Integra Lifesciences Holdings Corp (IART) 2003 Q2 法說會逐字稿

Good morning. Welcome to your Integra LifeSciences Holdings Corporation's Second Quarter 2003 Earnings Conference Call. At this time, all participants have been placed on a listen-only mode, and the floor will be open for questions and comments following the presentation. I would now like to turn the floor over to your host, Mr. Stuart Essig. Sir, the floor is yours.

Thank you. Good morning, everybody, and thank you for joining us for the Integra LifeSciences Investors' Conference Call. As many of you know, I am Stuart Essig, President and CEO of Integra LifeSciences Holdings Corporation. Joining me today are David Holtz, SVP, Finance, and Jack Henneman, EVP, CAO. During this call, we will review our financial results for the second quarter of 2003, which we released earlier this morning. And our forward-looking guidance for the years 2003 and 2004. At the conclusion of our prepared remarks, we will take questions from members of the telephonic audience. Before we begin, Jack Henneman will make some remarks regarding the content of this Conference Call.

This presentation is open to the general public and can be heard through telephone access or via live web cast. A replay will be accessible starting one hour after the conclusion of the live event. Access is available through August 14th, 2003 by dialing (973) 341-3080, access code 360-9052, or through the web cast accessible on our home page. Today's call is a proprietary presentation of Integra LifeSciences Holdings Corporation and is being recorded by Integra. No recording, reproduction, transmission, or distribution of today's presentation is permitted without Integra's consent because the content of this call is time sensitive.

The information provided is accurate only as of the date of this live broadcast, July 31st, 2003. Unless otherwise posted or announced by Integra, the information on this call should not be relied upon beyond August 14th, 2003. The last day that an archived replay of the call authorized by Integra will be available. Certain statements made during this call are forward-looking within the meaning of the Private Securities Litigation Reform Act of 1995. Among other statements concerning management's expectation of future financial results, new product launches and market acceptance of these new products, future product development programs and potential business acquisitions are forward-looking. Forward-looking statements involve risks and uncertainties that could cause actual results to differ materially from predicted results.

For a discussion of such risks and uncertainties, please refer to the risk factors included in the business section of Integra's annual report on form 10-K for the year ended December 31st, 2002 and information contained in our subsequent filings with the Securities and Exchange Commission. These forward-looking statements are made based upon our current expectations, and we undertake no duty to update information provided during this call.

Thank you, Jack. Integra develops, manufactures and markets medical devices for use primarily in neurotrauma and neurosurgery, plastic and reconstructive surgery, general surgery, and soft tissue repair. Our product lines include traditional medical devices such as monitoring and drainage systems, surgical instruments and fixation systems, as well as innovative tissue repair products such as the DuraGen Duraowe (ph) graft matrix, the NeuraGen Nerve Guide and the (inaudible) regeneration template that incorporate our proprietary absorbable implant technology.

We had a strong quarter, meeting the analysts' consensus estimates for earnings per share while achieving record operating earnings and revenues. We reported net income of $5.4 million or 18 cents per share for the second quarter of 2003 as compared to net income of $4.2 million or 14 cents per share in the second quarter of 2002. Operating income for the period was $8.3 million, a 51% increase over the second quarter of 2002. Total revenues in the second quarter of 2003 increased by $16.3 million to $42.7 million, a 62% increase over the second quarter of 2002. Product revenues increased by $16.5 million or 66% over the prior year period and accounted for all of the growth in total revenues. Acquisitions continued to contribute significantly to our revenue growth.

Revenues from product line acquired since the beginning of the second quarter of 2002 accounted for $12.2 million, or 74% of the increase in our total product revenues. Excluding revenues attributable to product lines acquired since the beginning of the second quarter of 2002, second quarter 2003 product revenues increased by $4.3 million, or 17% over the prior year period. Changes in foreign currency exchange rates accounted for $382,000 of this increase. Revenues from our instrument product lines more than tripled, Principally as a result of our acquisition of the Padgett and JARIT Surgical instrument lines in 2002 and 2003. Increased sales of our Redman Ruggles instrument and Selector Ultrasonic Aspirator Product line also contributed to the growth in our instrument revenues.

Our operating room product line revenues increased by 53% as a result of sales of neurosurgical shunt products acquired from NMP medical and Radionics in 2002, and have continued growth in sales of our DuraGen Dural Graft Matrix and NeuraGen guide. Our private label product revenue grew by 28%, primarily due to the contribution of revenues from the Signature business acquired in 2002. The declining revenues from the absorbable collagen sponge we supply for use in Medtronics infused bone product was offset in part by sales growth in other collagen-based private label products.

Neuromonitoring product line revenues increased 26% primarily as a result of our increased sales of our drainage systems and intra-cranial monitoring products. Our gross margin on product revenues in the second quarter of 2003 decreased three percentage points from the prior year period to 59%, largely as a result of fair value purchase accounting adjust adjustments for acquired inventories sold during the quarter and the change in product mix caused by our acquisition of JARIT Surgical Instruments.

Excluding the $514,000 of inventory of fair value purchase accounting adjustments, recorded to cost of product revenue during the quarter, our gross margin would have been 60%. We recorded no inventory fair value purchase accounting adjustments in the second quarter of 2002. Other revenue which consists primarily of development funding from strategic partners and licensed and distribution revenues decreased by $170,000 from the prior-year quarter to $1.5 million, as an increase in product development revenue offset in part the effect of a $500,000 event payment we received from Johnson & Johnson in the second quarter of 2002.

Total other operating expenses, which exclude cost of product revenue but include amortization, increased 51% to $17.4 million in the second quarter of 2003. Compared to $11.5 million in the second quarter of 2002. As a percentage of total revenues, total other operating expenses declined 2 percentage points from the prior year period to 41%. Sales and marketed expenses increased 53% over the prior-year period to $9.1 million. As a result of increased sales commission and the build out of our marketing and sales support and management functions. As a percentage of product revenue, sales and marketing expenses declined slightly from 24% in the second quarter of 2002 to 22% in the second quarter of 2003. This decrease is a percentage of product revenues is primarily attributable to costs incurred in recruiting and training new Integra neurosciences sales people in the first half of 2002.

