter of 2016. Compared to the second quarter of the prior year, total Company revenues increased 33% to $47.1 million. This was primarily driven by the acquisition of On-X and increases in tissue processing and BioGlue revenues.

On a non-GAAP basis, revenues increased 9% compared to the second quarter of last year. The non-GAAP revenue increase was primarily driven by improved performance in our tissue processing business, BioGlue, On-X, and PhotoFix. 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, North American revenues, which include the United States and Canada, were $35.1 million, up 23% year over year, driven largely by the acquisition of On-X. On a non-GAAP basis, North American revenues increased 9%, primarily driven by increases in tissue processing revenues, BioGlue, and On-X.

Revenues from our European region were $8.1 million, up 81% year over year, primarily as a result of the acquisition of On-X and commencements of our direct sales operation in France in October 2015. On a non-GAAP basis, revenues from this region increased 27%, driven primarily by increases in BioGlue and On-X revenues.

And finally, revenues from Asia-Pacific and Latin America were $4.0 million, up [58%] year over year, primarily as a result of the acquisition of On-X. On a non-GAAP basis, revenues from this region decreased 14% year over year, primarily due to distributor ordering patterns.

I'd like to spend some time focusing on individual product lines and specifically on On-X, tissue processing, and BioGlue, which combined account for over 90% of our total revenues. As Pat mentioned earlier, we continue to make progress in our tissue processing business, where both revenues and gross margins are improving. In total, tissue processing revenues increased 9% for the quarter compared to the second quarter of 2015.

We are beginning to see the results of our recent initiatives to improve our cardiac tissue processing. During the second quarter, cardiac tissue processing revenues increased 10% year over year on a 9% increase in unit shipments. Vascular revenues increased 9% year over year on (technical difficulty) decrease in unit shipments. The decrease in unit shipments was not unexpected, as our supply and shipments of longer saphenous vein segments, which carry higher ASPs, have increased significantly compared to the prior year.

BioGlue revenues in the second quarter increased 12% year over year to $16.1 million. North American BioGlue revenues were $9.5 million, which was an increase of 9% year over year. This was a significant improvement compared to North American BioGlue revenue performance over the past several years, where our growth has been in the low-single digits annually on a percentage basis. We believe this is a direct result of our broader and more focused sales channel in the US.

Total US BioGlue revenues increased 16% year over year to $6.6 million. The primary driver of the OUS increase was our direct sales effort in France, where we recorded $1.2 million in BioGlue revenue in the second quarter.

On-X revenues for the second quarter were $9.6 million, a 7% non-GAAP increase compared to the second quarter of 2015. On-X revenues of $8.9 million, which represents our toughest quarterly prior-year comp. For reference, prior-year On-X revenues were $8.4 million in the third quarter of 2015 and $8.3 million in the fourth quarter of 2015.

North American On-X revenues were $5.3 million, which represented a 9% year-over-year increase. OUS On-X revenues were $4.3 million, which represented a 5% year-over-year increase.

Moving on, our overall gross margins for the second quarter were 64%. This was ahead of our full-year guidance of 63%. If you exclude the $902,000 write-up of acquired On-X inventory that is included in cost of goods sold, gross margins would have been 66%.

Regarding On-X, gross margins for the second quarter were 55% (technical difficulty) the $902,000 mentioned above, gross margins on On-X sales were approximately 64%. We estimate that the remaining On-X inventory step-up that will be amortized into cost of goods sold over the balance of the year to be around $1.7 million.

In addition to the inventory basis step-up, we have purchased inventory from recently terminated international and domestic distributors. The unit cost of that purchased inventory is higher than the unit cost to manufacture valves. The current aggregate incremental carrying value of that inventory, which is approximately $1.9 million, will eventually run through cost of goods sold beginning later this year or early next year and will accordingly reduce gross margins up through the first quarter of next year.

Tissue processing gross margins improved to 47% for the quarter compared to 38% in the prior year. This is a direct result of our efforts in late 2014 and during 2015 to improve efficiency in the tissue processing lab.

SG&A expenses for the quarter were $22.4 million, including approximately $1.1 million in transaction- and integration-related costs. Excluding these items, SG&A expense for the quarter was $21.4 million. Over the balance of the year, we expect to incur approximately $800,000 more in integration-related cost, with the bulk of these occurring during the third quarter. These costs primarily include salaries and other miscellaneous cost.