Research and development expenses increased 21% to $2.8 million in the second quarter of 2003, largely as a result of increased spending on our development of a next generation ultrasonic aspirator and research and development activity associated with recently acquired businesses.

General and administrative expenses increased 64% to $4.7 million in the quarter due primarily to costs incurred in operating and integrating businesses acquired in 2002 and 2003. Amortization expense increased 109% to $762,000 in the second quarter of 2003 because of acquisitions. In the first half of 2003, we continued to rationalize our acquired manufacturing and distribution facilities.

In the first quarter, we completed the consolidation of the Padgett distribution operation from the Kansas City facility into our New Jersey distribution center. In the second quarter, we completed the transition to manufacturing the recently acquired Radionics epilepsy electrode product line into our (inaudible) France (ph) plant. We also closed our Pennsylvania assembly operation and have recently completed the transfer of the Camino and Ventrix monitor manufacturing from our San Diego manufacturing facility to our and over our Andover, England operation.

Looking to the second half of 2003 we are planning to consolidate our Integra's supplies distribution operation based in Connecticut into our Integra Signature technologies facility in Massachusetts during the month of August. We expect to consolidate many of the activities performed in our corporate research center into our San Diego manufacturing facility in the third quarter and later this year. Each of these activities should improve the efficiency of Integra's operations in the next 12 months. I will now turn the presentation over to David Holtz, our SVP of Finance, who will provide more information regarding our tax rate and our cash flows.

Thank you, Stuart. The company generated $14.2 million in cash flows from operations in the second quarter of 2003 as compared to $6.8 million in the prior-year quarter. Operating cash flows improved in the second quarter of 2003, primarily as a result of higher net income, improved inventory and accounts receivable management, increased advances on product purchases received from distribution partners, and a $2.7 million benefit from increase in accrued expenses.

We expect that much of the $2.7 million benefit will be reversed in the third quarter, as many of the liabilities associated with this increase including interest accrued on the contingent convertible subordinated notes will be paid in the third quarter.

In the second quarter of 2003, we received $14.2 million in net proceeds from the sale of an additional $15 million of contingent convertible subordinated notes. Our cash and investments totaled $202 million at June 30th, 2003. We recorded net interest expense of $200,000 in the second quarter of 2003 as compared to net interest income of $1 million in the prior year period, primarily as a result of $1 million of interest expense recorded on the recently issued contingent convertible subordinated notes.

Of this amount, approximately $215,000 represents non-cash amortization on debt issuance costs. Other income increased by $400,000 to $450,000 and included $280,000 in realized gains on the sale of securities and $150,000 in foreign currency-based transactions. The weighted average common shares outstanding used for the calculation of diluted earnings per share in the second quarter of 2003 was approximately 30.1 million shares. The benefit of 1.5 million share buyback in March was partially offset by an increase in dilutive stock options resulting from higher average price of our common stock during the second quarter.

Finally, I note that the $835,000 increase in income tax expense in the second quarter of 2003 reflects an increase in our projected effective tax rate for 2003 to 36.5% as compared to a 35% effective rate in 2002. Consistent with our continued use of net operating loss carry-forwards in 2003, we expect our actual cash tax rate to remain under 10% for the year. And now I will turn the presentation back over to Stuart.

Thank you, David. As I have stated on previous calls, our management team continues to seek out external opportunities for growth, and any such opportunities that we consummate would affect our results going forward. It is a top priority of our management team to complete significant and accretive transactions this year and next. However, the forward-looking guidance that we have provided and now we'll update does not reflect the impact of any such future business acquisitions or additional strategic partnerships.

We expect that product revenues will total approximately 41.5 to $42.5 million in the third quarter of 2003. Other revenues are expected to approximate $1.5 million in the third quarter with total revenues estimated to be between 43 and $44 million. We anticipate that consistent with our past experience, the fourth quarter will be our strongest this year. The company expects total revenues to be between $169 million and $171 million in 2003, and between $196 million and $206 million in 2004.

I'd like to take a moment to focus on the expectations for each of our product categories and for other revenue for modeling purposes. Based on our total revenue guidance for 2004, we expect neuromonitoring revenues of approximately 51 to $53 million, operating room revenues of approximately 66 to $69 million, instrument revenues of 57 to $60 million, private label revenues of 18 to $20 million, and other revenues of $4 million.

Looking beyond 2004, longer-term growth expectations are approximately 25% for the operating room product lines, 15% for the neuromonitoring product lines, and 10% for instruments. Private label sales are expected to increase only modestly from 2004 to 2005, and then resume growing at approximately 15% per annum. Sales of the absorbable sponge sold to Wyeth are expected to be -- during 2004 while existing inventory is consumed. Sales to Medtronic of cranial screws will continue to strong through mid 2004 but will likely be reduced significantly at the end of the current contract. Other revenues are expect today decline to $2.2 million beginning in the year 2005 and remain flat.

Overall, we continue to forecast total long-term revenue growth at the target 18% corporate organic growth rate. Gross margin is expected to be 60% of product revenues for the full year 2003 and 62% of product revenues for the year 2004. Longer term, we are modeling gross margins increasing to 65% to 70%. We expect to earn between 18 cents and 19 cents per share in the third quarter of 2003. This guidance includes the negative impact of approximately 400,000 of inventory fair value purchase accounting adjustments we expect to record in connection with the JARIT acquisition and an additional amount of severance and other charges we expect to adjust in connection with the restructuring and consolidations I described earlier. Although we have not yet determined the amount of these charges, we expect that they will be less than $400,000.

We expect that earnings per share for the full year 2003 will be between 78 cents and 82 cents per share. We expect earnings per share for 2004 excluding the potential for an in process research and development charge related to a future milestone payment to be within a range of $1.05 to $1.10 per share. We currently anticipate making the $1.5 million milestone payment in 2004. Integra will be presenting at the upcoming Adams, Harkness & Hill summer seminar on August 5th at 2:30 p.m. in Boston. Can you listen to the live presentation or a replay via a Web cast that can be accessed from the calendar page of the investor relations section of our Web site. This concludes our prepared remarks.

I'd now be happy to answer all your questions.

Thank you. The floor is now open for questions. If you have a question or comment, please press 1followed by4 on your touchstone phone at this time. If at any point your question is answered, you may remove yourself from the queue by pressing the pound key. Please hold while I poll for questions.

Our first question is coming from Jayson Bedford of Adams Harkness.

Hey, Jayson.

Hi, Stuart. How are you?

Good, how are you?

Good. Neuromonitoring sales came in a little stronger than we expected. Can you just highlight some of the key drivers in that segment and maybe give us a little more detail on like placements and are you still seeing kind of strong reorder rates?

Ok. Yeah, neuromonitoring did come in stronger than expected, which was pretty gratifying. The fundamental reason is the strength and continued growth in our U.S. sales force, the benefits we're getting from new products developed by Integra including, for example, our hermetic plus product that we introduced several quarters ago, and in addition to that, the continued growth in the international business both through our direct sales force and our distributors. So overall, we are the market leader in neuromonitoring, and I think we are seeing the benefit of that market leadership as LICOX pulls through our base Camino and Ventrix business and vice versa.

In terms of LICOX, it was, in fact, a very good quarter for LICOX. I do have some statistics. Since the launch in the United States, we've sold 90 LICOX monitors, so those are sold as opposed to either placed or on evaluation. That represented 11 additional monitors sold in the third quarter --excuse me -- in the second quarter. There are currently just 39 monitors in place currently under clinical evaluation in hospitals, in the United States, and outside the United States, there are active 150 monitors including 11 additional monitors sold in the second quarter. So worldwide, 22 LICOX monitors sold around the world, and that business continues to grow and interest continues to be strong.

Ok. And then just secondly, on the guidance for fiscal 2003, it seems like the low end is a little lower. Are you guys spending more, are the integration of these acquisitions going along a little slower? Can you just walk us through kind of the guidance for fiscal 2003?

Yes. What we did in the guidance is widened the guidance from 80 to 82 to 78 to eight 82. Frankly the most significant impact of that is the guidance that we gave for third quarter, because what we wanted to do was leave ourselves enough room to do some of the spending that we're talking about.

Let me give you some of the components of what we think is unusual in the third quarter. First, we still have about $400,000 of purchase accounting adjustments remaining from JARIT, fair value accounting, and then we should be done working through that inventory adjustment. And we've also tried to make an estimate for a maximum estimate of additional severance and shutdown cost for activities in the third quarter, and we've said we would expect that would be as much as $400,000. Obviously that's an estimate, it could be more, it could be less, but all in all, we're anticipating approximately $800,000 of fair value purchase accounting charges, severance and restructuring charges, so that represents about a penny and a half a share.

We are making significant investments in the business. We did announce the shutdown of yet another facility, which is to move our neuro supplies and consolidate it into our Pembroke signature facility. We're also executing on a restructuring of our research and development group, which will involve some layoffs and severance. So overall, we think we're making significant investments in the next quarter principally in the third quarter but to some extent in the fourth, in order to support the future growth of the business, the timing is somewhat unpredictable and we want to leave our self enough room for a range in the quarter of the year to have the flexibility to do what we need to in order to run the business. That being said, we did not change the range in 2004, and so we view this as principally a 2003 additional spend.

One thing I will mention, several spending items have increased significantly since we prepared our 2003 budget. Health care spending in the U.S. has increased significantly, so for our U.S.-based employees, we've had to build into our guidance the additional cost from our health care and insurance spending, similarly having renewed some product liability indemnity, D & O and other insurance premiums, there's a somewhat significant increase from 2002 going into now 2003, and then finally, we had to build into the budget for the next several quarters the next phase of our Merck litigation. If you recall, we have the damages trial coming up and so we've though build that -- to build that into our expectation. So we've now modeled the impact of all of these increases into our updated 2003 and 2004 guidance. I'd also point out we reiterated our guidance for total revenues for 2003 and 2004 and, in fact, brought up the bottom of the range for 2003 by about a million dollars.

Ok. That's helpful. Thanks, Stuart.

Our next question is coming from Robert Goldman from Buckingham Research.

Good morning.

How are you?

I'm fine. How are you doing, Stuart?

Good.

On the guidance, following up the last call, it sounds like you brought down the low end of the range as the result of additional -- in part in the result of additional severance payments beyond what you might have been projecting before. One would assume that that would have resulted in additional cost savings in 2004, but as you say, you haven't changed your guidance for 2004, so perhaps you could explain that to us. And then a couple other financial things just to sort of get them, you know, on the table. You had mentioned a gain on the sale of securities of about $450,000, I think, in the quarter. You know, curious what that is, and also curious how much money you have invested in securities right now. And then as far as these initiatives that you've outlined in the second quarter and others to happen in the third quarter consolidating facilities, et cetera, can you put some numbers on that as far as what the annualized cost savings are as a result?

Ok. Yes. Let me try to take these, and if I miss one of the questions, you'll come back and remind me I didn't get it. First of all, what changed from Q2 to Q3 in terms of our guidance? We give guidance for the next quarter and the year typically on these calls, so we never before gave specific guidance for Q3, and then for the year, we brought down the bottom of the range from 80 to 82 cents to 78 to 82 cents, and I would say the significant component of that potential decrease in the bottom end of the range or the potential for coming in the 78, 79 or 80 came principally from activities in the third quarter. One component of that as I mentioned is about $400,000 of working through the remainder of the JARIT inventory and the purchase accounting there.