Amortization charges were approximately $1.2 million for the quarter. This includes approximately $600,000 in amortization related to the On-X acquisition. Going forward, we anticipate that total amortization expense, which is included as an addback to arrive at non-GAAP income, will be approximately $1.1 million to $1.2 million per quarter.

Our tax rate for the second quarter was 39%. We expect our tax rate for the third quarter to be in the low 30% range and for the fourth quarter to be in the low 40% range.

On the bottom line, we reported GAAP net income of $2.3 million or $0.07 per share in the second quarter of 2016 compared to a net loss of $502,000 or $0.02 per share in the second quarter of 2015. Non-GAAP net income was $4.2 million or $0.13 per share for the second quarter of 2016 compared to non-GAAP net income of $1.3 million or $0.04 per share in the second quarter of 2015. Non-GAAP income in the second quarter of 2016 excludes business development and integration charges of $1.1 million, amortization expenses of $1.2 million, and On-X inventory basis step-up of $902,000.

In calculating non-GAAP income, a 38% normalized income tax rate was applied to pre-tax income. A complete reconciliation of GAAP to non-GAAP net income and the earnings per share is included in the press release that we issued last night.

As of July 18, 2016, we had approximately $52 million in cash, cash equivalents, and restricted securities. We had approximately $74 million outstanding on our senior credit facility and had our full $20 million revolving facility available to us. The interest rate on our credit facility is approximately 3.5%.

And now for the 2016 financial guidance. As Pat indicated, we are raising our 2016 full-year revenue and non-GAAP earnings guidance. We now expect total revenues to be in the range of $180 million to $182 million compared to our previous range of $178 million to $180 million.

We expect product revenues to grow in the mid- to upper-single digits percent on a non-GAAP basis compared to the prior year. And tissue processing revenues to increase in the mid-single digits percent basis compared to the prior year.

Gross margins are expected to be approximately 64%, up from our previous guidance of 63%. And non-GAAP earnings per share are now expected to be in the range of $0.32 to $0.34 per share compared to our previous guidance of between $0.29 and $0.32.

I have a couple of comments regarding guidance for the second half of the year and then some general comments regarding our outlook. We expect that fourth-quarter revenues will be slightly better than third-quarter revenues. This contemplates a seasonal slowdown in Europe during the holiday season and the expected gradual ramp in the On-X business.

We also expect that R&D expenses will be higher in the fourth quarter compared to the third quarter. This reflects primarily the resumption of enrollment in the PerClot IDE during the late third or early fourth quarter as well as expenses related to other development projects.

That concludes my comments, and now I will turn it over to Pat.

Thanks, Ashley. So as you have heard today, we continue to track towards delivering on all of our key initiatives for 2016 designed to transform CryoLife into a higher-growth and more profitable company. We are still in the early days of achieving the full potential of the On-X portfolio and are excited about the reception we are receiving goes far.

The integration has gone better than expected and we are very encouraged by the effectiveness and productivity of a larger sales team. We will continue to look for further business development opportunities to leverage our strong sales platform and core strengths. Our goal is to establish a leadership position in the cardiac surgery market, and we are well on our way.

Last, I would like to thank all of our employees for making this quarter a successful one. Your work is important and makes a very positive difference in people's lives all around the world.

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

(Operator Instructions) Brooks West, Piper Jaffray.

Couple quick ones for me. Pat, you mentioned there was a bit of an impact in the switch from distributor to direct in On-X in Q2, and there might be a tailwind in the second half. Can you quantify that at all? Is it a couple million bucks, million bucks?

Yes; I'm not going to get into the revenue impact of it. I think the way to think about it is in the two different regions of the world -- so in the US, we had about 50 hospitals that had been served by On-X distributors prior to the acquisition.

And through the second quarter, we were unwinding those relationships and also having to get new consignment agreements put in place. So really, we were not up and running in those accounts probably until the mid-June time frame. And then conversely in Europe, we basically unwound six different countries over really the balance of mostly Q1 to a little bit in Q2.

So I think the way to think about it is that starting in the third quarter, we basically have access to all of our direct markets in Europe and the US. And we are not planning on anything further. So it definitely impeded the growth rate and revenue of what On-X could have been. So we will obviously be pushing hard to get to double digit in the back half.

Okay. And you're confident you can recover that in the back half?

Yes. And again, I don't think it -- we were very clear upfront about unwinding our distributor relationships in the first half of the year. It was a lot of work, and we weren't focused on getting to double-digit growth. I think it was a fairly unreasonable expectation and we didn't commit to that. So I think it's a -- something we planned for. We are ahead of our schedule and I think we are confident we can do better in the second half.

Okay. Perfect, perfect. And then I know you had working on turning on some more supply on the tissue side. I wonder if you could just give us an update on how that's going.

Yes. I think, as we have walked through this journey together, vascular tissue has had very strong performance in the first half of the year. And as Ashley alluded to in his comments, we have been selling really what the customers want: are longer saphenous vein segments. And even with a 5% decrease in units, revenue was up 9%. We had also said that we expect cardiac tissue to come along as we improve the procurement. And we've started to see the first signs of that.

So we have had a big effort in the area of efficiencies and bringing more procurement groups. And as you saw in the quarter, we had a nice rebound in the cardiac segment. So we've seen pretty significant increases in procurement over the last three or four months, really in the first half of the year, that we would expect to see the fruits of that in the back half of year.

Okay, perfect. Congratulations, guys. Great start to the year.

Jeffrey Cohen, Ladenburg Thalmann.

Thanks for taking the questions. I was wondering if, firstly, you could discuss a little bit about On-X and its historic presence in Europe. And how that might be helping with your existing product lines.

I think we are seeing it -- you certainly saw it in the BioGlue numbers in the US and in Europe, which is -- and this was one of the investment theses we had on On-X, which is we think On-X is a great product with lots of opportunity for growth. Because we think it's the most differentiated of all the mechanical valves. It's truly unique. It's got its own indication that nobody else has got.

But what that enables the sales force is we are now, every time we call on a surgeon about On-X, we can talk about other topics like BioGlue or cardiac tissue or PhotoFix. So I just think having more feet on the street focused on specific segment, talking about cutting-edge products, it allows you to pull through and you obviously get more cross-selling, which we see in the numbers.

Perfect. Could you discuss a little bit about the PerClot trials? So what is going to change as far as the endpoints being measured in some of the centers being enrolled as you go forward?

Yes, so I'm not going to get into all the details. I will tell you that we had a very productive exchange with the FDA. We put in a number -- and this is fairly -- I have been involved in a lot of clinical trials over the years. And you work with the FDA, you get to a final ID, and then you start to try to implement it. And there are parts of the trial that are just not practical: doing CT scans on someone who is having liver surgery and things like that. And the FDA was extremely receptive to the changes that we suggested.

So through the hard knocks of that trial, we saw some of the things that weren't working. And we put together a submission that addressed a lot of those issues. And frankly, the FDA was very receptive and pretty much approved all of them.

So I think it's everything from how often people have to be tested -- it's not going to compromise the data collection or the robustness of the trial. But I think what it's going to do is allow us to enroll at a better pace. And we are very happy with the changes that we got.

Do you expect the size of the trial number centers to be similar than previously thought?

Yes. Actually, one of the things we did ask for was an increase in center -- number of centers. So I believe we were at 15 and we've gone up to 25, which is a big one. I'm glad you asked that, Jeff, because that's a big one.

Okay, got it. One more, if I may. Ashley, can you talk about the effective tax rate and your commentary about Q3 and Q4 being a low 30% and a low 40%? Can you explain that a little bit for us?

Yes. So occasionally, we get the benefit of some specific tax items. And I don't want to get too technical on these things. But you are allowed to recognize them and take the benefit from them as they occur.

So in the third quarter of this year, we expect to get the tax benefit of some items that are going to be reversing, and that's reflected in the tax rate. [We're seeing] the benefit of those types of items in the fourth quarter. So that's why you see a low 30% tax rate in the third quarter and then a low 40% tax rate in the fourth quarter.

Going forward, absent any other business development activity, which typically has like a lot of nondeductible expenses for tax related to those types of endeavors, we would expect that our effective tax rate to be in the upper 30% range.