Of the other $400,000, approximately $200,000 -- again, $400,000 an estimate -- approximately $200,000 relates to various severance activities that we did not anticipate when we gave our guidance last quarter. In other words, decisions had not yet been made or expectations had not yet been reached as to reductions in head count in our R&D group and the decision to close the neuro supplies facility and merge it with Pembroke. So that's roughly $200,000 of the $400,000.

Other potential activities include the actual shutdown costs of the facilities, some remaining shutdown costs of the -- facility from last quarter because we did keep people working for about an extra three weeks into this quarter, and nothing specific above that, which is why we gave a maximum end of the range of about $400,000. So those are the things that would leave us to believe that we should leave some room in this quarter and leave some room in the range for 2003.

In terms of what is the impact of these activities in 2004, we, in fact, did not change the range for the year 2004, and on the one hand, we believe that these additional activities would give us the possibility of coming out at the high end of that range. I also tried to outline for you things that we did not anticipate last quarter that we've now built into our budget for the remainder of 2003 and 2004, and the biggest of those are, one, the increased accrual that we've built into our roughly 400 employees of additional health care costs, and the impact of the Merck trial which we said will cost somewhere on the order of $0.75 million to $1 million over the next 12 months to get through the next phase of the trial, and if you recall, we only got the word from the judge of our, on the one hand, win, and on the other hand, need for a new damages trial after we reported last quarter. So we didn't update our guidance in any period until this period from the Merck trial.

What are the long term benefits of these various shutdowns? Well, I would first say, one, they are implicit in the guidance we've given, so the 2004 guidance we've built in the impact as we have always done of anything we have done already, but we haven't built in any impact of other activities we might do in the future, including acquisitions. In terms of the actual dollars involved, order of magnitude, we will save between three quarters of a million and a million dollars a year from the shutdown of Exton and its move into Puerto Rico and our (inaudible) plant. We're estimating we'll save on the order of a quarter of a million dollars a year from the shutdown of our neuro supplies facilities and the move into Pembroke. Again, those are built into our guidance. In terms of what we call the other income and expense, if you look at the last two quarters, first of all, I think there may be a little confusion, when we talk about our securities portfolio, what we're principally talking about is the short, medium and long-term investments we make with our cash, and we have, as of the end of June, $202 million of cash, which is in a bond portfolio managed by outside investment managers with input from us. In fact, of the $400,000 -- $450,000 of other income in the period, approximately 100 -- help me out, David.

$280,000 were gains on the sale of the securities, and 150 was foreign currency based transaction gains.

The foreign currency based transaction gains are not really anything in our control. It's just the accounting for assets overseas, and recall, we have about 300 people in Europe, and we have significant assets in Europe. So because we hold those assets in Europe, they're translated, and given the change in the Euro in the last quarter, that represented a gain that we have to put through our P&L. If it goes the other way, it's a cost that we have to put through our P&L. So in terms of actual discretionary activities, it was about $250,000. Of that, we owned stock in one company from a settlement. We had several years ago, which we sold last quarter, because their stock went up, and that was about $50,000 of gain, and in our bond portfolio, we sold various bonds that had high interest rates and, therefore, generated capital gains, and we took advantage of that and got a $200,000 gain from the bonds that were sold.

Just if I could, sir, follow up on the first of the questions or, I guess, the second, the savings related to the restructuring that you've done in the second quarter and announced for the third quarter. I just want to double-check. I thought you had mentioned that the annualized expense savings as a result of the restructuring that you've done in the second quarter and intend to do in the third quarter would amount to a total of between a million and a $1,250,000?

Yes. But again, just a little bit of clarification. We closed Exton in the second quarter and moved most of its -- all of its activities into Puerto Rico and Plainsboro. We anticipated doing that in the second quarter, and that was built into the guidance we gave last quarter.

Right. Ok.

Some of the costs have rolled into this quarter. I'll make a guess. 50 to $75,000.

Right.

Then this quarter, the new initiative is the shutdown of our neuro supplies facility. That will cost us, plus or minus, $100 to $125,000, and we will get on the order of a 2 to $250,000 benefit going forward, and then finally, without going into too much detail, we're restructuring some of our R&D group that will generate severance payments, and that savings will potentially accrue to a decrease in research and development spending. More likely, it will just be a reallocation of those activities.

Could I just ask one more follow-up and then I'll give somebody else a chance, but that covers the second quarter restructuring as well as the third quarter to come. Were there any restructurings in the first quarter of this year? Could you just refresh my memory, and to the extent they were, what the annualized cost savings of those are?

Well, because we're pretty acquisitive there's often a plant shutdown every couple quarters, and because we report only on a GAAP basis, that goes through our P&L. We don't show restructuring charges. So all we're trying to do is explain to you what some of the costs are that are going through our P&L. That being said, this year, we closed down manufacturing of monitors in our Camino facility and moved it to Andover, England. That happened during the first and second quarter and was completed in the second quarter. I'm looking at David. Were there other activities?

The Radionics transfer.

I'm sorry. We acquired the Radionics business from Tyco at the beginning of the year, and there were costs, which we didn't break out in anywhere, but there were costs associated with moving that to our Biot, France plant. The net impact of that is very significant because we took on no people, no overhead, and were able to absorb that complete activity, which represents on the order of a couple million of revenues a year into our Biot plant.

Thank you, Stuart.

Sure.

Our next question is coming from David Pearl of Steinberg Priest & Sloane Capital Management.

Hi. Dave, are you there? Maybe we should let him try again and move on to the next speaker.

Our next question is coming from Carl Berg.

Hi. We're having trouble hearing people here,

Operator. Are there people on?

Carl, your line is live.

Why don't you go to the next, please.

Are you there?

Our next question is coming from Bill Plovanic from First Albany.

Hi, Bill. I hope you're there.

I'm here, Stuart. I was wondering if could you give us a little color on the DuraGen and NeuraGen product line, maybe what the revenue run rate is looking like, the number of docks that are using it and maybe reorder rates?