Okay, got it. That does it for me. Thanks for taking the questions.

Jason Mills, Canaccord Genuity.

Congrats on a great quarter and good start to the revised strategy here since you started, Pat. The quarter came in, obviously, above everyone's expectations. And the top-line was about a 7% beat. But the guidance increase was a little less than that (technical difficulty) of the year.

You beat our On-X number and you are talking about some of the things that actually prevented you from doing even better. And you are hoping those things abate and you are able to drive even better growth in On-X in the second half of the year.

So I'm just wondering the guidance, and I understand the desire not to get too far ahead of yourself. But it seems a bit conservative, to be frank. And maybe you can just talk about the puts and takes there in the second half of the year, at least from a top-line perspective.

Yes. No, I think that's a fair question, Jason. And I think there's a couple pieces to this that I think we want to be very transparent about. First off, the divestiture of HeRO and ProCol. There was about $2.5 million of revenue in the first half in our numbers. In the $90 million of revenue we had in the first half, there's about $2.5 million of basically revenue that's not going to repeat in the second half because we have divested those businesses. So I think that's the first point to make.

The second point to make is if you go back to last year, if you look at the three product lines and if you look at tissue, glue, and On-X, which are really the Company, tissue was getting progressively better last year. Every quarter that we came out, tissue revenue increased quarter to quarter to quarter. So the comps on tissue are going to get tougher, and the same with glue.

This year, and we've said it in every call, we've had great growth in Europe. A lot of that has been driven by the going direct strategy in France, which will annualize on itself in the fourth quarter.

So I think when you look at all those pieces and you put it together, we want to put guidance out there that we feel like we can deliver on. And obviously, we will be working hard to beat it again. But I think if you take all those factors in place, it makes a little more sense.

Okay, that's helpful. I guess just the one pushback, Pat, is on the tissue side, the fourth quarter was down sequentially and sort of in line with the second quarter's. Is there anything in the -- remind me what happened in the fourth quarter of last year. That was a little easier comp than the third. Third looks like a real tough comp.

Yes, typically some people, to the extent that they can, will elect to not have surgery during the holiday season, during the fourth quarter. So, seasonally, we see it actually down sequentially historically from the third quarter to the fourth quarter.

Yes, I think that's a fair point, Jason, because a lot of particularly the -- we have a heavy pediatric portion of the operation that, frankly, is bigger in the summer than it is in other times of the year, for obvious reasons. Kids are off and parents are off.

Right. Got it, okay. Following up on On-X, to be frank, there are, at least from my perspective, a lot of investors doing work on the stock for the first time in a long time, which is great news.

The one thing that -- the one question that I get is On-X -- boy, it looks like a really interesting product, but isn't it a declining market? Of course everyone brings up TAVR, et cetera. As people dig in, they're trying to get their arms around why they should be investing in a mechanical heart valve, which a fair question, I think.

Maybe you could talk about what you're seeing in the marketplace since you have purchased On-X in the mechanical heart valve space. You've known it from Medtronic. It seems to us like the market is hanging in there. It's not growing. It declined maybe a little bit, but not going away.

Maybe talk about that. And talk about, given the label that you have -- and for those that are listening to the call -- I guess I'll ask the question this way. Why you wouldn't have 50%-plus, a Medtronic-like share of this market with the kind of label you have eventually?

Yes, no, I think those are all -- we get those questions all the time, and I think they're fair. So first, I think to really in a simple way to describe the aortic valve (technical difficulty), there's really three segments -- well, actually, there's four segments.

And it's really kind of -- and this is the way surgeons interact with their patients. It's really by age. Again, not every seven-year-old is the same; not every 80-year-old is the same. So these were all with the caveat of each patient is an individual, you know, has its individual set of circumstances.

But TAVR, the average age of a TAVR patient today is probably 80 years old. People say well, TAVR, isn't TAVR going to start eating into mechanical valves?

The most advanced trial from Edwards, called Partner III, the lower limit of age is 65 years old. We don't even play in over 65-year-olds in mechanical valves. I always say, we don't -- the mechanical valve isn't even in the same zip code as the TAVR valve. We don't even -- those aren't even the same patients.

So the first category, and kind of the oldest and sickest population is TAVR. And TAVR is clearly working down, but they are working down into the tissue, which is the standard bioprosthetic valves. And that's actually what we run into (technical difficulty) is in tissue, which is the Edwards and the Medtronics, St. Jude tissue valves.

And frankly, I think that is a very interesting conversation. Because the On-X valve, for years the bugaboo of mechanical valves has been you've got to anticoagulate these patients. So why don't you get a tissue valve, and you don't have to anticoagulate?

Of the fact of the matter is for a patient, if you're a 60-year-old patient, are you going to forgo taking an anticoagulant so you can have tissue valves that last 7 to 10 years? And so you're going to have another operation when you're 70. You're going to have another operation when you're 80. Or you can get one operation for the rest of your life, which is a mechanical On-X valve, and take half the anticoagulation that you'd normally take.

So I think this is where the clash is happening. And I'm hearing from surgeons that they think they potentially overshot how far tissue has gone down in age. And I think that's where we are going to start kind of taking share really from -- and our research has shown that the On-X valves can actually take share from standard bioprosthetic valves.

And then the third category with mechanical valves, which has traditionally been between 40 and 65, and that population is kind of where we play.

And the fourth category, which is very interesting, where we also play is in the pulmonary valves in people under 40. There was just an editorial that came out from Tirone David in JACC -- who's one of the top, he's probably the top aortic surgeon in the world -- that basically says, the best operation for anyone under 40 with aortic stenosis is a pulmonary homograft.

So CryoLife is the market leader in pulmonary homografts. So under 40, we dominate that segment. And if you look at mechanical valves between the ages of 40 and 65, we think the market -- we will be the market leader with the On-X valve over the next (technical difficulty). I think you're point is a good one. And that's why we acquired the company, and that's why we had 50 reps in the US, and 25 reps in Europe. And our plan is to -- with more sophisticated marketing, a better salesforce and a constant message -- we will be pushing to be the market leader in aortic valves below the age of 65.

That's helpful, Pat. I appreciate that. Just a few follow-ups and I'll get back in queue. Thanks for taking all the questions. I wanted to just shift to the PerClot trial. Could you give us any more details about the target indications you'll pursue in it, and the target addressable markets that eventually investors can start modeling and thinking about, as you get into the latter part of the decade?

Yes, and that's actually fairly easy. First, as far as the market size, if you define sealants and hemostats, it's obviously a multibillion-dollar market. You've got to start to narrow down kind of where is the product going to be tried, and where is it going to be used?

And so the three indications that we are going after are cardiac surgery, liver surgery, and urology surgery. And those are all fairly significant operations with lots of bleeding. We have, for example, on the liver side, we've got major cancer centers like Sloan-Kettering, MD Anderson, Fox Chase.

So we're going after the big kind of liver cancer centers. And we want to have technology that's very meaningful for patients. And so cardiac surgery, one of the changes -- and I apologize to Jeff for not answering this -- one of the things we got added to the trial is we now get an anastomotic sealing. So as the surgeon does a vein graft or an arterial graft, the connection between the vein and the artery, we can now put PerClot there to kind of stop bleeding, which is a nice add to the trials.

So if someone is trying to look at kind of defining the populations, it's cardiac surgery; it's liver surgery and urology surgery. And those would be -- we'll see what the FDA says. But those will be fairly broad indications.

If you want to look at the market size, the best surrogate to look at is Bard's new product. I haven't seen their latest because it's obviously a big company and it's kind of -- those numbers are varied. But our most recent data from them is they're probably doing $70 million a year and we're growing double digits. And this is a very high-margin, 80% gross margin item. So you can do the math.

We've got a pretty powerful salesforce in the US. With those indications, with those kind of margins in that kind of market, you can figure out what you think we can do in there.

Great. And last questions for me, speaking of the salesforce, talk about your plans for it, both in the US and outside the US over the next, let's say, 12 to 18 months. And then BioGlue in China, I know it's a couple of years away, but another potential whale for you in terms of a growth driver. Talk about -- what is that market opportunity that I guess, whittled down, what do you think that revenue opportunity (technical difficulty) for you in China after you get that approval? Thanks, Pat.