Sure. First of all, as you know, Bill, we have been studious over the last couple years in not giving out our individual product line numbers as we are not interested in having our competition know our numbers exactly. What we have tried to do is provide information on purchases and reorders and the like. Le me start first with DuraGen.

DuraGen continued to grow very strongly in the U.S., and I would say excitingly grew very strong outside the U.S. as well. So in fact, I would say in a new way, it grew very well outside the U.S., so we were very pleased with that. Overall, domestic sales nonetheless continue to represent about 85% of total sales. In the U.S., we're estimating we have just about a thousand active accounts. That thousand accounts -- I'm sorry, internationally, we sell through 34 distributors, and we're direct in about 100 accounts in foreign market, so in England, Belgium and Germany. We think the biggest impact continues to be our continued penetration of our U.S. sales force getting into untapped areas and accounts.

We've continued to grow that sales force and we'll continue to do that, and they are very, very focused on growing DuraGen. Our sales split remains very similar to the past. We're just under -- sorry, just under 90% cranial in dollars and about 80% cranial in units, so spine is about 10% in dollars and about 20% in units. We see substantial penetration in spine, but as you know, the ASPs are lower. So the truth is, I didn't tell you much more there than I told you in prior quarters except that the news continues to be very good.

On NeuraGen, since the commercial launch in late 2004, we believe there's been approximately 1,300 implants, and we've sold plus or minus 1,700 nerve guides, so there's obviously some on the shelf awaiting implant and with distributors now, since we're and are selling outside the United States, we have 220 active accounts in the United States that have purchased NeuraGen, and our CE mark came in January. We (inaudible) shipping into Europe in the second quarter, and we had good early results, although not meaningful in terms of dollars. The NeuraGen product has been used in nerve repair in the upper and lower extremities, crane yell nerve repair, brachial plexus reconstruction and repair of the - nerve following prostate surgery, and we've also taken advantage of our Padgett sales organization. Each of those folks have 10 accounts that they're working aggressively in coordination with the neuro reps, and they're spending a significant amount of time detailing NeuraGen in particular to plastic and reconstructive surgeons.

If I can ask you on DuraGen, Stuart, can you kind of give us an idea of what your definition is of "very strong growth" in the U.S.? Are we talking 25%, are we talking 50%?

Yeah. I haven't given it out, but I guess the point is, if you take a look at our operating room products and look at the significant growth in the operating room products, if you consider that our forward-looking guidance beyond 2004 is 25-plus%, you'd have to assume that DuraGen would have to be well above 25% since it's not only the largest product there but the fastest growing product there. I'm not trying to be cagey, but I want you to get the sense that it's growing quickly.

And I was wondering, can you give us an update in the sales force, any changes made in the third quarter and where we're sitting right now?

Yeah. First of all, our strategy this year was to grow the sales force but grow it in a more cautious and methodical way than last year. I think we learned in early 2002 that such an aggressive expansion, basically 50% in such a short period of time threw off too many people's momentum, and I think one of the reasons we're doing as well as we are this year with year-to-date 18% organic growth is because we haven't let the sales force take its eye off the ball, and we don't intend to. So what we've tried to do since the beginning of the year, I think we started the year with 63 territories, of which I think there were 2 open, we now have I think it's 67 or 68 almost all full, and our objective will be to finish the year at between 70 and 72 full. We will probably expand add an additional one or more regions, but the way we'll do that is by promoting from within and then back filling so that when we walk into 2004, we have the potential to go from, say, 70 to 80-plus, but to do it one or two a month and without significant dislocations.

We also see an opportunity to promote a number of our neuro-specialists to regional positions, we'd like to add more to our management so we're likely to go from seven regions where we are to closer to, say, nine regions, and some of those people who we're likely to promote have $2 million plus region, and it will be very easy to add two or even three people in the territories that they've vacated, become regional managers. This has been what we've been doing this year. I am quite confident it's what we will do next year, and it's allowed us to not have nearly the pain and suffering that we had last year in trying to grow the sales force quickly. It also let's us do a lot more training and education and keep people in the field rather than doing interviews full time.

And then lastly, and then I'll jump back in queue, just give us an idea what the product pipeline over the next six to 12 months looks like.

Sure. First of all, in terms of pipeline, our next big meeting will be in late October at the Congress of neurosurgery. We tend to use that to announce new products and new initiatives. Most of what we have this year are product extensions of our major product lines. We had a number of LICOX additions, we're planning to have some improvements on our ultrasonic aspirator, a series of new drainage products, and I think that's the bulk of it this year. 2004, we have a lot of things going on which I'm hoping is the result of our reorganization earlier this year and our continued improvement of our R&D organization, and that includes the launch of our Novus neurocenter blood flow monitor, our cranial flow system, our aspirator, and some additional LICOX products. We also have in the pipeline some interesting things going on in tissue engineering, but for the moment, we haven't and don't intend to talk about them.

Great. Thanks, Stuart.

Thanks.

Our next question is coming from Scott Davidson from Piper Jaffray.

Hi, Scott.

Can you hear me?

Yes.

Stuart, can you tell us a little bit about the integration process with JARIT, how's that going, how have sales just in a qualitative sense been tracking relative to your plan, and does the fact that there is going to be some additional marked up inventory running through cost of goods sold in Q3, does that read at all on how sales have gone relative to expectations? Thanks.

Good. A couple of thoughts on JARIT. I'm glad you asked the question. First of all, the integration has been extremely smooth. One of the nice things about JARIT is we acquired a well-run business with an intact and motivated management and sales team. So it's been a remarkably easy integration, and their organization culturally fits in very well. That being said, one of the reasons -- to answer your question, JARIT came up a little short in terms of our expectations this quarter, and only in the top line, and I think we've thought we could get it to grow more quickly earlier than it actually did. And so we did, in fact, moderate our expectations down by on the order of 3- or $400,000 a quarter for Q3 in the estimates. And so, yeah, we thought probably we could push it harder, more quickly than we were able to. I wouldn't want to say that was the reason for the additional purchase accounting. I'm not sure that's accurate. But certainly we would have expected to be doing on the order of 3- or $400,000 more a quarter and grown the business more this quarter and next. That all being said, integration is going fine. The sales force is intact, we haven't lost a single salesperson, and one of the reasons we acquired that business was for the sales force. The process of moving our Redmond-Ruggles and Padgett lines into their sourcing operation is going very well, and, in fact, we are already sourcing on the order of 25% of our products through their organization so through their buying power in Germany. You won't see any significant financial impact on cost of goods till mid to late 2004 in my opinion, but the process is going well, and we're able to take out some operations overhead accordingly. So you a little bit hit the nail on the head in terms of our revenue expectations, but the rest of the business is running so strong, it's made up for being the 3- or $400,000 short in JARIT.

Thanks. Just as a quick follow-up, can you talk maybe generally, Stuart, about the competitive environment in neuro? I think last quarter you had referenced a couple of your competitors maybe having ratcheted down a notch or two from a performance standpoint. Is that still the case, and how are things kind of stacking up competitively?

I wouldn't say there's anything new this quarter. You know, I think we're competing very effectively in the ICU. I think we've taken share from both -- and Medtronic in the intensive care unit with our Camino/LICOX drainage, et cetera, and then in the OR, you know, our business has been extremely strong, and I don't think we've seen any significant impact, you know, either positive or negative in terms of behavior of the competition there, and in our instruments, we're so new to the business, I'm not sure we would really know we were seeing any significant impact, but we're not aware of any significant changes in the business. So there's nothing really new.

Ok. Thanks. And actually I lied, one more quick follow-up. Can you talk about visibility on Q4? I remember the capital equipment component to the business came in surprisingly strong in Q4 of last year. As you look out and kind of, you know, look at guidance for the fourth quarter, how do you feel just qualitatively about, you know, your visibility on how that's going to look?

Good, and I think that's important. First of all, we've tried to get across and hopefully you'll take the time to look at our forward-looking guidance by various product lines. We tried to get across that, in fact, we've got a lot of visibility on our private label business, and we know that in the fourth quarter, private label product and other revenues in that group traditionally have come in very strong, so there is built into our model, if you look at our guidance, obviously the assumption is a very strong revenue Q4, and certainly a significant chunk of that is programmed in terms of anticipated revenues from our private label customers either meeting their end of the year requirements, contractual requirements, or other revenue requirements. In terms of base business, Q4 is always -- or always has been strong. As you go back and look at the last couple years, you can see a pattern of a substantially improved Q4 over the prior two quarters, and that is to some extent due to international which tends to buy in at the end of the year in anticipation of any price increases coming in the new year. It's also in anticipation of salespeople who try and meet their quotas at the end of the year, and get recognition in terms of sales performance statistics, and it's also just a reality of the capital cycle that hospitals try to spend their money at the end of the year, which is typically December, although sometimes June. So the answer is we think we have pretty good visibility, and we've tried to set our guidance to be achievable and not aggressive when we give our forward-looking guidance both in revenues and earnings.

Terrific. Thanks very much.

Our next question is coming from Alex Arrow from Lazard Freres & Co.

Hi, Alex.

Hi, Stuart. Good morning. Congratulations.

Good morning.

You have now got so many manufacturing facilities from these acquisitions you've done that I was wondering if I could ask you to go over them a bit. It sounds to us like over the next 12 months through this consolidation, you're going to end up with a total of five manufacturing facilities. Andover, Pembroke, you're getting rid of Exton, you're closing down something else as well. It's not exactly clear, all the things getting shuffled around, and if you will intervene maybe you could say briefly which product lines are going to be centered at which of these manufacturing facilities and maybe also what you're planning to achieve by doing all this changing around of manufacturing.

It's a very good question, and I would first like to -- because we're so enthusiastic about what we're doing with the company, but we probably do confuse people a little bit. We do not have so many facilities since all these acquisitions because many of them have already been closed. And so let me make sure -- let me sort of walk you through geographically what we're doing. First of all, in California, we have two activities. And this is in San Diego.

We manufacture catheters, and about four blocks away, we do biomaterials R&D. And through the consolidations over the next year, what we're trying to do is shrink the real estate out there and shrink the overhead out there but maintain those activities. Because the bulk of the consolidation has already been done as we've moved a variety of product lines and activities out of what was formerly known as the Camino plant. So that Camino plant now makes catheters, does some repair and field work, field service work, and we have too much real estate and too much overhead, and through the consolidation, we will try to get everybody fundamentally under one roof. And that means you take out some overhead when you're doing that. So that's currently two sites within four blocks of each other hopefully going into one. In New Jersey, we have our corporate headquarters, which has about -- oh, and on the West Coast, it's about 130 people.

In New Jersey, we have our corporate headquarters. All of our customer service in the United States, all of our in-office marketing, sales, operations, regulatory quality, finance, IT are all in one facility, and it's about 110 people in one facility. A two-block walk away is our Plainsboro (ph) manufacturing plant, which is our collagen plant. We do on the order of $40 to $50 million of product out of that plant, and that plant has about 110 people and does some collagen development work in conjunction with the West Coast group.

That's where you make the skin product, but that's much less than $40 to $50 million. What's the majority of your collagen manufacturing?

It's virtually all of our OEMs and DuraGen, NeuraGen, ACS. Everything made out of collagen is in that one plant.

Ok.

Then a few blocks away, we have our distribution center where we handle all of our distribution in the U.S., Asia and Latin America. That is only about 20 people, but it handles about 300 shipments a day. Then we have the Jarit headquarters, which is located in New York in a place called Horithon (ph), about a two-hour drive away. It's essentially customer service, management and distribution facility with about 50 people, and then by the end of this quarter in Pembroke, we'll have about 40 people doing the cranial plant screw, some OEM activity, and the neurosupplies distribution. And there's nothing related between the neurosupplies distribution and the cranial plate screw manufacturing except that we can do it all in the same space and reduce a complete facility.