Okay, thanks, Jason. So the first one on the US salesforce. I mean again, I've been around this industry for 25 years. One of the things I like about the On-X transaction was that I believed a 50-person salesforce would give us the appropriate coverage for quite a while.

I think as an investor, the fact that I can acquire a company and then just drop it into my salesforce's bag and not add a single new rep is very appealing. We -- with a 50-person salesforce, we reduced our sales territories by about one-third. We have reps in cities now where CryoLife has never had a rep. And just the leverage we're going to get from that I think is significant.

We don't plan any real changes in the US on the cardiac surgery side. I think our team is pretty much in place. They are executing well, and our plan is to bring them more product.

I'm Europe, we feel good about the six countries we are direct. There are obviously other countries in Europe that we are not direct. We haven't set our sights on the next one. We are always kind of evaluating what the right time is to take (technical difficulty) direct. So I think that should answer the US, European distribution channels.

And as for China, we're very excited about it. One of the things about a product like this is there has never been a product like BioGlue in China. In fact, our head of clinical is in China now, working on this trial. We've recruited the PI who comes from -- is probably the top aortic surgeon in all of China. The number of aortic surgeries that they do in China kind of dwarfs what you see in a typical US center. We're talking in the thousands.

Our clinical trial will be done in five or six of the top aortic centers in all of China. We are in the process of trying to uncover what we think this market opportunity is going to be, because again it's still fairly early stages.

But again, I'm very excited about the Chinese opportunity because we already have the On-X valve there for aortic and mitral surgery. And when you combine the opportunity with BioGlue, I think it creates a really unique opportunity for CryoLife in China to create a nice presence, and even to add other things to that offering.

So again, we'll come back when I feel more confident on what that will [look like]. But there's 40,000 aortic surgeries in China. So I don't think it's unrealistic to say that that's not a significant opportunity, similar to the Japan market, which is probably in the 10 million range.

Thanks, Pat. Congrats.

Thanks, Jason.

Joe Munda, First Analysis.

Congrats on the quarter, very solid performance. Couple of questions I have that I was wondering. Pat, as far as the acquisitions that you made in divestitures, you're building a nice, cardiac-focused company here. But from our view of other players in this space, there seems to be a gap, if you will, in products that you'll need to effectively compete.

I was wondering -- get your thoughts on if and when you'd come back into the market and make acquisitions, and possible areas that you see attractive where you see that there's opportunity to leverage up what you've built already and run it through the sales channel.

I think one of the things that's -- clearly, we like the focus. And people -- I hear this all the time from investors. And I have the benefit from 25 years I've worked in cardiac surgery. I've worked in interventional cardiology. I've worked in electrophysiology. I've worked in interventional vascular. So I've kind of been around the horn here in the markets.

People forget, there's a million cardiac surgery procedures done a year. It is a very big market. And I think the challenge that a lot of the other companies have is there's a lot of legacy portfolios that they have that aren't growing, that are stagnant, that aren't that exciting. And we are kind of in a unique position where we can kind of cherry-pick the areas we think are hot that have a big benefit for patients, as well as a good benefit for the healthcare system financially.

And it's a nice position to be in, because we aren't really competing against a lot of the multinationals and some of these transactions. But at the same time, we think we can put together a portfolio that really -- it leverages the size of this market, but having really unique and novel technology that will allow us to grow.

So, Joe, I'm not going to get specific on what we're going to buy, and all that. I don't really want to give a blueprint to our competitors. I can tell you we are always looking. And since we've announced our intent to acquire On-X and our focus on the divestitures, we've had a lot of inbound of very interesting technologies that together, as a smaller company, a business that we can take from $20 million to $100 million; it makes a huge impact.

And we're concentrating on bringing technology that is different, and it's in our vision. Differentiated technology that has a significant clinical outcome to patients that has a positive impact on the economics of the healthcare system. And when we find products like those, we will acquire them.

Okay. So, no shortage of interesting stuff out there.

We probably have -- in any time, we have probably a dozen things in the queue that we're looking at: different markets, different technologies, different companies. They're all at different phases of evolution. We are not -- we've been pretty clear, we're not going to go out and just acquire to acquire. But I think you could expect to see us looking at tuck-ins over the next 12 months that would fit what I just described.