We have about 100 people in Puerto Rico and manufacture the bulk of our drainage and hydrocephalus products, and then over in Europe, we have our Andover, England site with about 100 people that does distribution in northern Europe and manufactures all of our capital products including our ultrasonic aspirators, Camino monitors, and Ventrix monitors. In France, we have a plant with about 120 full time equivalents manufacturing hydrocephalus, epilepsy and shunts, and then we have two small sites in Germany, one that sources the instruments and one that manufactures the LICOX disposables. And they each have about 15 to 25 people. So admittedly, quite a few plants for a small company, but down something on the order of five or six if you go back and add up all the acquisitions we've done. And we've been pretty work manlike trying to get an integration done every quarter or two.

The main things that's changing over the next 12 months, you're closing at least one place, Exton. What else is changing giving you the benefits you mentioned over the next 12 months?

Exton shut in the second quarter, there are some costs from people that remained after the shutdown to complete the project that. Shutdown will give us about a $1 million a year benefit going forward. We are shutting the neurosupplies facility and moving it into the Pembroke facility this quarter. That generates about a $250,000 benefit going forward. And then we will be reducing certain -- and have reduced certain R&D heads this quarter, which will not give us any benefit in terms of actual savings, but will allow us to redeploy certain activities. In other words, we'll spend less on some things and more on others. And that's also happening this quarter. Everything else happened already and is done.

OK. So the benefit over the next 12 quarters, is sounds like it's more from what happened over the last 12 months rather than the things that you've just mentioned?

Yes, and all we were trying to get across on this call was to try to explain somewhere just under $400,000 of additional expenses this quarter from the things we were doing this quarter.

OK. Got it. Could you also say a bit about the cranial plate and screw situation with Medtronic? You said there's a contract that's ending. And so you're getting a benefit over the next couple quarters, and what happens after that, what happens to that product line?

What we were tying to do is help people who build models to look at our private label business over the next two years, and to model plat private label revenues in 2004 and 2005 and then explain why it would continue to grow at 15% after that. And the main reasons for that is between now and mid 2004, we believe we will continue to see a shortfall or a reduction which we had described as anticipated a year ago as Medtronic and Wyeth work through the inventory of ACS that we ship shipped them last year, and we think that that drought will likely go away in mid 2004. That happens to overlap with when our contract with Medtronic is expired for the cranial plate and screw business we acquired. We bought that business knowing it would expire in mid 2004, so that was not news to us, and, in fact, we bought that business not for the contract with Medtronic, but for the built-in know-how to make our own cranial plate and screw system, which we anticipate launching in mid 2004. So that cranial plate and screw system, which is the reason we bought Signature in the first place, we continue to expect a launch in mid 2004, and will you see those revenues in the OR products.

What you will see go away is a significant chunk of the Medtronic sales because they will bring that activity, but we don't know what they'll do, but we're guessing they'll bring it in-house. So what we wanted to do was provide an explanation for relatively flat private label revenues over the next couple years. Now, by the way, to some extent, we could have interfered with that or we could have done more with it and we've made a conscious decision not to.

Our view is, while we like these private label businesses, we don't really want to go out and solicit new customers in addition to Medtronic for the cranial plate and screw business in any substantial way. We do the private label to leverage overhead should we stumble into some customers, should our business development activity generate customers, of course we will do that. But we believe as the business has grown that we want to continue to focus on our own proprietary product and the needs of our sales force, and so we wanted to appropriately guide you to expect relatively flat revenues for that private label business in 2004 and 2005 because our intention is to throw the available resources at the proprietary product that we will sell through our neuro sales force and potentially through our other direct sales forces.

OK. Great. Thanks. And then my last question, your trial with Merck, this is the damages phase that you're going into. I understand you're saying up to a million dollars worth of expenses in the next 12 months. Can you say anything about what you hope to get from the damages? Are you looking to get a large one-time judgment, and if so, would you speculate as to how large it might be, or are you looking for an injunction of some kind? What is the carrot at the end of that, assuming you get what you hope for in this trial?

Well, this trial is relatively old news, and, in fact, we were awarded -- Jack, the number was $18 million?

No, the original damages we were awarded by the jury in the spring of 2000 was $15 million plus a little over a million in prejudgment interest and then post judgment interest had been accruing. The federal circuit this spring vacated the damages award on a number of grounds, but basically on account of the -- their view that the time of the hypothetical negotiation by the jury to calculate the damages award was unclear, and sent it back for a new trial on damages. Merck has filed a petition for a rehearing at the federal circuit, and we will know probably in September whether the federal circuit will hear the case in its entirety or whether it will go back for a new trial. Our expectation is it will go back for a new trial, which will occur sometime in the next six to nine months.

So we've built into our model and assumption it will go through the trial and, therefore, we'll need to spend on the order of three-quarters after million to a million dollars.

But we have not built in any expectation of collecting the damages. Just so everyone's clear.

But if you do get that up side gravy to our modeling would be an $18 one time payment potential?

It could be any number of things. The new trial could result in substantially lower damages than we were originally ordered or it could result in higher damages than originally ordered. There's too many variables really to know.

OK.

And the most important point, Alex, is we would not build that into any model.

OK Thank you.

We have a follow-up question coming from Robert Goldman.

Hi, Robert.

Hi, Stuart. Another question, if I could, just on the 2004 guidance. Approached from a different way, and probably oversimplified, but based on the quarter you just reported, you're kind of at an 80-cent per share base and that's kind of the middle of your guidance for this year. Have you organic growth revenue of 17 or so percent. If margins don't change, you'd be at maybe -- and the cost savings initiatives you announced really amount to pennies. Maybe you can get to the dollar. But how do I get to the $1.05, $1.10?

First of all, I would not -- I wanted to answer your question on these cost savings and try to let you have enough numbers do whatever you want with those, but that's not how we would think about it. We have a great deal of confidence in our 62% gross margin guidance, and so the combination of 18% organic growth plus the 62% gross margin, and then our R&D continuing to grow in line with the past, our G&A remaining essentially flat, and then our sales costs growing in line with the growth in our revenues should allow you to, without any, you know, hard work get to our range. My own guess is, you have to believe the 62% gross margin to get there, though.

And to get there, how much of that improvement is the result of these restructuring savings?

Very little.

Very little?

Very little. The biggest impact on our gross margin, and we've talked about this on prior calls but it's worth relating. First of First of all, keep in mind we should come out of this year with in excess of a 60% gross margin. The reason you've seen in last quarter and next quarter gross margin being down slightly is purchase accounting adjustments, and to some extent, the impact of JARIT moving into the business, which has about a 50 plus or minus percent gross margin when it's inside of our business.

Now, why would the gross margin grow? Well, first of all, it to a great extent is volume-driven. That 18% organic growth or that range of revenues that we've given you, we do not need to add any significant plant overhead to achieve the production. So you're talking about all of that incremental revenue only translating into incremental labor and incremental product. The incremental overhead that would be needed to meet those revenue objectives is very low. So our variable gross margin is substantially higher than our average 60% corporate gross margin. That's the primary reason. The second reason is mix. Our fastest-growing products tend to be our highest gross margin product, things like DuraGen, NeuraGen, LICOX. These all have high gross margins, certainly higher than our corporate 60% gross margin. The restructuring activity does help the bottom line, but in many ways, it does a little bit what one of the prior questioners asked, it helps simplify the business.

Right. And we'll see those benefits in SG&A primarily?

You will see the benefits of the plant shutdowns to a small extent in cost of goods. For example, if we eliminate a plant manager or we eliminate a quality person or we eliminate rent that will go into cost of goods. There are other costs that go into G&A, but again, as you point out, it's not the dollars compared to our overall dollars.

Right. And a product question, if I could. On the dermal regeneration template, could you give us any sense of the growth or not there on sort of an end user basis by J and J and any updates if there are on your discussions with J and J?

Sure. Again, we don't break out individual products, so what I can say is over the past several years, they have continued to grow at or above the corporate growth rate with that product, the guidance, 18%. I will say the growth has slowed in the last 12 months, and I believe that -- and in particular in the last several quarters. And I believe that has more to do with perhaps the status of our relationship and the fact that we would like to see them put more resources into sales and marketing than has to do with anything inherent in the product. As I have said on prior calls, you know, we continue to be in a dialog with Epicon. They have not been successful in meeting its minimum amounts specifying in its agreement with us.

Furthermore, we've notified Epicon of clinical and regulatory events that have been achieved and payments that are due to us. So we do have a disagreement with Epicon, and furthermore, Epicon has informed us that if we don't agree to substantial amendments in the agreement, they may terminate the agreement. This has been discussed on a number of calls, it's in our public filings, and we're certainly hopeful that we'll reach an amicable resolution. In any event, I believe we've done everything that we need to be prepared if they terminate to take it back and effectively grow the business in line with our corporate rates or above, and if they don't terminate, we certainly would like to continue to pressure them to grow the business. We had actually cash flow from our alliance with them irrespective of whether they grow the business, but certainly if they're not putting the sales and marketing resources again against it to meet their minimums, it's not helping their revenue growth.

Thanks, Stuart.

We have a follow-up question coming from Bill Plovanic.

Hi, Bill.

Hi, Stuart. Actually I just wanted to ask in regards to the new hire that you had for the private label OEM products. I believe you'd brought gentleman on a quarter or two ago and just wanted to know what progress had been made there.

OK, yeah. We did bring him on, and despite my comments about our expectations of private label being flat, that's no re-election on him. We, in fact, are actively pursuing additional private label relationships, and, in fact, have a number of them underway and, in fact, have recognized other revenues from preliminary product development activities with them. So I'm quite optimistic that there will be additional alliances, in particular in the collagen business. They're not built into our guidance, and I think we felt when we put together our modeling, it would be more appropriate to assume the business was flat, and then add in any additional activity, and that really has very little to do with his activity, but rather our observation on what's going on with ACS and what's going on with the cranial plate and screw business, which at the moment swamped anything he might be doing.

OK. Great. Thanks.

We have another follow-up question coming from Jayson Bedford.

Hi, Jayson.

Hi, Stuart. Just a quick question. Maybe I missed this, but what's your gross margin expectation for the third quarter?

I don't know that I gave a quarterly gross expectation margin, but it's reasonable to assume north of 60 minus the purchase accounting and any impact of the potential severance if that should hit cost of goods and not G&A. It probably hits G&A. So, I mean, as you saw from this quarter, we ran at 60 minus the 514,000 of purchase accounting.

Sure.

And our guidance for the year was 60, so I'm not expecting it to go down, so it could be north of 60 if you back out the impact of the purchase accounting adjustment.

OK. Super. Then just one quick question. Are you seeing an impact at all from the repositioning of the Orbis sigma valve.

Honestly, not yet, but we are as enthusiastic as ever. We circulated recently to our clinicians a paper that was published a 5-year study showing that the valve had excellent results in terms of the lack of obstruction, occlusion or re-operation. We're about to kick off in the context of the Congress of Neurosurgeons a whole new advertising and marketing campaign. There is an impact in the U.S., but it is not enough to have an impact on our overall revenues in that segment. But the sales force is actually quite excited about it, and the fact that we're going to start spending some money to advertise makes me, you know, pretty confident that we're going to have an impact. But the truth is, there's nothing material in the numbers yet.

OK. Thanks.

Sir, there appear to be no further questions at this time.

OK. Well, thank you all for joining our second quarter call, and we'll look forward to reporting our results next quarter.

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