Okay, that's helpful. Ashley, real quick: the impact to gross margin. You talked a little bit about it. Can you run through that one more time for us? The $1.7 million and the $1.9 million through the P&L through first-quarter 2017? Can you just run through that one more time? I think I missed the detail there.

So, we have about $1.7 million still remaining from the write-up of the acquired On-X inventory. That's the inventory that we acquired as part of the acquisition. And that will run through our P&L over, more or less, the balance of this year. And if you recall, we had (technical difficulty) hundred thousand dollars that flowed through the second-quarter P&L. So that's roughly kind of the magnitude that we're talking about on a quarterly basis.

In addition to the inventory that we acquired as part of the acquisition, we purchased inventory from distributors that we terminated. And we bought that inventory back at the price that we sold it to them for. So the unit cost of that inventory is higher than the unit cost to manufacture a valve. The incremental value that inventory, over and above what it typically costs us, is $1.9 million.

Okay.

And that $1.9 million will, by and large, flow through cost of sales in the first quarter of next year, by and large.

In the first quarter, or through until the first quarter?

In the first quarter of next year. So the $1.7 million, more or less, is going to hit in the third and fourth quarter of this year. The $1.9 million, more or less, is going to hit in the first quarter of next year.

Okay, thank you.

Okay.

Bruce Jackson, Lake Street Capital Markets.

Most of my questions have been answered, but I was hoping you could just remind me of how you guys deal with your foreign exchange. You've got an increasing amount of international revenue. Do you guys do any hedging, or just let it flow through? Tell us how you approach that and how that factors into your guidance?

Bruce, we don't have a lot of currency exposure. We currently have roughly about $10 million in business that is denominated in foreign currencies. The rest of our business is predominantly denominated -- transacted in US dollars.

And even the amount of business that we transact in foreign currencies, we kind of have a natural hedge against that because of our operations in Europe. So on the bottom line, we have not a lot of risk. On the top line, we do have -- we are at some risk because of movements in foreign currency, but it's not significant.

Okay. That's perfect. Thank you very much.

Jason Mills, Canaccord Genuity.

I just wanted to be clear, this gross margin issue that you discussed, you just answered to, is factored into the gross margin guidance that you've given? Or will that be pro forma'd out of that guidance?

The guidance that we gave for 64% for the full year includes the impact of that $1.7 million over the balance of this year. Does that make sense?

Great; yes, it does. I just wanted to make sure everyone was clear on that. So that will run through the pro forma model. You will not pro forma that out. That was number one.

Number two, the amortization expense, which has been -- you have been pro forma-ing it out. I just want to make sure that your higher earnings guidance excludes that as well.

Yes, our higher earnings guidance excludes amortization, and it excludes the inventory write up.

Great. Thank you very much.

Just so that we are clear -- the three items that we add back to our GAAP net income to arrive at pro forma are business development and acquisition-related (technical difficulty), the step up for the inventory. And then the third item is severance.

So, just going back again. So your 64% guidance for the year for gross margins, which you increase from 63% -- that is burdened by this inventory that you talked about that will flow through the model in the second half of the year, and then in 2017.

That's right. That's correct.

And so, therefore, your guidance of $0.32 to $0.34, which is higher than your previous guidance, is also burdened by those same cost of goods sold costs.

Yes, those items -- the inventory write-off is excluded from income to arrive at our adjusted income. There's a reconciliation in the back of the press release that walks you through that calculation, item by item.

Right, I got it for this quarter. I'm just wanting to make sure that we are all clear on the go-forward period that you just discussed as it relates to gross margin. Wanted to be clear whether or not the guidance includes those gross margin impacts, or excludes it.

It includes them in it.

That's it -- okay, thank you.

There are no further questions at this time.

I would like to turn the call back over to management for any closing comments.

Yes, well, first of all, thank you all for attending this morning. And obviously we're very pleased with the quarter. We pretty much kind of hit on all cylinders. We're building a stronger Company.

We've raised our guidance on the top and bottom line. Our team is in place, and we've got momentum. So we're going to be pushing hard to deliver the results we've talked about; as well as we are always looking for additional technologies and companies to further our mission to deliver unique technologies that deliver better clinical results at a lower cost to patients.

So we look forward to seeing you guys on the next quarter's call.

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